Is There An Opportunity With Advance Auto Parts, Inc.’s (NYSE:AAP) 32{ca2182fc8fed51dc37b95061ee48b5056cde1176732b225548c54a0c0156d303} Undervaluation?

Key Insights

• The projected fair value for Advance Auto Parts is US$174 based on 2 Stage Free Cash Flow to Equity

• Advance Auto Parts’ US$119 share price signals that it might be 32{ca2182fc8fed51dc37b95061ee48b5056cde1176732b225548c54a0c0156d303} undervalued

• The US$155 analyst price target for AAP is 11{ca2182fc8fed51dc37b95061ee48b5056cde1176732b225548c54a0c0156d303} less than our estimate of fair value

Does the March share price for Advance Auto Parts, Inc. (NYSE:AAP) reflect what it’s really worth? Today, we will estimate the stock’s intrinsic value by taking the expected future cash flows and discounting them to today’s 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!

Remember though, that there are many ways to estimate a company’s value, and a DCF is just one method. If you still have some burning questions about this type of valuation, take a look at the Simply Wall St analysis model.

See our latest analysis for Advance Auto Parts

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. In the first stage we need to estimate the cash flows to the business over the next ten years. 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) estimate

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

Story continues

We now need to calculate the Terminal Value, which accounts for all the future cash flows after this ten year period. 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 (2.1{ca2182fc8fed51dc37b95061ee48b5056cde1176732b225548c54a0c0156d303}) 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 9.6{ca2182fc8fed51dc37b95061ee48b5056cde1176732b225548c54a0c0156d303}.

Terminal Value (TV)= FCF₂₀₃₂ × (1 + g) ÷ (r – g) = US$955m× (1 + 2.1{ca2182fc8fed51dc37b95061ee48b5056cde1176732b225548c54a0c0156d303}) ÷ (9.6{ca2182fc8fed51dc37b95061ee48b5056cde1176732b225548c54a0c0156d303}– 2.1{ca2182fc8fed51dc37b95061ee48b5056cde1176732b225548c54a0c0156d303}) = US$13b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= US$13b÷ ( 1 + 9.6{ca2182fc8fed51dc37b95061ee48b5056cde1176732b225548c54a0c0156d303})¹⁰= US$5.2b

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$10b. In the final step we divide the equity value by the number of shares outstanding. Compared to the current share price of US$119, the company appears quite undervalued at a 32{ca2182fc8fed51dc37b95061ee48b5056cde1176732b225548c54a0c0156d303} 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.

The Assumptions

The calculation above is very dependent on two assumptions. The first is the discount rate and the other is the 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 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 9.6{ca2182fc8fed51dc37b95061ee48b5056cde1176732b225548c54a0c0156d303}, which is based on a levered beta of 1.260. 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

Weakness

Opportunity

Threat

Moving On:

Valuation is only one side of the coin in terms of building your investment thesis, and it is only one of many factors that you need to assess for a company. It’s not possible to obtain a foolproof valuation with a DCF model. Preferably you’d apply different cases and assumptions and see how they would impact the company’s valuation. 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 Advance Auto Parts, we’ve compiled three further items you should look at:

1. Risks: Case in point, we’ve spotted 2 warning signs for Advance Auto Parts you should be aware of.

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 High Quality Alternatives: Do you like a good all-rounder? Explore our interactive list of high quality stocks to get an idea of what else is out there you may be missing!

PS. Simply Wall St updates its DCF calculation for every American stock every day, so if you want to find the intrinsic value of any other stock 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.

Join A Paid User Research Session
You’ll receive a US$30 Amazon Gift card for 1 hour of your time while helping us build better investing tools for the individual investors like yourself. Sign up here