Chewy, Inc. (NYSE: CHWY) shares could be 22% lower than their estimate of intrinsic value
How far is Chewy, Inc. (NYSE: CHWY) from its intrinsic value? Using the most recent financial data, we’ll examine whether the stock price is fair by taking expected future cash flows and discounting them to their present value. Our analysis will use the discounted cash flow (DCF) model. Before you think you won’t be able to figure it out, read on! It’s actually a lot less complex than you might imagine.
We generally think of a business’s value as the present value of all the cash it will generate in the future. However, a DCF is only one evaluation measure among many, and it is not without its flaws. For those who are passionate about equity analysis, the Simply Wall St analysis template here may be something of interest to you.
Check out our latest review for Chewy
The method
We are going to use a two-step 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 “steady growth”. To begin with, we need to get cash flow estimates for the next ten years. Where possible, we use analyst estimates, but when these are not available, we extrapolate the previous free cash flow (FCF) from the last estimate or stated 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 down more in the early years than in subsequent years.
Generally, we assume that a dollar today is worth more than a dollar in the future, and so the sum of these future cash flows is then discounted to today’s value:
10-year Free Cash Flow (FCF) estimate
2022 | 2023 | 2024 | 2025 | 2026 | 2027 | 2028 | 2029 | 2030 | 2031 | |
Leverage FCF ($, Millions) | US $ 100.2 million | $ 212.9 million | US $ 414.9 million | US $ 711.0 million | US $ 945.5 million | US $ 1.12 billion | US $ 1.28 billion | US $ 1.41 billion | US $ 1.52 billion | US $ 1.61 billion |
Source of estimated growth rate | Analyst x5 | Analyst x6 | Analyst x4 | Analyst x2 | Analyst x2 | Est @ 18.83% | Est @ 13.77% | East @ 10.23% | Est @ 7.75% | Est @ 6.01% |
Present value (in millions of dollars) discounted at 6.4% | US $ 94.2 | US $ 188 | US $ 345 | US $ 555 | US $ 694 | US $ 776 | $ 829 | US $ 860 | US $ 871 | US $ 868 |
(“East” = FCF growth rate estimated by Simply Wall St)
10-year present value of cash flows (PVCF) = US $ 6.1 billion
We now need to calculate the Terminal Value, which takes into account all future cash flows after this ten year period. For a number of reasons, a very conservative growth rate is used that cannot exceed that of a country’s GDP growth. In this case, we used the 5-year average of the 10-year government bond yield (2.0%) to estimate future growth. Similar to the 10 year “growth” period, we discount future cash flows to their present value, using a cost of equity of 6.4%.
Terminal value (TV)= FCF_{2031} × (1 + g) ÷ (r – g) = US $ 1.6 billion × (1 + 2.0%) ÷ (6.4% to 2.0%) = US $ 37 billion
Present value of terminal value (PVTV)= TV / (1 + r)^{ten}= US $ 37 billion ÷ (1 + 6.4%)^{ten}= US $ 20 billion
Total value, or net worth, is then the sum of the present value of future cash flows, which in this case is US $ 26 billion. To get the intrinsic value per share, we divide it by the total number of shares outstanding. From the current share price of $ 48.5, the company appears to be slightly undervalued at a 22% discount from the current share price. Ratings are imprecise instruments, however, much like a telescope – move a few degrees and end up in another galaxy. Keep this in mind.
Important assumptions
Now, the most important inputs to a discounted cash flow are the discount rate and, of course, the actual cash flow. Part of investing is coming up with your own assessment of a company’s future performance, so try the math yourself and check your own assumptions. The DCF also does not take into account the possible cyclicality of an industry or the future capital needs of a company, so it does not give a full picture of a company’s potential performance. Since we view Chewy 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 6.4%, which is based on a leveraged beta of 1.007. Beta is a measure of the volatility of a stock relative to the market as a whole. We get our beta from the industry average beta of comparable companies globally, with an imposed limit between 0.8 and 2.0, which is a reasonable range for a stable company.
Next steps:
While important, calculating DCF is just one of the many factors you need to assess for a business. DCF models are not the ultimate solution for investment valuation. Instead, the best use of a DCF model is to test certain assumptions and theories to see if they would lead to undervaluation or overvaluation of the company. For example, if the terminal value growth rate is adjusted slightly, it can dramatically change the overall result. Can we understand why the company trades at a discount to its intrinsic value? For Chewy, we’ve compiled three essential aspects to consider:
- Risks: You should be aware of the 2 warning signs for Chewy we found out before considering an investment in the business.
- Management: Have insiders increased their stocks to take advantage of market sentiment about CHWY’s future prospects? Check out our management and board analysis with information on CEO compensation and governance factors.
- Other high quality alternatives: Do you like a good all-rounder? Explore our interactive list of high-quality stocks to get a feel for what you might be missing!
PS. Simply Wall St updates its DCF calculation for every US stock every day, so if you want to find the intrinsic value of any other stock just 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 using only unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock and does not take into account your goals or your financial situation. Our aim is to bring you long-term, targeted analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price sensitive companies or qualitative documents. Simply Wall St has no position in any of the stocks mentioned.