Discount-Variety Stores Industry Module 9:Valuation of Equity Kate Johnson

1. Discount-Variety Stores Industry Module 9:Valuation of Equity Kate Johnson

2. Agenda for Presentation • Company Information and Comparable • Valuation of Equity • Residual Earnings Model • Sensitivity Analysis • Analysts Reports • Uncertainties

3. “Save Time. Save Money.” • Largest discount retailer in the US by number of stores • Goodlettsville, Tennessee • 11,000 stores • 40 States • Southern, Southwestern, Midwestern, Eastern US • Merchandise is typically $10 or less • Founded in 1939 • Stock publicly traded in 2009

4. Product Types • Two brands: 1)High quality nationalbrands from leading manufacturers 2)Comparable quality privatebrand selections 10,000 SKUS/store 10$ or less

5. How are they profitable? • Convenient Locations • Time Saving Shopping Experience • Everyday Low Prices on Quality Merchandise • Key items in a broad range of general merchandise categories • Most basic shopping needs are met in one trip

6. Discount-Variety Stores **Costco is least comparable

7. But DG is a Dollar Store? • Dollar General is more suited to be compared with Walmart, Target, and Costco, as not everything is $1 (DLTR) and they have produce (unlike FDO) • Characteristics such as industry and size are often chosen for comparable

8. Store Growth • 2011-2012 Growth: 5.72% • 2012-2013 Growth: 5.96% DG is a February 2 year end 2013 . . . . . . . . . . . . . . . . . . . . . . . . . . 10,506 650 24 626 11,132

9. Estimated Equity Value and Market Value of Debt • Enterprise operating activities we have valued belong to both debt and equity holders • Valuing based on enterprise activities: the total value of BOTHdebt and equity holders’ interests • To compute the value of the equity holders’ interest: Value of equity= Enterprise value-value of debt = Enterprise Value $25, 404, 826, 266

10. NFL computation Preferred stock is included as computation of debt because they are amounts owed to parties other than common equity holders

11. Value of Equity Equations • Value of equity can be calculated directly using many different equations

12. Valuation of Enterprise Activities • Chosen to focus on valuation of enterprise activities • When we estimate the cost of capital we assume the stability of risk going forward so we can assume a constant cost of capital in the future • When we value the enterprise activities, we use the cost of enterprise capital which would not be expected to change from period to period unless the risk of the enterprise operating activities change • Assuming the cost of equity capital will be constant going forward is a much less justifiable assumption than assuming a constant cost of enterprise capital

13. The risk of equity arises as a result of the enterprise and the leverage that the debt offers to the equity holders • Effect of this leverage dependent on the ratio of the value of debt to the value of equity and the difference (spread) between the expected return on the enterprise operations of the firm and the expected interest rate on debt • Cost of capital of equity is dependent on the leverage of the firm

14. Residual Earnings Model • Growth rate during the horizon is significantly larger than cost of equity capital of 6.8% • Want a stable growth rate in RE that is less than our cost of equity capital and is therefore sustainable • Dollar General DOES NOT pay dividends, so a dividend discount model cannot be calculated • Therefore hard to compare the two different value estimates when one cannot be performed (2.63% g rate, arbitrary)

15. Residual Earnings Model (cont.) • Firm is not in steady state • Optimistic bias in analysts’ forecasts leads to inflated estimates of equity value • These are, at best, very rough ways to use analyst forecast data to obtain an indication of value

16. Long Term Growth in Earnings/Sales • Substituting an arbitrary growth rate of 2.63%, we find that the market price suggested by the residual earnings model is $90.00 • Again, because DG does not have dividends, there is no way to compare this suggested market price to the suggested market price that the dividend discount model would suggest • Solving for the growth rate, it is approximately 6.53% • Long term earnings/sales levels out at around 2.67% • Good news, because in Modules 6-8, I had a long term steady state at 2.29%

17. Issues in Valuation • Misalignment of the dates on which we wish to determine value and the end of the fiscal periods for which F/S are prepared and financial accounting data are forecasted • The analysis of the sensitivity of our valuations to key assumptions

18. Adjusting Valuation to the Valuation Date • So far we have estimated the value of the enterprise as of the B/S date using • available accounting numbers • forecasts of cash flows • future EPAT and NEA • We often want to know the value today, not the date of the last balance sheet • Ex. If a new product is launched with great initial sales, an adjustment is needed

19. Adjusting date of Value Estimate • Balance sheet date is as of January 31, 2014 • It is now March 24 • Value of enterprise operations would be expected to increase at the cost of enterprise capital • In order to change an estimate of value at January 31, 2014, we roll the value estimate forward at the cost of enterprise capital • $25,404,826,266* (1+.0655)^(2/12) • =$25,674,882,898

20. Mid-Year Adjustment • No payoffs, as DG has not declared dividends

21. Sensitivity Analysis

22. Analysts-ValueLine

23. Analysts-MorningStar

24. Analysts-ValuEngine

25. Analysts- Sadif

26. BUY/Sell/Hold Recommendation • Based upon: - Analysts reports • Residual earnings model • Modules 6-8 Enterprise Value -Friday’s closing price DG is undervalued

27. Uncertainties • No dividends for DG, therefore dividend discount model cannot be computed • Thus, detailed analysis comparing the dividend discount model’s stock price to the residual earnings model’s suggested stock price also can’t be analyzed • Sensitivity analysis is $573,000 different from the enterprise value calculated from Modules 6-8 • I am guessing that it won’t exactly match if you are only sensitizing one growth rate (3.10%) when there are two in the equation (3.10% and 2.29%) • Will investigate further