- United States
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- Hospitality
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- NYSE:ARCO
Arcos Dorados Holdings Inc.'s (NYSE:ARCO) Intrinsic Value Is Potentially 24% Below Its Share Price
Key Insights
- Arcos Dorados Holdings' estimated fair value is US$6.71 based on 2 Stage Free Cash Flow to Equity
- Arcos Dorados Holdings' US$8.80 share price signals that it might be 31% overvalued
- Analyst price target for ARCO is US$13.56, which is 102% above our fair value estimate
Today we will run through one way of estimating the intrinsic value of Arcos Dorados Holdings Inc. (NYSE:ARCO) by estimating the company's future cash flows and discounting them to their present value. One way to achieve this is by employing the Discounted Cash Flow (DCF) model. There's really not all that much to it, even though it might appear quite complex.
Companies can be valued in a lot of ways, so we would point out that a DCF is not perfect for every situation. For those who are keen learners of equity analysis, the Simply Wall St analysis model here may be something of interest to you.
Check out our latest analysis for Arcos Dorados Holdings
The Calculation
We're using the 2-stage growth model, which simply means we take in account two stages of company's growth. In the initial period the company may have a higher growth rate and the second stage is usually assumed to have a stable growth rate. To start off with, we need to estimate the next ten years of cash flows. Where possible we use analyst estimates, but when these aren't available we extrapolate the previous free cash flow (FCF) from the last estimate or reported value. We assume companies with shrinking free cash flow will slow their rate of shrinkage, and that companies with growing free cash flow will see their growth rate slow, over this period. We do this to reflect that growth tends to slow more in the early years than it does in later years.
Generally we assume that a dollar today is more valuable than a dollar in the future, and so the sum of these future cash flows is then discounted to today's value:
10-year free cash flow (FCF) estimate
2025 | 2026 | 2027 | 2028 | 2029 | 2030 | 2031 | 2032 | 2033 | 2034 | |
Levered FCF ($, Millions) | US$80.0m | US$34.0m | US$83.0m | US$125.0m | US$145.9m | US$164.2m | US$179.7m | US$193.0m | US$204.4m | US$214.4m |
Growth Rate Estimate Source | Analyst x2 | Analyst x1 | Analyst x1 | Analyst x1 | Est @ 16.76% | Est @ 12.48% | Est @ 9.49% | Est @ 7.39% | Est @ 5.92% | Est @ 4.90% |
Present Value ($, Millions) Discounted @ 12% | US$71.3 | US$27.0 | US$58.7 | US$78.8 | US$82.0 | US$82.2 | US$80.2 | US$76.8 | US$72.5 | US$67.8 |
("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$697m
We now need to calculate the Terminal Value, which accounts for all the future cash flows after this ten year period. 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 2.5%. We discount the terminal cash flows to today's value at a cost of equity of 12%.
Terminal Value (TV)= FCF2034 × (1 + g) ÷ (r – g) = US$214m× (1 + 2.5%) ÷ (12%– 2.5%) = US$2.3b
Present Value of Terminal Value (PVTV)= TV / (1 + r)10= US$2.3b÷ ( 1 + 12%)10= US$715m
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$1.4b. The last step is to then divide the equity value by the number of shares outstanding. Relative to the current share price of US$8.8, the company appears potentially overvalued at the time of writing. 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.
Important Assumptions
The calculation above is very dependent on two assumptions. The first is the discount rate and the other is the cash flows. Part of investing is coming up with your own evaluation of a company's future performance, so try the calculation yourself and check your own 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 Arcos Dorados Holdings 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 12%, which is based on a levered beta of 1.600. 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 Arcos Dorados Holdings
- Debt is well covered by earnings and cashflows.
- Earnings growth over the past year underperformed the Hospitality industry.
- Dividend is low compared to the top 25% of dividend payers in the Hospitality market.
- Annual earnings are forecast to grow for the next 3 years.
- Good value based on P/E ratio compared to estimated Fair P/E ratio.
- Paying a dividend but company has no free cash flows.
- Annual earnings are forecast to grow slower than the American market.
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. DCF models are not the be-all and end-all of investment valuation. Instead the best use for a DCF model is to test certain assumptions and theories to see if they would lead to the company being undervalued or overvalued. For example, changes in the company's cost of equity or the risk free rate can significantly impact the valuation. Why is the intrinsic value lower than the current share price? For Arcos Dorados Holdings, there are three fundamental elements you should assess:
- Risks: For example, we've discovered 2 warning signs for Arcos Dorados Holdings that you should be aware of before investing here.
- Future Earnings: How does ARCO'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: 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.
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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.
About NYSE:ARCO
Arcos Dorados Holdings
Operates as a franchisee of McDonald’s restaurants.
Good value with mediocre balance sheet.