Both companies are from the same industry, so it will be easier to conduct an assessment. First we’ll make a ratios comparison to understand whether these companies are better or worse relative to the rest of the industry, and therefore whether they are undervalued or overvalued. Then we will try to determine the fair value of the shares of the companies according to DDM and FCFE models and compare it with the current stocks prices.
The table below shows data for 25 US companies from the RETAIL-FAMILY CLOTHING STORES industry according to SIC classification. Data are presented for the TTM period (12 months) until the second quarter of 2019 inclusive:
Gross Margin. The industry average is 36.53%. The undisputed leader is Tiffany with 62.68%. GAP shows 37.56%, which is slightly above the average. Nordstrom has 35.78%, slightly below the industry average. That is, both GAP and Nordstrom as a whole are no worse and nor better in this respect.
Net Profit Margin. The industry average is 2.72%. The clear leader again is Tiffany with 12.79%. GAP shows 5.71%, which is two times higher than the industry average. Nordstrom has 3.17%, which is also not bad.
Cash Ratio and Quick Ratio. For these two indicators, GAP has 0.47, which is slightly higher than the industry average for the Cash ratio and corresponds to the industry average for the Quick ratio. Nordstrom’s business is slightly worse, both are below the industry average.
Inventory Turnover. In terms of performance, both GAP and Nordstrom are below the industry average.
EV/EBITDA, Debt Ratio. GAP is higher for these indicators, but Nordstrom, on the contrary, is below the industry average.
ROE и ROIC. For these two indicators, both GAP and Nordstrom are significantly better than the industry average.
EPS и FCF/S. Comparison of these indicators with industry average values will not say anything special. Well, unless GAP and Nordstrom are profitable and they have positive free cash flow.
PE. In terms of this indicator, both GAP and Nordstrom are below the industry average.
GAP For all indicators, except the performance indicator, the company looks better than the market. A PE score below the industry average in this case indicates that the company is greatly undervalued by the market.
Nordstrom. In some respects, the company is slightly better than the industry average, in some slightly worse. In general, we can say that it corresponds to average values. However, PE below the industry average still indicates that the company is undervalued by the market.
This valuation method for a company’s shares is based on the hypothesis that the fair value of a share is the sum of all future dividend payments discounted to the current point in time. Here you can find more detailed informations about model.
The calculation formula in general is as follows:
where: P – is the current fair value of the share, g – is the annual growth rate of dividends, r – is the required discount rate, D1 – is the amount of annual dividends in the next period.
The calculation formula for the required discount rate in general is as follows:
where: Es – is the expected stock return or our desired required discount rate, Rf – is the risk-free rate, βs – is the beta stock, Rm – is the historical market return.
GAP. The size of the annual dividend is 0.24 * 4 = $ 0.96. The annual growth of dividends is g ~ 2%. D1 = 0.98. Since GAP is included in the S&P500 index, we can take the historical profitability of the index as Rm = 10%, βs = 0.71, Rf = 2%. r = 0.02 + 0.71 (0.1-0.02) = 0.0768. Now we have all the source data for calculating the fair value of the stock, which is: P = 0.98 / (0.0768-0.02) = $ 17.25.
The current stock price of the GAP is ~ $ 17, therefore, the DDM valuation is approximately equal to the company’s valuation in the market.
Nordstrom. The size of the annual dividend is 0.37 * 4 = $ 1.48. The annual growth of dividends over the past 5 years is g ~ 2.4%. D1 = 1.51. Since Nordstrom is also included in the S&P500 index, we can take the historical profitability of the index as Rm = 10%, βs = 0.7, Rf = 2%. r = 0.02 + 0.7 (0.1-0.02) = 0.0768. Now we have all the initial data for calculating the fair value of the stock: P = 1.51 / (0.0768-0.024) = $ 28.59.
The current Nordstrom stock price is ~ $ 34, which is slightly higher than the company’s DDM stock price estimate.
FCFE (Free cash flow to equity model).
Using this method of valuing a company’s stock price implies that shareholders can receive not only future dividend payments, but also all future retained earnings of the company upon its liquidation. Therefore, the fair value of a share should equal the sum of all expected future free cash flows, discounted to the current point in time.
We will use the formula from the DDM model, but instead of dividends we will substitute FCFE into it:
The formula for calculating FCFE per share is as follows:
where: FCFF – annual free cash flow per share, Net Borrowings – annual change in debt per share.
GAP. FCFF = 2.48. Net Borrowings = 3.32 – 3.24 = 0.08. “g” we will define as the growth of the company as a whole and it is approximately 1.2%. FCFE1 = (2.48 + 0.08) * 1.012 = 2.59. “r” we have calculated earlier and it is 0.0768. Finally P = 2.59 / (0.0768-0.012) = $ 39.9
The current GAP stock price is ~ $ 17, which is significantly lower than the estimate of its fair value using the FCFE model.
Nordstrom. FCFF = 3.42. Net Borrowings = 17.28 – 16.32=0.96. “g” we will define as the growth of the company as a whole and it is approximately 3.2%. FCFE1 = (3.42 + 0.96) * 1.032 = 4.52. “r” we have calculated earlier and it is 0.0768. Finally P = 4.52 / (0.0768-0.032) = $ 100.9
The current Nordstrom quote is ~ $ 34, which is significantly lower than the estimate of its fair value using the FCFE model.
If you look at the Ratios, GAP is underestimated by the market, Nordstrom also has a small underestimation by the market.
If you look at DDM, then the fair price of GAP is fully consistent with market valuation. Nordstrom is a bit overvalued.
If you look at the FCFE model, then the fair price of GAP is much higher, and it means that the market significantly underestimates. With Nordstrom, the situation is similar.
In terms of aggregate indicators, GAP is strongly underestimated by the market, Nordstrom is weakly underestimated by the market. In the near future, if there is no force majeure, we are likely to see the growth of stock prices of these companies towards their fair value: GAP to ~ $ 30, Nordstrom to ~ $ 50.