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Is There An Opportunity With Ross Stores, Inc.'s (NASDAQ:ROST) 39% Undervaluation?

Key Insights

  • Ross Stores' estimated fair value is US$248 based on 2 Stage Free Cash Flow to Equity

  • Ross Stores' US$151 share price signals that it might be 39% undervalued

  • The US$173 analyst price target for ROST is 30% less than our estimate of fair value

In this article we are going to estimate the intrinsic value of Ross Stores, Inc. (NASDAQ:ROST) by projecting its future cash flows and then discounting them to today's value. We will take advantage of the Discounted Cash Flow (DCF) model for this purpose. Models like these may appear beyond the comprehension of a lay person, but they're fairly easy to follow.

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 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.

View our latest analysis for Ross Stores

The Calculation

We're using the 2-stage growth model, which simply means we take in account two stages of company's growth. In the initial period the company may have a higher growth rate and the second stage is usually assumed to have a stable growth rate. To begin with, we have to get estimates of 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.

A DCF is all about the idea that a dollar in the future is less valuable than a dollar today, and so the sum of these future cash flows is then discounted to today's value:

10-year free cash flow (FCF) estimate

2025

2026

2027

2028

2029

2030

2031

2032

2033

2034

Levered FCF ($, Millions)

US$1.79b

US$1.98b

US$2.27b

US$2.74b

US$3.37b

US$3.81b

US$4.19b

US$4.52b

US$4.80b

US$5.04b

Growth Rate Estimate Source

Analyst x7

Analyst x7

Analyst x5

Analyst x4

Analyst x3

Est @ 13.24%

Est @ 10.02%

Est @ 7.76%

Est @ 6.18%

Est @ 5.08%

Present Value ($, Millions) Discounted @ 6.9%

US$1.7k

US$1.7k

US$1.9k

US$2.1k

US$2.4k

US$2.6k

US$2.6k

US$2.6k

US$2.6k

US$2.6k

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$23b

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 (2.5%) 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)= FCF2034 × (1 + g) ÷ (r – g) = US$5.0b× (1 + 2.5%) ÷ (6.9%– 2.5%) = US$117b

Present Value of Terminal Value (PVTV)= TV / (1 + r)10= US$117b÷ ( 1 + 6.9%)10= US$60b

The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is US$83b. 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$151, the company appears quite undervalued at a 39% discount to where the stock price trades currently. Remember though, that this is just an approximate valuation, and like any complex formula - garbage in, garbage out.

dcf
dcf

The Assumptions

Now the most important inputs to a discounted cash flow are the discount rate, and of course, the actual 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 6.9%, which is based on a levered beta of 1.072. 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

  • Earnings growth over the past year exceeded the industry.

  • Debt is not viewed as a risk.

  • Dividends are covered by earnings and cash flows.

Weakness

  • 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.

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. The DCF model is not a perfect stock valuation tool. 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. Why is the intrinsic value higher than the current share price? For Ross Stores, we've compiled three important elements you should further examine:

  1. Financial Health: Does ROST 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 ROST'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 Solid Businesses: Low debt, high returns on equity and good past performance are fundamental to a strong business. Why not explore our interactive list of stocks with solid business fundamentals to see if there are other companies you may not have considered!

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.