Choosing the right financial tool to evaluate a company can be a daunting task, especially when different models are giving you drastically different conclusions. For example, my discounted cash flow (DCF) model tells me that Fastenal Company’s (NASDAQ:FAST) is overvalued by 20.26%, but my relative valuation tells me it’s overvalued by 60.75%. So, which valuation methodology should I listen to and why?
Examining intrinsic valuation
Since forecasting future free cash flows (FCFs) accurately into the future is often difficult and a highly subjective task, I’ve used analysts’ FCF forecasts as a starting point for my DCF. For those less familiar with valuation, the assumption behind the DCF is that a firm’s intrinsic value is equal to the sum of all its future FCFs, which is why quality forecasts are a high priority. When I discount all of FAST’s future FCFs by 9.5%, I obtain an equity value of $US$12b, then 287.06k shares outstanding are divided through. This results in an intrinsic value of $43.29. Take a look at how I arrived at this intrinsic value here.,
But how dependable is this value? A key assumption in DCFs is that by the final year of our forecast horizon, which is year 5 in FAST’s case, a company is assumed to be mature and therefore FCF should be growing at a sustainable rate. FAST’s final year FCF growth rate of -2.68%, is too low. If this assumption held true, FAST would shrink to a point where it would cease to exist very soon, which is a highly unlikely outcome. To improve our DCF analysis, we could extend the terminal year until FCF growth moderates to a more sustainable level around 1% to 5%. But investors also have to be mindful that there are far less data points the further out we go.
Deep-dive into relative valuation
The assumption behind relative valuation is that two companies with similar risk-return characteristics should have the same price since investors theoretically would be indifferent to purchasing either company. Unfortunately, the hardest part is finding companies that are similar enough to FAST to compare it against. As such, I’ve used the overall Trade Distributors industry as FAST’s proxy. To calculate the “true” value of FAST, we multiply FAST’s earnings by the industry’s P/E ratio to obtain a share price of $20.44, which means FAST is overvalued. But is this a dependable conclusion?
To check the robustness of our relative valuation, let’s take a look at if FAST has a similar growth profile to the overall Trade Distributors industry. With a projected earnings growth rate of 7.32% for next year, FAST has a similar growth profile when compared with the Trade Distributors industry, which is projected to grow at 7.58%. This demonstrates that the Trade Distributors industry is a good proxy for FAST and ideal for our relative valuation.
Which Model Is Superior?
Unfortunately, both models have their own merits and deficiencies, which means the truth lies somewhere in the middle. While intrinsic valuation is immune from market irrationality and mispricing, it is highly exposed to forecasting error. On the other hand, relative valuation is easy to calculate but affected by overall market mispricing. For example, relative valuation would not have been an effective tool to value a technology company at the height of the dotcom bubble in 2000. Given the pros and cons that I have laid out, I encourage you to derive a valuation by calculating a weighted average share price by using both models.
For FAST, I’ve put together three essential factors you should look at:
- Financial Health: Does FAST 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.
- Future Earnings: How does FAST’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.
- Other High Quality Alternatives: Are there other high quality stocks you could be holding instead of FAST? 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 does a DCF calculation for every US stock every 6 hours, so if you want to find the intrinsic value of any other stock just search here.
To help readers see past the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price-sensitive company announcements.
The author is an independent contributor and at the time of publication had no position in the stocks mentioned. For errors that warrant correction please contact the editor at firstname.lastname@example.org.