Are Dollarama Inc. (TSE:DOL) Investors Paying Above The Intrinsic Value?

Key Insights

• The projected fair value for Dollarama is CA$92.61 based on 2 Stage Free Cash Flow to Equity

• Dollarama is estimated to be 31% overvalued based on current share price of CA$122

• Our fair value estimate is 29% lower than Dollarama's analyst price target of CA$130

Today we'll do a simple run through of a valuation method used to estimate the attractiveness of Dollarama Inc. (TSE:DOL) as an investment opportunity 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. It may sound complicated, but actually it is quite simple!

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.

View our latest analysis for Dollarama

The Calculation

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 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.

Generally we assume that a dollar today is more valuable than a dollar in the future, and so the sum of these future cash flows is then discounted to today's value:

10-year free cash flow (FCF) estimate

	2024	2025	2026	2027	2028	2029	2030	2031	2032	2033
Levered FCF (CA$, Millions)	CA$982.3m	CA$1.11b	CA$1.20b	CA$1.26b	CA$1.32b	CA$1.37b	CA$1.42b	CA$1.46b	CA$1.50b	CA$1.53b
Growth Rate Estimate Source	Analyst x5	Analyst x5	Analyst x5	Est @ 5.56%	Est @ 4.51%	Est @ 3.78%	Est @ 3.27%	Est @ 2.91%	Est @ 2.66%	Est @ 2.49%
Present Value (CA$, Millions) Discounted @ 6.9%	CA$919	CA$970	CA$980	CA$968	CA$946	CA$919	CA$887	CA$854	CA$820	CA$787

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = CA$9.1b

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 6.9%.

Terminal Value (TV)= FCF₂₀₃₃ × (1 + g) ÷ (r – g) = CA$1.5b× (1 + 2.1%) ÷ (6.9%– 2.1%) = CA$32b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= CA$32b÷ ( 1 + 6.9%)¹⁰= CA$17b

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$26b. In the final step we divide the equity value by the number of shares outstanding. Compared to the current share price of CA$122, the company appears potentially overvalued at the time of writing. 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.

dcf

The Assumptions

The calculation above is very dependent on two assumptions. The first is the discount rate and the other is the 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 Dollarama 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 1.047. 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 Dollarama

Strength

• Earnings growth over the past year exceeded its 5-year average.

• Debt is well covered by earnings and cashflows.

Weakness

• Earnings growth over the past year underperformed the Multiline Retail industry.

• Dividend is low compared to the top 25% of dividend payers in the Multiline Retail market.

• Expensive based on P/E ratio and estimated fair value.

Opportunity

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

Threat

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

Looking Ahead:

Whilst important, the DCF calculation shouldn't be the only metric you look at when researching a company. The DCF model is not a perfect stock valuation tool. Preferably you'd apply different cases and assumptions and see how they would impact the company's valuation. For instance, if the terminal value growth rate is adjusted slightly, it can dramatically alter the overall result. Can we work out why the company is trading at a premium to intrinsic value? For Dollarama, we've put together three essential factors you should further research:

1. Risks: For example, we've discovered 2 warning signs for Dollarama that you should be aware of before investing here.

2. Future Earnings: How does DOL'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 Canadian 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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team@simplywallst.com