Does the July price of O’Reilly Automotive, Inc. (NASDAQ: ORLY) stock reflect what it’s really worth? Today we are going to estimate the intrinsic value of the stock by taking the expected future cash flows and discounting them to the present value. Our analysis will use the discounted cash flow (DCF) model. Patterns like these may seem beyond a layman’s comprehension, but they’re pretty easy to follow.
Businesses can be valued in many ways, which is why we emphasize that a DCF is not perfect for all situations. Anyone interested in learning a little more about intrinsic value should read the Simply Wall St.
Check out our latest analysis for O’Reilly Automotive
Is O’Reilly Automotive correctly valued?
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.
Generally, we assume that a dollar today is worth more than a dollar in the future, 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)||US$2.05 billion||$2.20 billion||$2.36 billion||$2.52 billion||$2.64 billion||$2.74 billion||$2.83 billion||$2.92 billion||$2.99 billion||$3.07 billion|
|Growth rate estimate Source||Analyst x6||Analyst x3||Analyst x1||Analyst x1||Is at 4.78%||Is at 3.93%||East @ 3.33%||Is at 2.92%||Is at 2.62%||Is at 2.42%|
|Present value (millions of dollars) discounted at 6.3%||$1,900||$1,900||$2,000||$2,000||$1,900||$1,900||$1.8,000||$1.8,000||$1.7,000||$1.7,000|
(“East” = FCF growth rate estimated by Simply Wall St)
10-year discounted cash flow (PVCF) = $19 billion
The second stage is also known as the terminal value, it is the cash flow of the business after the first stage. 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 terminal cash flows to present value at a cost of equity of 6.3%.
Terminal value (TV)= FCF2032 × (1 + g) ÷ (r – g) = US$3.1 billion × (1 + 1.9%) ÷ (6.3%–1.9%) = US$71 billion
Present value of terminal value (PVTV)= TV / (1 + r)ten= $71 billion ÷ (1 + 6.3%)ten= $38 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 $57 billion. In the last step, we divide the equity value by the number of shares outstanding. Compared to the current share price of US$662, the company looks slightly undervalued at a 24% discount to the current share price. Remember though 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 flows. 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 complete picture of a company’s potential performance. Since we view O’Reilly Automotive 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 factors in debt. In this calculation, we used 6.3%, which is based on a leveraged beta of 1.038. 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.
Valuation is only one side of the coin in terms of building your investment thesis, and it’s just one of many factors you need to assess for a company. It is not possible to obtain an infallible valuation with a DCF model. Instead, the best use of 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 pace, or if its cost of equity or risk-free rate changes sharply, output may be very different. Can we understand why the company is trading at a discount to its intrinsic value? For O’Reilly Automotive, we’ve compiled three relevant factors you should dig into:
- Risks: To this end, you should inquire about the 2 warning signs we spotted some at O’Reilly Automotive (including 1 which is a little worrying).
- Management:Have insiders increased their shares to take advantage of market sentiment on ORLY’s future prospects? View our management and board analysis with insights into CEO compensation and governance factors.
- Other high-quality alternatives: Do you like a good all-rounder? Explore our interactive list of high-quality actions to get an idea of what you might be missing!
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.