Is There An Opportunity With Dollar Tree, Inc.'s (NASDAQ:DLTR) 43% Undervaluation?

Simply Wall St · 10/18 11:58

Key Insights

  • The projected fair value for Dollar Tree is US$120 based on 2 Stage Free Cash Flow to Equity
  • Dollar Tree is estimated to be 43% undervalued based on current share price of US$67.86
  • Analyst price target for DLTR is US$85.73 which is 28% below our fair value estimate

Today we'll do a simple run through of a valuation method used to estimate the attractiveness of Dollar Tree, Inc. (NASDAQ:DLTR) as an investment opportunity by taking the expected future cash flows and discounting them to their present value. We will take advantage of the Discounted Cash Flow (DCF) model for this purpose. Before you think you won't be able to understand it, just read on! It's actually much less complex than you'd imagine.

Remember though, that there are many ways to estimate a company's value, and a DCF is just one method. For those who are keen learners of equity analysis, the Simply Wall St analysis model here may be something of interest to you.

View our latest analysis for Dollar Tree

Crunching The Numbers

We use what is known as a 2-stage model, which simply means we have two different periods of growth rates for the company's cash flows. Generally the first stage is higher growth, and the second stage is a lower growth phase. In the first stage we need to estimate the cash flows to the business over the next ten years. Where possible we use analyst estimates, but when these aren't available we extrapolate the previous free cash flow (FCF) from the last estimate or reported value. We assume companies with shrinking free cash flow will slow their rate of shrinkage, and that companies with growing free cash flow will see their growth rate slow, over this period. We do this to reflect that growth tends to slow more in the early years than it does in later years.

Generally we assume that a dollar today is more valuable than a dollar in the future, so we discount the value of these future cash flows to their estimated value in today's dollars:

10-year free cash flow (FCF) forecast

2025 2026 2027 2028 2029 2030 2031 2032 2033 2034
Levered FCF ($, Millions) US$396.4m US$766.1m US$1.01b US$1.08b US$1.14b US$1.20b US$1.24b US$1.29b US$1.33b US$1.37b
Growth Rate Estimate Source Analyst x4 Analyst x3 Analyst x2 Est @ 7.14% Est @ 5.75% Est @ 4.77% Est @ 4.09% Est @ 3.61% Est @ 3.28% Est @ 3.05%
Present Value ($, Millions) Discounted @ 6.6% US$372 US$675 US$832 US$836 US$830 US$816 US$797 US$775 US$751 US$726

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$7.4b

We now need to calculate the Terminal Value, which accounts for all the future cash flows after this ten year period. The Gordon Growth formula is used to calculate Terminal Value at a future annual growth rate equal to the 5-year average of the 10-year government bond yield of 2.5%. We discount the terminal cash flows to today's value at a cost of equity of 6.6%.

Terminal Value (TV)= FCF2034 × (1 + g) ÷ (r – g) = US$1.4b× (1 + 2.5%) ÷ (6.6%– 2.5%) = US$35b

Present Value of Terminal Value (PVTV)= TV / (1 + r)10= US$35b÷ ( 1 + 6.6%)10= US$18b

The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is US$26b. In the final step we divide the equity value by the number of shares outstanding. Compared to the current share price of US$67.9, the company appears quite undervalued at a 43% discount to where the stock price trades currently. The assumptions in any calculation have a big impact on the valuation, so it is better to view this as a rough estimate, not precise down to the last cent.

dcf
NasdaqGS:DLTR Discounted Cash Flow October 18th 2024

The Assumptions

Now the most important inputs to a discounted cash flow are the discount rate, and of course, the actual cash flows. You don't have to agree with these inputs, I recommend redoing the calculations yourself and playing with them. The DCF also does not consider the possible cyclicality of an industry, or a company's future capital requirements, so it does not give a full picture of a company's potential performance. Given that we are looking at Dollar Tree as potential shareholders, the cost of equity is used as the discount rate, rather than the cost of capital (or weighted average cost of capital, WACC) which accounts for debt. In this calculation we've used 6.6%, which is based on a levered beta of 0.988. Beta is a measure of a stock's volatility, compared to the market as a whole. We get our beta from the industry average beta of globally comparable companies, with an imposed limit between 0.8 and 2.0, which is a reasonable range for a stable business.

Next Steps:

Whilst important, the DCF calculation shouldn't be the only metric you look at when researching a company. It's not possible to obtain a foolproof valuation with a DCF model. Rather it should be seen as a guide to "what assumptions need to be true for this stock to be under/overvalued?" For example, changes in the company's cost of equity or the risk free rate can significantly impact the valuation. Can we work out why the company is trading at a discount to intrinsic value? For Dollar Tree, there are three additional elements you should further examine:

  1. Risks: As an example, we've found 1 warning sign for Dollar Tree that you need to consider before investing here.
  2. Management:Have insiders been ramping up their shares to take advantage of the market's sentiment for DLTR's future outlook? Check out our management and board analysis with insights on CEO compensation and governance factors.
  3. Other High Quality Alternatives: Do you like a good all-rounder? Explore our interactive list of high quality stocks to get an idea of what else is out there you may be missing!

PS. The Simply Wall St app conducts a discounted cash flow valuation for every stock on the NASDAQGS every day. If you want to find the calculation for other stocks just search here.