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An Intrinsic Calculation For Ross Stores, Inc. (NASDAQ:ROST) Suggests It's 33% Undervalued

Key Insights

  • Using the 2 Stage Free Cash Flow to Equity, Ross Stores fair value estimate is US$156

  • Ross Stores is estimated to be 33% undervalued based on current share price of US$105

  • Analyst price target for ROST is US$121 which is 22% below our fair value estimate

Today we will run through one way of estimating the intrinsic value of Ross Stores, Inc. (NASDAQ:ROST) by taking the expected future cash flows and 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!

Remember though, that there are many ways to estimate a company's value, and a DCF is just one method. If you want to learn more about discounted cash flow, the rationale behind this calculation can be read in detail in the Simply Wall St analysis model.

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Check out our latest analysis for Ross Stores

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.

A DCF is all about the idea that a dollar in the future is less valuable 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

2023

2024

2025

2026

2027

2028

2029

2030

2031

2032

Levered FCF ($, Millions)

US$1.07b

US$1.50b

US$1.94b

US$1.94b

US$2.48b

US$3.31b

US$3.78b

US$4.17b

US$4.51b

US$4.78b

Growth Rate Estimate Source

Analyst x6

Analyst x5

Analyst x5

Analyst x4

Analyst x2

Analyst x1

Est @ 14.08%

Est @ 10.47%

Est @ 7.95%

Est @ 6.19%

Present Value ($, Millions) Discounted @ 8.3%

US$991

US$1.3k

US$1.5k

US$1.4k

US$1.7k

US$2.1k

US$2.2k

US$2.2k

US$2.2k

US$2.2k

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$18b

The second stage is also known as Terminal Value, this is the business's cash flow 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 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 8.3%.

Terminal Value (TV)= FCF2032 × (1 + g) ÷ (r – g) = US$4.8b× (1 + 2.1%) ÷ (8.3%– 2.1%) = US$79b

Present Value of Terminal Value (PVTV)= TV / (1 + r)10= US$79b÷ ( 1 + 8.3%)10= US$36b

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$53b. To get the intrinsic value per share, we divide this by the total number of shares outstanding. Compared to the current share price of US$105, the company appears quite good value at a 33% discount to where the stock price trades currently. Valuations are imprecise instruments though, rather like a telescope - move a few degrees and end up in a different galaxy. Do keep this in mind.

dcf
dcf

The Assumptions

The calculation above is very dependent on two assumptions. The first is the discount rate and the other is the 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 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 accounts for debt. In this calculation we've used 8.3%, which is based on a levered beta of 1.043. 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 Ross Stores

Strength

  • Debt is not viewed as a risk.

  • Dividends are covered by earnings and cash flows.

Weakness

  • Earnings declined over the past year.

  • Dividend is low compared to the top 25% of dividend payers in the Specialty Retail market.

Opportunity

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

  • Trading below our estimate of fair value by more than 20%.

Threat

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

Moving On:

Although the valuation of a company is important, it ideally won't be the sole piece of analysis you scrutinize for a company. It's not possible to obtain a foolproof valuation with a DCF model. Instead the best use for a DCF model is to test certain assumptions and theories to see if they would lead to the company being undervalued or 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. Why is the intrinsic value higher than the current share price? For Ross Stores, we've put together three essential aspects you should further research:

  1. Risks: For example, we've discovered 2 warning signs for Ross Stores (1 is a bit concerning!) that you should be aware of before investing here.

  2. Management:Have insiders been ramping up their shares to take advantage of the market's sentiment for ROST'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.

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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