March 31, 2023

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Advance Auto Parts, Inc. (NYSE:AAP) Shares Could Be 31% Below Their Intrinsic Value Estimate

Advance Auto Parts, Inc. (NYSE:AAP) Shares Could Be 31% Below Their Intrinsic Value Estimate

Key Insights

  • The projected fair value for Advance Auto Parts is US$176 based on 2 Stage Free Cash Flow to Equity
  • Current share price of US$122 suggests Advance Auto Parts is potentially 31% undervalued
  • Analyst price target for AAP is US$155 which is 12% below our fair value estimate

In this article we are going to estimate the intrinsic value of Advance Auto Parts, Inc. (NYSE:AAP) by taking the expected future cash flows and discounting them to their present value. One way to achieve this is by employing the Discounted Cash Flow (DCF) model. There’s really not all that much to it, even though it might appear quite complex.

Companies can be valued in a lot of ways, so we would point out that a DCF is not perfect for every situation. Anyone interested in learning a bit more about intrinsic value should have a read of the Simply Wall St analysis model.

See our latest analysis for Advance Auto Parts

The Method

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. 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.

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) estimate

2023 2024 2025 2026 2027 2028 2029 2030 2031 2032
Levered FCF ($, Millions) US$450.0m US$680.8m US$745.4m US$913.0m US$907.0m US$908.8m US$915.7m US$926.2m US$939.4m US$954.7m
Growth Rate Estimate Source Analyst x4 Analyst x4 Analyst x4 Analyst x1 Analyst x1 Est @ 0.20% Est @ 0.76% Est @ 1.15% Est @ 1.43% Est @ 1.62%
Present Value ($, Millions) Discounted @ 9.5% US$411 US$568 US$568 US$636 US$577 US$528 US$486 US$450 US$417 US$387

(“Est” = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$5.0b

The second stage is also known as Terminal Value, this is the business’s cash flow after the first stage. The Gordon Growth formula is used to calculate Terminal Value at a future annual growth rate equal to the 5-year average of the 10-year government bond yield of 2.1%. We discount the terminal cash flows to today’s value at a cost of equity of 9.5%.

Terminal Value (TV)= FCF2032 × (1 + g) ÷ (r – g) = US$955m× (1 + 2.1%) ÷ (9.5%– 2.1%) = US$13b

Present Value of Terminal Value (PVTV)= TV / (1 + r)10= US$13b÷ ( 1 + 9.5%)10= US$5.3b

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$10b. The last step is to then divide the equity value by the number of shares outstanding. Relative to the current share price of US$122, the company appears quite undervalued at a 31% 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.

NYSE:AAP Discounted Cash Flow March 16th 2023

The Assumptions

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 evaluation of a company’s future performance, so try the calculation yourself and check your own 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 Advance Auto Parts 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 9.5%, which is based on a levered beta of 1.244. 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 Advance Auto Parts

Strength

  • Debt is well covered by earnings and cashflows.

  • Dividend is in the top 25% of dividend payers in the market.

Weakness

  • Earnings declined over the past year.

Opportunity

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

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

Threat

  • Dividends are not covered by cash flow.

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

Moving On:

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. 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. Can we work out why the company is trading at a discount to intrinsic value? For Advance Auto Parts, we’ve compiled three fundamental aspects you should explore:

  1. Risks: Be aware that Advance Auto Parts is showing 2 warning signs in our investment analysis , you should know about…
  2. Future Earnings: How does AAP’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 NYSE every day. If you want to find the calculation for other stocks just search here.

Valuation is complex, but we’re helping make it simple.

Find out whether Advance Auto Parts is potentially over or undervalued by checking out our comprehensive analysis, which includes fair value estimates, risks and warnings, dividends, insider transactions and financial health.

View the Free Analysis

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.