CarMax, Inc. (NYSE:KMX) is Priced in for Strong Used Car Demand in 2022

Stjepan Kalinic
December 22, 2021
Source: Shutterstock

Where there are problems, there are opportunities. The global chip shortage, paired up with other supply chain issues, created a lot of trouble in the automotive industry, with multiple OEMs reducing or completely halting the production.

On the other hand, for companies like CarMax, Inc. (NYSE: KMX), this created an opportunity as the stock significantly outperformed in 2021.

See our latest analysis for CarMax

Earnings Results

  • GAAP EPS: US$1.63 (beat by US$0.19)
  • Revenue: US$8.5b (beat by US$1.12b)
  • Revenue growth: +64.1% Y/Y

Other highlights

  • Sold 451,054 units – up 29.3% in comparison to Q3 2020
  • Retail and wholesale units set new Q3 records
  • FY expectations to open 10 new locations

Arguably strongest used car market in history propelled CarMax to the all-time highs, with the peak gain in 2021 standing at over 65% at some point.

While nobody can perfectly predict the future, the global chip shortage is improving, although the car manufacturers are behind the curve – likely giving the used car market a tailwind for at least a few more quarters.

Once the situation is resolved, we expect the margins to return to the historical averages, at least 10% weaker relative to the current situation.

NYSE: KMX Net Margins 2016-2021 Source: MacroTrends

Calculating the Intrinsic Value

Companies can be valued in many ways, so we would point out that a discounted cash flow (DCF) is not perfect for every situation. Anyone interested in learning a bit more about intrinsic value should have a read of the Simply Wall St analysis model.

We're using the 2-stage growth model, which means we take into account two stages of the 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. In the first stage, we need to estimate the cash flows to the business over the next ten years. 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 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 discount the value of these future cash flows to their estimated value in today's dollars:

10-year free cash flow (FCF) estimate

2022 2023 2024 2025 2026 2027 2028 2029 2030 2031
Levered FCF ($, Millions) US$518.7m US$1.13b US$1.06b US$1.73b US$1.59b US$1.52b US$1.48b US$1.46b US$1.46b US$1.46b
Growth Rate Estimate Source Analyst x4 Analyst x4 Analyst x3 Analyst x1 Analyst x1 Est @ -4.58% Est @ -2.62% Est @ -1.25% Est @ -0.28% Est @ 0.39%
Present Value ($, Millions) Discounted @ 9.1% US$475 US$949 US$815 US$1.2k US$1.0k US$899 US$802 US$726 US$664 US$610

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$8.2b

The second stage is also known as Terminal Value. This is the business's cash flow after the first stage. 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 (2.0%) 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 9.1%.

Terminal Value (TV)= FCF2031 × (1 + g) ÷ (r – g) = US$1.5b× (1 + 2.0%) ÷ (9.1%– 2.0%) = US$21b

Present Value of Terminal Value (PVTV)= TV / (1 + r)10= US$21b÷ ( 1 + 9.1%)10= US$8.7b

The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is US$17b. The last step is to divide the equity value by the number of shares outstanding. Compared to the current share price of US$137, the company appears potentially overvalued at the time of writing.

Remember, though, that this is just an approximate valuation.

NYSE: KMX Discounted Cash Flow December 22nd, 2021

The 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 evaluation of a company's future performance, so try the calculation yourself and check your 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 complete picture of its potential performance.

Given that we are looking at CarMax as potential shareholders, the cost of equity is used as the discount rate rather than the cost of capital (or the weighted average cost of capital, WACC), which accounts for debt. We've used 9.1% in this calculation, which is based on a levered beta of 1.637. Beta is a measure of a stock's volatility compared to the market as a whole.

Moving On:

Despite the projections that the used car market will likely exhibit a few more quarters of elevated demand, it seems that CarMax stock has it priced in. On the other hand, the company has not focused on reducing the debt over the last years, as it currently stands at over US$16b. In a bottoming interest rate environment, this is a reason for concern.

While important, the DCF calculation shouldn't be the only metric you look at when researching a company. It's not possible to obtain a foolproof valuation with a DCF model. Instead, it should be seen as a guide to "what assumptions need to be true for this stock to be under/overvalued?"

For CarMax, we've put together three essential items you should look at:

  1. Risks: Take risks, for example - CarMax has 1 warning sign we think you should be aware of.
  2. Future Earnings: How does KMX's growth rate compare to its peers and the broader market? Dig deeper into the analyst consensus number for the upcoming years by interacting with our free analyst growth expectation chart.
  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. The Simply Wall St app conducts a discounted cash flow valuation for every stock on the NYSE every day. If you want to find the calculation for other stocks, search here.

Simply Wall St analyst Stjepan Kalinic and Simply Wall St have no position in any of the companies mentioned. This article 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.

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