Pet Valu Holdings Ltd. (TSE:PET) Shares Could Be 44% Below Their Intrinsic Value Estimate

Key Insights

• Pet Valu Holdings' estimated fair value is CA$54.65 based on 2 Stage Free Cash Flow to Equity

• Current share price of CA$30.72 suggests Pet Valu Holdings is potentially 44% undervalued

• Our fair value estimate is 48% higher than Pet Valu Holdings' analyst price target of CA$36.88

How far off is Pet Valu Holdings Ltd. (TSE:PET) from its intrinsic value? Using the most recent financial data, we'll take a look at whether the stock is fairly priced by estimating the company's future cash flows and discounting them to their present value. We will take advantage of the Discounted Cash Flow (DCF) model for this purpose. Believe it or not, it's not too difficult to follow, as you'll see from our example!

We would caution that there are many ways of valuing a company and, like the DCF, each technique has advantages and disadvantages in certain scenarios. For those who are keen learners of equity analysis, the Simply Wall St analysis model here may be something of interest to you.

See our latest analysis for Pet Valu Holdings

Crunching The Numbers

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 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 discount the value of these future cash flows to their estimated value in today's dollars:

10-year free cash flow (FCF) forecast

	2024	2025	2026	2027	2028	2029	2030	2031	2032	2033
Levered FCF (CA$, Millions)	CA$81.2m	CA$120.0m	CA$157.5m	CA$188.3m	CA$211.1m	CA$230.2m	CA$246.2m	CA$259.6m	CA$271.1m	CA$281.1m
Growth Rate Estimate Source	Analyst x5	Analyst x6	Analyst x2	Analyst x1	Est @ 12.10%	Est @ 9.06%	Est @ 6.94%	Est @ 5.46%	Est @ 4.42%	Est @ 3.69%
Present Value (CA$, Millions) Discounted @ 7.4%	CA$75.6	CA$104	CA$127	CA$141	CA$148	CA$150	CA$149	CA$146	CA$142	CA$137

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = CA$1.3b

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 (2.0%) 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 7.4%.

Terminal Value (TV)= FCF₂₀₃₃ × (1 + g) ÷ (r – g) = CA$281m× (1 + 2.0%) ÷ (7.4%– 2.0%) = CA$5.3b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= CA$5.3b÷ ( 1 + 7.4%)¹⁰= CA$2.6b

The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is CA$3.9b. In the final step we divide the equity value by the number of shares outstanding. Relative to the current share price of CA$30.7, the company appears quite good value at a 44% 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

Important Assumptions

We would point out that the most important inputs to a discounted cash flow are the discount rate and of course the actual cash flows. If you don't agree with these result, have a go at the calculation yourself and play with the 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 Pet Valu Holdings 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 7.4%, which is based on a levered beta of 1.179. 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 Pet Valu Holdings

Strength

• Debt is well covered by earnings and cashflows.

• 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 faster than the Canadian market.

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

Threat

• Revenue is forecast to grow slower than 20% per year.

Moving On:

Valuation is only one side of the coin in terms of building your investment thesis, and it ideally won't be the sole piece of analysis you scrutinize for a company. DCF models are not the be-all and end-all of investment valuation. 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. For example, changes in the company's cost of equity or the risk free rate can significantly impact the valuation. What is the reason for the share price sitting below the intrinsic value? For Pet Valu Holdings, there are three further factors you should consider:

1. Risks: Case in point, we've spotted 1 warning sign for Pet Valu Holdings you should be aware of.

2. Future Earnings: How does PET'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 TSX every day. If you want to find the calculation for other stocks just search here.

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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.