Stock Analysis

# Estimating The Fair Value Of Grocery Outlet Holding Corp. (NASDAQ:GO)

Today we'll do a simple run through of a valuation method used to estimate the attractiveness of Grocery Outlet Holding Corp. (NASDAQ:GO) as an investment opportunity by projecting its future cash flows and then discounting them to today's value. The Discounted Cash Flow (DCF) model is the tool we will apply to do this. Don't get put off by the jargon, the math behind it is actually quite straightforward.

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 Grocery Outlet Holding

### Step by step through 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 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 need to discount the sum of these future cash flows to arrive at a present value estimate:

#### 10-year free cash flow (FCF) estimate

 2022 2023 2024 2025 2026 2027 2028 2029 2030 2031 Levered FCF (\$, Millions) US\$57.0m US\$50.0m US\$61.0m US\$85.0m US\$109.0m US\$127.0m US\$142.4m US\$155.3m US\$166.1m US\$175.1m Growth Rate Estimate Source Analyst x1 Analyst x1 Analyst x1 Analyst x1 Analyst x1 Est @ 16.52% Est @ 12.14% Est @ 9.07% Est @ 6.93% Est @ 5.43% Present Value (\$, Millions) Discounted @ 5.3% US\$54.1 US\$45.1 US\$52.2 US\$69.0 US\$84.0 US\$92.9 US\$98.9 US\$102 US\$104 US\$104

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US\$806m

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 (1.9%) 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 5.3%.

Terminal Value (TV)= FCF2031 × (1 + g) ÷ (r – g) = US\$175m× (1 + 1.9%) ÷ (5.3%– 1.9%) = US\$5.2b

Present Value of Terminal Value (PVTV)= TV / (1 + r)10= US\$5.2b÷ ( 1 + 5.3%)10= US\$3.1b

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\$3.9b. To get the intrinsic value per share, we divide this by the total number of shares outstanding. Relative to the current share price of US\$37.5, the company appears about fair value at a 7.4% discount to where the stock price trades currently. The assumptions in any calculation have a big impact on the valuation, so it is better to view this as a rough estimate, not precise down to the last cent.

### The assumptions

We would point out that the most important inputs to a discounted cash flow are the discount rate and of course the actual 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 Grocery Outlet Holding 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 5.3%, which is based on a levered beta of 0.808. 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.

### Next Steps:

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. Rather it should be seen as a guide to "what assumptions need to be true for this stock to be under/overvalued?" If a company grows at a different rate, or if its cost of equity or risk free rate changes sharply, the output can look very different. For Grocery Outlet Holding, there are three pertinent elements you should consider:

1. Risks: For example, we've discovered 3 warning signs for Grocery Outlet Holding that you should be aware of before investing here.
2. Management:Have insiders been ramping up their shares to take advantage of the market's sentiment for GO's future outlook? Check out our management and board analysis with insights on CEO compensation and governance factors.
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. 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.

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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.