Today we perform one method of estimating the intrinsic value of Advance Auto Parts, Inc. (NYSE:AAP) by projecting its future cash flows and discounting them to today’s value. We will use the discounted cash flow (DCF) model. Don’t let the jargon fool you. The math behind it is actually pretty simple.
Note that there are many methods of evaluating a company and, like DCF, each method has its strengths and weaknesses in certain scenarios. If you want to learn more about discounted cash flow, you can read more about the rationale behind this calculation in our Simply Wall St analytical model.
Our analysis AAP may be underestimated.
What is an estimated valuation?
We use what is called a two-stage model. This simply means that he has two different periods in the company’s cash flow growth rate. Generally, the first stage is the high growth stage and the second stage is the low growth stage. First, you need to estimate your cash flow over the next 10 years. We use analyst estimates when available, but if these are not available, we extrapolate previous free cash flow (FCF) from previous estimates or reported values. Over this period, we expect companies with shrinking free cash flow to contract at a slower rate, and those with growing free cash flow to see slower growth. This is to reflect that growth tends to slow in the early years rather than in later years.
In general, we assume that a dollar today is worth more than a dollar in the future, so we discount the value of these future cash flows to an estimate in current dollars.
10-Year Free Cash Flow (FCF) Estimate
|Leverage FCF ($, million)||$763.7 million||$841.6 million||$954 million||$988 million||$1.02 billion||US$1.04 billion||US$1.07 billion||US$1.09 billion||$1.12 billion||$1.14 billion|
|growth rate source||Analyst x 4||Analyst x 3||Analyst x 1||Analyst x 1||estimated @ 2.85%||estimated @ 2.59%||estimated @ 2.41%||Est @ 2.28%||estimated @ 2.19%||estimated @ 2.13%|
|Present Value ($, Millions) Discount @ 8.1%||$706||$720||$755||$723||$687||$652||$618||$584||$552||$522|
(“Est” = FCF growth rate estimated by Simply Wall St)
10-Year Present Value of Cash Flows (PVCF) = US$6.5 billion
The second stage, also called terminal value, is the cash flow of the business after the first stage. A very conservative growth rate is used that cannot exceed the country’s GDP growth rate for a number of reasons. In this case, we used the 5-year average of 10-year government bond yields (2.0%) to estimate future growth. Similar to the 10-year “growth” period, we discount future cash flows to their present value using an 8.1% cost of equity.
Terminal value (TV)= FCF2032 × (1 + g) ÷ (r – g) = USD 1.1 billion × (1 + 2.0%) ÷ (8.1%– 2.0%) = USD 19 billion
Present Value of Terminal Value (PVTV)= television / (1 + r)Ten= US$19 billion ÷ ( 1 + 8.1%)Ten= US$8.7 billion
The total value, or equity value, is the sum of the present value of the future cash flows, in this case US$15 billion. The final step is to divide the stock value by the number of outstanding shares. Compared to the current stock price of US$153, the company’s stock is 41% cheaper than its current stock price and looks like a good deal. However, evaluation is an imprecise tool, like a telescope. Move a few degrees and you’ll end up in another galaxy. Remember this.
The most important input to discounted cash flows is the discount rate and, of course, the actual cash flows. Part of investing is also self-evaluating the company’s future performance. So try the calculations yourself and check your assumptions. The DCF also does not give a complete picture of a company’s potential performance, as it does not take into account the cyclicality of the industry or the company’s future capital requirements. Given that we see Advance Auto Parts as a potential shareholder, the cost of capital is used as the discount rate rather than the cost of capital (or weighted average cost of capital, WACC) that accounts for the liability. For this calculation we used 8.1% based on a leverage beta of 1.199. Beta is a measure of a stock’s volatility relative to the market as a whole. Our betas are derived from industry average betas of globally comparable companies and are capped between 0.8 and 2.0. This is a reasonable range for a stable business.
SWOT analysis of advanced auto parts
- Debt is well covered by earnings and cash flow.
- Revenue has declined over the past year.
- Dividends are lower than the top 25% of dividend payers in the specialty retail market.
- Annual revenue is projected to grow faster than the US market.
- Transactions that are 20% or more below the estimated fair value.
- Dividends are not included in cash flows.
- Annual sales are projected to grow more slowly than the US market.
A company’s reputation is important, but it’s only one of many factors by which a company should be evaluated. A DCF model cannot give foolproof estimates. Instead, the DCF model’s best use is to test certain assumptions and theories to see if they lead to a company being undervalued or overvalued. If companies grow at different rates, or if their cost of capital or risk-free rates change abruptly, their outputs can look very different. Why is the intrinsic value higher than the current stock price? For Advance Auto Parts, we’ve summarized three relevant factors to consider.
- risk: For example, consider the ever-present specter of investment risk. Identified two warning signs Understanding these should be part of the investment process.
- future earnings: How does AAP’s growth rate compare to its peers and the wider market? Manipulate our free analyst growth forecast charts to dig deeper into analyst consensus numbers for the next few years.
- Other solid businesses: Low debt, high return on equity and a strong past performance are the cornerstones of a strong business. Explore interactive stock listings with solid business fundamentals to see if there are other companies you haven’t considered.
PS. The Simply Wall St app conducts discounted cash flow valuations for all NYSE stocks on a daily basis. If you want to find calculations for other stocks, search here.
Valuation is complicated, but we’re here to help make it simple.
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This article by Simply Wall St is general in nature. We provide comments based on historical data and analyst projections using only unbiased methodologies and our articles are not intended as financial advice. It is not a recommendation to buy or sell stocks and does not take into account your objectives or financial situation. We aim to deliver long-term focused analysis based on fundamental data. Please note that our analysis may not take into account the latest price-sensitive company announcements or qualitative materials. Is not …