Are investors undervaluing Ross Stores, Inc. (NASDAQ: ROST) by 49%?
How far is Ross Stores, Inc. (NASDAQ: ROST) from its intrinsic value? Using the most recent financial data, we will examine whether the stock price is fair by estimating the company’s future cash flows and discounting them to their present value. The Discounted Cash Flow (DCF) model is the tool we will apply to do this. This may sound complicated, but it’s actually quite simple!
We generally believe that the value of a company is the present value of all the cash it will generate in the future. However, a DCF is just one of many evaluation metrics, and it is not without its flaws. Anyone interested in learning a little more about intrinsic value should read the Simply Wall St.
Check out our latest analysis for Ross Stores
We will use a two-stage DCF model which, as the name suggests, takes into account two stages of growth. The first stage is usually a period of higher growth which stabilizes towards the terminal value, captured in the second period of “sustained growth”. To start, we need to estimate the cash flows for the next ten years. Wherever possible, we use analysts’ estimates, but where these are not available, we extrapolate the previous free cash flow (FCF) from the latest estimate or reported value. We assume that companies with decreasing free cash flow will slow their rate of contraction and companies with increasing free cash flow will see their growth rate slow during this period. We do this to reflect the fact that growth tends to slow more in early years than in later years.
A DCF is based on the idea that a dollar in the future is worth less than a dollar today, 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
|Leveraged FCF ($, millions)||$982.1 million||$1.53 billion||US$2,000,000,000||US$2.11 billion||$2.53 billion||$2.81 billion||US$3.05 billion||$3.25 billion||$3.41 billion||US$3.56 billion|
|Growth rate estimate Source||Analyst x7||Analyst x8||Analyst x5||Analyst x4||Analyst x3||Is at 11.26%||Is at 8.46%||Is at 6.51%||East @ 5.14%||Is at 4.18%|
|Present value (millions of dollars) discounted at 6.6%||$921||$1,300||$1.7,000||$1,600||$1.8,000||$1,900||$2,000||$1,900||$1,900||$1,900|
(“East” = FCF growth rate estimated by Simply Wall St)
10-year discounted cash flow (PVCF) = $17 billion
We now need to calculate the terminal value, which represents all future cash flows after this ten-year period. The Gordon Growth formula is used to calculate the terminal value at a future annual growth rate equal to the 5-year average 10-year government bond yield of 1.9%. We discount the terminal cash flows to their present value at a cost of equity of 6.6%.
Terminal value (TV)= FCF2032 × (1 + g) ÷ (r – g) = $3.6 billion × (1 + 1.9%) ÷ (6.6%–1.9%) = $78 billion
Present value of terminal value (PVTV)= TV / (1 + r)ten= $78 billion ÷ (1 + 6.6%)ten= $41 billion
The total value is the sum of the cash flows for the next ten years plus the present terminal value, which gives the total equity value, which in this case is $58 billion. To get the intrinsic value per share, we divide it by the total number of shares outstanding. Compared to the current share price of $84.2, the company appears to be pretty good value at a 49% discount to the current share price. The assumptions of any calculation have a big impact on the valuation, so it’s best to consider this as a rough estimate, not accurate down to the last penny.
The above calculation is highly dependent on two assumptions. One is the discount rate and the other is the cash flows. You don’t have to agree with these entries, I recommend that you redo the calculations yourself and play around with them. The DCF also does not take into account the possible cyclicality of an industry, nor the future capital needs of a company, so it does not give a complete picture of a company’s potential performance. Since we consider Ross Stores 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 takes debt into account. In this calculation, we used 6.6%, which is based on a leveraged beta of 1.097. Beta is a measure of a stock’s volatility relative to the market as a whole. We derive our beta from the average industry beta of broadly comparable companies, with an imposed limit between 0.8 and 2.0, which is a reasonable range for a stable company.
Although the valuation of a business is important, it will ideally not be the only piece of analysis you will look at for a business. DCF models are not the be-all and end-all of investment valuation. Preferably, you would apply different cases and assumptions and see their impact on the valuation of the business. For example, if the terminal value growth rate is adjusted slightly, it can significantly change the overall result. Can we understand why the company is trading at a discount to its intrinsic value? For Ross stores, we’ve rounded up three more items you should look into:
- Risks: To this end, you should inquire about the 2 warning signs we spotted with Ross Stores (including 1 which is significant).
- Management:Did insiders increase their shares to take advantage of market sentiment about ROST’s future prospects? View our management and board analysis with insights into CEO compensation and governance factors.
- Other strong companies: Low debt, high returns on equity and good past performance are essential to a strong business. Why not explore our interactive list of stocks with strong trading fundamentals to see if there are any other companies you may not have considered!
PS. The Simply Wall St app performs a daily updated cash flow assessment for each NASDAQGS stock. If you want to find the calculation for other stocks, search here.
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This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts only using unbiased methodology and our articles are not intended to be financial advice. It is not a recommendation to buy or sell stocks and does not take into account your objectives or financial situation. Our goal is to bring you targeted long-term analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price-sensitive companies or qualitative materials. Simply Wall St has no position in the stocks mentioned.