Is there an opportunity with the 38% undervaluation of Central Garden & Pet Company (NASDAQ: CENT)?
Today we are going to review a valuation method used to estimate the attractiveness of Central Garden & Pet Company (NASDAQ: CENT) as an investment opportunity by taking the forecast of future cash flows from the company and discounting them to today’s value. . This will be done using the Discounted Cash Flow (DCF) model. Don’t be put off by the lingo, the underlying calculations are actually pretty straightforward.
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.
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What is the estimated valuation?
We use the 2-step growth model, which simply means that we take into account two stages of business growth. During the initial period, the business can have a higher growth rate, and the second stage is usually assumed to have a stable growth rate. To begin with, we need to estimate the next ten years of cash flow. 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.
A DCF is based on the idea that a dollar in the future is worth less than a dollar today, so we need to discount the sum of these future cash flows to arrive at an estimate of the present value:
10-year Free Cash Flow (FCF) estimate
|Leverage FCF ($, Millions)||US $ 88.0 million||US $ 167.0 million||168.0 million US dollars||US $ 169.6 million||$ 171.8 million||US $ 174.3 million||US $ 177.1 million||US $ 180.2 million||US $ 183.4 million||US $ 186.8 million|
|Source of estimated growth rate||Analyst x1||Analyst x1||Analyst x1||Est @ 0.97%||Est @ 1.27%||Is @ 1.48%||Est @ 1.62%||Est @ 1.72%||Est @ 1.79%||East @ 1.84%|
|Present value (in millions of dollars) discounted at 5.5%||$ 83.4||US $ 150||143 USD||USD 137||$ 132||US $ 127||US $ 122||118 USD||114 USD||110 USD|
(“East” = FCF growth rate estimated by Simply Wall St)
10-year present value of cash flows (PVCF) = US $ 1.2 billion
The second stage is also known as terminal value, it is the cash flow of the business after the first stage. 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 5.5%.
Terminal value (TV)= FCF2031 × (1 + g) ÷ (r – g) = US $ 187 million × (1 + 2.0%) ÷ (5.5% to 2.0%) = US $ 5.4 billion
Present value of terminal value (PVTV)= TV / (1 + r)ten= US $ 5.4 billion ÷ (1 + 5.5%)ten= US $ 3.2 billion
Total value, or net worth, is then the sum of the present value of future cash flows, which in this case is US $ 4.4 billion. To get the intrinsic value per share, we divide it by the total number of shares outstanding. From the current share price of US $ 50.1, the company appears to be quite undervalued with a 38% discount from the current share price. Remember, however, that this is only a rough estimate, and like any complex formula – trash in, trash out.
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 consider Central Garden & Pet 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 into account the debt. In this calculation, we have used 5.5%, which is based on a leverage beta of 0.800. 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.
While important, calculating DCF shouldn’t be the only metric you look at when looking for a business. DCF models are not the ultimate solution for investment valuation. Preferably, you would apply different cases and assumptions and see their impact on the valuation of the business. If a business grows at a different rate, or if its cost of equity or risk-free rate changes sharply, output can be very different. What is the reason why the stock price is below intrinsic value? For Central Garden & Pet, we’ve put together three relevant factors that you should take a closer look at:
- Risks: Every company has them, and we have spotted 1 warning sign for Central Garden & Pet you should know.
- Future benefits: How does CENT’s growth rate compare to that of its peers and the broader market? Dig deeper into the analyst consensus number for years to come by interacting with our free analyst growth expectations chart.
- 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. The Simply Wall St app performs a daily discounted cash flow assessment for each NASDAQGS share. If you want to find the calculation for other actions, 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.