Disney: 3 Different Valuation Approaches Signal It's Time To Buy

Summary

• Mixed revenue results in 2017 have been a major factor in Disney's lackluster stock performance over the last year.
• Disney's Trailing P/E of 14.59x is 28% less than its 5-year average of 20.2x.
• Disney has a growing dividend that's supported by strong free cash flow.
• Wall Street expects 18% upside potential in the stock.
• The 21st Century Fox deal gives Disney a real chance to compete with Netflix.

Disney (NYSE:DIS) struggled during 2017, but a recent slump in the stock price puts the company into deep buy territory. My opinion is based on multiple valuation approaches all signalling the stock is on sale:

1. Disney trades at steep discounts relative to its 5-year averages across multiple valuation metrics.
2. Disney trades at a 30% EV/FCF discount relative to peers.
3. A conservative single-stage discounted cash flow model shows 15% upside potential.

Disney's Financial Snapshot

2017 was a mixed-bag for Disney and is one of the main reasons the stock price has been slumping in my opinion. Almost all major operating metrics were down year over year. This was a result of decreasing performance at Disney's Media Networks, Studio Entertainment and Consumer Products & Interactive Media divisions, which was partially offset by growth in its Parks & Resorts division. According to Disney:

The decrease at Media Networks was due to contractual rate increases for sports programming, lower advertising revenue and higher losses from our equity investments in BAMTech LLC (BAMTech) and Hulu LLC (Hulu), partially offset by higher affiliate revenue. Lower Studio Entertainment and Consumer Products & Interactive Media results were due to the exceptional performance of the Star Wars franchise in the prior year, which benefited all of our key distribution channels.'

One of Disney's major weaknesses is its balance sheet. Both net cash position and current ratio have trended in the wrong direction the last couple of years. The primary driver of this was an aggressive stock repurchase program, which amounted to $28.2 billion in net cash spent from 2014 through 2017. I am a fan of stock repurchases, especially when the stock is undervalued, but I'd really like to see Disney focus on lowering debt in the future since interest rates could be on the rise and Disney will also be assuming an additional $13.7 billion worth of debt as a result of the 21st Century Fox deal.

• Data Source: Google Finance
• Disney's fiscal year-end is in September

The good news is Disney performed well in the first quarter of 2018 (i.e. ending December 31st, 2017), but results were still mixed across operating divisions. Revenues increased by 4% compared to the prior year's quarter. Excluding a $1.6 billion one-time net tax benefit associated with new U.S. tax reform, EPS also increased 22%. These results were driven by strong performance in its Parks & Resorts division, but other segments remained sluggish.

Dividend Analysis - 1.64% Annual Yield

Disney doesn't provide the largest yield, but I think it's poised to continue growing in the future. As you can see by the table below, Disney only used 28% of its free cash flow over the last two years. That means there's plenty of room for growth and Disney could easily sustain a 3-4% dividend yield if it wanted to.

Historical Valuation Multiples

Disney's historical valuation multiples have trended down significantly over the last couple of years and are well-below 5-year averages (Note - 5-year averages provided by Reuters):

• Trailing P/E of 14.59x is 28% less than its 5-year average of 20.2x.
• Forward P/E of 13.68x is 25% less than its 5-year average of 18.2x.
• Forward PEG of 1.38x is 8% less than its 5-year average of 1.5x.
• Price/Sales of 2.78x is 7% less than its 5-year average of 3x.

Looking at the chart below, Disney's trailing P/E and EV/FCF also look good relative to a longer time period (10 years). You have to go back to the last recession to find a time when these multiples were consistently below the levels they are at now.

DIS PE Ratio (TTM) data by YCharts

Comparables Analysis

Disney trades at a premium in terms of forward P/E and Price/Sales, but I've always considered EV/FCF as the most important metric and Disney trades at a 30% discount to peers. A strong long-term growth rate also leads to a better than average PEG too.

• Enterprise Value, Forward P/E, Price/Sales, PEG Ratio, and Yield provided by Yahoo Finance.
• I derived LT Growth rates by using Forward P/E and PEG ratio listed on Yahoo Finance.
• FCF is based on every company's free cash flow from the most recent full fiscal year. This equals a EV/FCF ratio that is slightly different compared to YCharts.

Discounted Cash Flow Model

There's a few reasons I consider this model conservative. First, Disney should be able to outpace 3% long-term earnings growth. Other sources, like Reuters, have its growth rate at a much higher percentage. Second, I've assumed the 21st Century Fox (FOX) (FOXA) deal closes, but only adds $3.4 billion in additional free cash flow. Keep in mind, Fox produced about $3.4 billion in free cash flow last year and Disney expects about $2 billion in cost savings, which I haven't included in this analysis. So basically, any cost synergies should provide upside.

• Risk-Free Rate - I used the yield on a 30-year Treasury bond.
• Equity Risk Premium - This figure is calculated every month by Aswath Damodaran, a Stern Business School Professor.
• Beta - I used a beta of 1. This model is very sensitive to beta and data points vary significantly by source.
• Required Rate of Return - Calculated by multiplying the Equity Risk Premium by Beta and then adding the Risk Free Rate.
• Value of Equity = CF1 / (r - g).
• CF1 = 2018's free cash flow, which I've estimated at approximately $8.7 billion for Disney (same as 2017) and $3.4 billion for the Fox acquisition.
• "r" is the required rate of return and "g" is the long-term growth rate.
• I've increased share count by 515 million given the Fox transaction.

Conclusion

While Disney's revenue stream has been mixed recently, there are multiple reasons why this could change positively in the near-future:

• Disney can continue to leverage its valuable Star Wars franchise to help lift its slumping media division. Multiple standalone movies and trilogies have been announced recently.
• The 21st Century Fox deal bolsters Disney's plans to become a dominant streaming service platform, and could make it a serious threat to Netflix (NFLX).
• I expect the Parks & Resorts division to remain strong. Disney opened a new location in Shanghai in 2016 and has other international markets it can still break into.

Given a steep discount across multiple valuation analyses, now is the time to buy in my opinion. Wall Street agrees with my assessment. According to MarketWatch, the average target price for Disney is $121.82, which represents an 18% upside potential.

Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.