I grew up in a small town in Ohio and remember riding my bike to the nearest Dollar General Store. In fact, I rode this track many times in my youth.
During her bi-weekly shopping trips, my mother sometimes forgot to take a small consumable item such as a soup. B. Take toothpaste with you. Instead of driving 20 minutes to the nearest Kroger, she sent her son on the important dental hygiene mission.
Another routine use of mine would be when a birthday, wedding, or other important event were to occur. I was sent to get a $ 1.00 card that we could quickly sign, stamp, and post in the mailbox. Crisis averted!
That kind of convenience and simplicity is a business model that has saved me many times over the day for my family. But how does Dollar General’s business model translate to shareholders?
Dollar General’s business breakdown
This post was written in collaboration with friend and blogger Thomas Chua from Steady Compounding. Check its breakdown by Dollar General’s business model and operations.
When you understand the basic Dollar General business model, return here for the review piece.
Dollar General’s past performance
When analyzing a company’s long-term growth, I want to examine four different metrics to ensure that the company is growing in line with shareholders. I like to call these metrics the “Core Four”. They are:
- Diluted earnings (net income)
- Free Cash Flow (FCF)
- Book value (or equity)
If all four of these core four metrics are steadily increasing over time, then congratulations! You’ve probably found a great company to invest in!
Back to Dollar General (DG). Let’s look at the performance of the Core Four metrics over the past 10 years.
As you can see, DG’s core four growth metrics were staggering. DG has recorded an almost perfect increase in all key figures in the last ten years, with FCF and EPS only increasing significantly in the last year.
Sales rose steadily by 8% per year, with the book value not lagging far behind at over 6% per year.
However, EPS and FCF were more impressive with a share of 18% and 17% per year, respectively.
Aligned with the shareholders
That growth has resulted in incredible returns for shareholders. DG saw the share price rise 660% since 2011 or so 22% yearly.
The DG has grown very well over the past ten years. This is largely due to the excellent management that has placed the company in a great position to capitalize on this growth.
DG executives saw patterns in their business and consumer base that enabled them to expand and maximize profits at the same time. These are difficult tasks for any company, but the management of the DG has adapted to the occasion, especially during COVID-19.
Here are some of the impressive work DG has done for all of its businesses lately:
- 31 consecutive years with the same branch growth
- Dollar General Mobile App
- “DG Pickup” for online orders and contactless shopping
In addition, management has focused on opening more stores and making them more efficient. Here are some long-term plans the DG team is already working on:
- Open a new chain of stores, Popshelf
- Introduction of the self-distribution model “DG Fresh” for chilled food
- Non-Consumables Initiative to offer consumers products that offer DG higher margins
This pre-eminent determination to step up the business has allowed DG to become even more profitable over the past year, as evidenced by the increase in FCF and EPS. In particular, profitability is in the top percentile in the industry.
In addition, the DG is even rewarding its frontline workers with salary bonuses for their resilience during COVID-19. It doesn’t get much better than that.
So we saw clearly that Dollar General is a wonderful business with fantastic management. How do we determine the price to be paid?
Roll up your sleeves, it’s time for evaluation work.
The gold standard for stock valuation is the discounted cash flow method. If you are unfamiliar with this concept, check out my detailed review over Calculation of the intrinsic value.
Let’s plug in our inputs.
Let’s explain these numbers a little. I aim for a return of at least 15% on every investment, and my standard safety margin is also 15%.
Choosing growth rates is always the hardest part of valuing stocks. DG’s FCF has grown at an astonishing rate of 17% per year over the past decade.
I went with somewhat aggressive growth rates of 14% and 10%, respectively, because I am confident that management will continue to find ways to tighten business as we emerge from COVID-19.
The final value was determined to be 17x, since it is the current (and historical) price / FCF.
A good buy?
We are lucky! According to our calculations, DG’s intrinsic value is currently undervalued as it is currently trading at $ 211.
However, at its current value of $ 211, DG is not significant undervalued. If we were to buy at $ 211 now and sell at $ 226 a year from now, we would only get an 8% return.
As such, GD’s current share price is not a great opportunity for value creation. If DG traded below $ 200 per share, we could potentially hit our target of 15% in a year.
How else should we value DG? Let’s look at a long-term hold situation.
Valuation of Reverse Convertible Bonds
Let’s try to evaluate DG as more long-term, buy and hold stocks by doing the Equity Bond Method.
First, in order for the GD to qualify for this valuation method, it must have a high ROE (> 15%) over long periods of time and at the same time increase the book value. Let’s see if it qualifies:
Sure enough, DG has had a phenomenal ROE over the past decade and has never fallen below 15% a single time. What is more impressive is that the ROE and book value have increased almost every year and the current ROE has reached almost 40%!
Now that we know DG is suitable for this method, let’s enter our numbers for calculation.
According to our calculations, DG is currently working with an ROE of 35% and offers an equity bond (return on income) of 4.8%. If DG can maintain this ROE and dividend payout ratio, our investment link could be close to 27% per annum, with a reverse convertible stock yielding over 24% at the end of 10 years.
If you think these projections seem a little high, it’s likely because they are. DG is currently working with an extremely high ROE (the highest ever) that is not easy to maintain. We are also continuing to look at the effects of COVID-19, which are likely to continue for some time.
That being said, DG’s 2020 performance was phenomenal in all adversities. Given their outstanding track record, I am confident that management can achieve a ROE of at least 25%. The continued plans and incentives may enable even better performance.
Also, let’s not forget that GD’s shares have risen about 22% a year over the past decade, not far from our forecast of 27%. Nothing is impossible, but it’s always good to keep your feet on the ground when valuing stocks.
Dollar General runs a wonderful business that offers great value to both customers. Wall Street also offers a quality stock with solid growth potential at a respectable price.
That’s why I added DG to mine VVI portfolio buy and hold as a long-term investment. It works with two crucial elements for the success of a company: a permanent and resilient business model and excellent management.