Deciding if you should use a relative valuation model over an intrinsic valuation model can be a difficult choice for many investors. For example, my discounted cash flow (DCF) model tells me that W.W. Grainger, Inc.’s (NYSE:GWW) is overvalued by 30.33%, but my relative valuation tells me it’s overvalued by 66.16%. Which model do I listen to and more importantly why?
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Deep-dive into intrinsic valuation
The DCF model follows the principle that a firm’s “true” value today is equal to the sum of all its the future free cash flows (FCF) it will make in the future (to infinity). Since the hardest part of constructing a DCF is forecasting this, I’ve decided to use the average expected FCF forecasted by broker analysts in my model. After discounting the sum of GWW’s future FCFs by 10%, it’s equity value comes to $US$13b, then 56.32k shares outstanding are divided through. This results in an intrinsic value of $234.31. Take a look at how I arrived at this intrinsic value here.,
Before we accept this value and move on, let’s take a look at how reliable it is. Since it is generally impossible to forecast FCFs indefinitely, it is common for analysts to forecast for an explicit forecast horizon and then assume the company is mature by the end of that period and in a stable growth phase. At -6.84%, final year FCF growth is unsustainably low. If this assumption held true, GWW 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%. The downside is that forecasts are less reliable the further into the future they are.
Deep-dive into relative valuation
While DCF models sum up future FCFs, relative valuation models are based on the idea that investors should pay the same price for two companies with identical risk and return profiles. Since the biggest dilemma is finding companies that are similar to GWW, a viable proxy would be the overall Trade Distributors industry itself. To calculate the “true” value of GWW, we multiply GWW’s earnings by the industry’s P/E ratio to obtain a share price of $103.34, which means GWW is overvalued. But is this a dependable conclusion?
To check the robustness of our relative valuation, let’s take a look at if GWW shares a similar capital structure with the overall Trade Distributors industry. This is especially important since we are using the P/E ratio, which is ineffective when comparing two entities with dramatically differing capital structures. At 106.42, GWW’s D/E ratio is significantly higher than the average firm in the Trade Distributors industry, which has a D/E ratio of 144.77%. Given the discrepancy of GWW’s D/E with the average Trade Distributors firm, we could improve our analysis by using enterprise multiples like EV/Sales instead, which aren’t affected by different capital structures.
Which Model Is Superior?
Both are somewhat weakened by assumptions we have used to fill in the gaps. Relative valuation is straightforward but prone to overall market mispricing. Meanwhile, intrinsic valuation is independent from market tendencies; however, is highly exposed to human error. Ultimately, investors should derive their final valuation based off both models. I encourage you to weight each model depending on your preferences to calculate a weighted average target price.
For GWW, I’ve put together three pertinent aspects you should look at:
- Financial Health: Does GWW 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 GWW’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 GWW? 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 email@example.com.