Are Investors Undervaluing Dollar Tree, Inc. (NASDAQ:DLTR) By 22%?

Key Insights

• The projected fair value for Dollar Tree is US$199 based on 2 Stage Free Cash Flow to Equity

• Dollar Tree is estimated to be 22% undervalued based on current share price of US$155

• Analyst price target for DLTR is US$158 which is 21% below our fair value estimate

Today we will run through one way of estimating the intrinsic value of Dollar Tree, Inc. (NASDAQ:DLTR) by projecting its future cash flows and then discounting them to today's value. We will use the Discounted Cash Flow (DCF) model on this occasion. Believe it or not, it's not too difficult to follow, as you'll see from our example!

We generally believe that a company's value is the present value of all of the cash it will generate in the future. However, a DCF is just one valuation metric among many, and it is not without flaws. If you still have some burning questions about this type of valuation, take a look at the Simply Wall St analysis model.

See 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. To start off with, we need to estimate the next ten years of cash flows. 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 need to discount the sum of these future cash flows to arrive at a present value estimate:

10-year free cash flow (FCF) estimate

	2023	2024	2025	2026	2027	2028	2029	2030	2031	2032
Levered FCF ($, Millions)	US$949.5m	US$826.0m	US$675.0m	US$1.46b	US$1.79b	US$2.09b	US$2.34b	US$2.56b	US$2.74b	US$2.90b
Growth Rate Estimate Source	Analyst x4	Analyst x1	Analyst x2	Analyst x1	Est @ 22.94%	Est @ 16.69%	Est @ 12.32%	Est @ 9.26%	Est @ 7.11%	Est @ 5.61%
Present Value ($, Millions) Discounted @ 6.9%	US$889	US$723	US$553	US$1.1k	US$1.3k	US$1.4k	US$1.5k	US$1.5k	US$1.5k	US$1.5k

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$12b

After calculating the present value of future cash flows in the initial 10-year period, we need to calculate the Terminal Value, which accounts for all future cash flows beyond 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 have used the 5-year average of the 10-year government bond yield (2.1%) to estimate future growth. In the same way as with the 10-year 'growth' period, we discount future cash flows to today's value, using a cost of equity of 6.9%.

Terminal Value (TV)= FCF₂₀₃₂ × (1 + g) ÷ (r – g) = US$2.9b× (1 + 2.1%) ÷ (6.9%– 2.1%) = US$62b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= US$62b÷ ( 1 + 6.9%)¹⁰= US$32b

The total value is the sum of cash flows for the next ten years plus the discounted terminal value, which results in the Total Equity Value, which in this case is US$44b. To get the intrinsic value per share, we divide this by the total number of shares outstanding. Relative to the current share price of US$155, the company appears a touch undervalued at a 22% 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

Important Assumptions

Now the most important inputs to a discounted cash flow are the discount rate, and of course, the actual cash flows. Part of investing is coming up with your own evaluation of a company's future performance, so try the calculation yourself and check your own assumptions. 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 6.9%, which is based on a levered beta of 0.800. 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.

SWOT Analysis for Dollar Tree

Strength

• Earnings growth over the past year exceeded the industry.

• Debt is not viewed as a risk.

Weakness

• No major weaknesses identified for DLTR.

Opportunity

• Annual earnings are forecast to grow for the next 3 years.

• Good value based on P/E ratio and estimated fair value.

• Significant insider buying over the past 3 months.

Threat

• Annual earnings are forecast to grow slower than the American market.

Next Steps:

Valuation is only one side of the coin in terms of building your investment thesis, and it 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?" If a company grows at a different rate, or if its cost of equity or risk free rate changes sharply, the output can look very different. Can we work out why the company is trading at a discount to intrinsic value? For Dollar Tree, we've compiled three important items you should further research:

1. Financial Health: Does DLTR have a healthy balance sheet? Take a look at our free balance sheet analysis with six simple checks on key factors like leverage and risk.

2. Future Earnings: How does DLTR's growth rate compare to its peers and the wider market? Dig deeper into the analyst consensus number for the upcoming years by interacting with our free analyst growth expectation chart.

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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.

This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an 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 account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.

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