DG - Dollar General's Growth Is Undervalued Relative To Dollar Tree

2023-08-10 14:10:51 ET

Summary

• Dollar General and Dollar Tree are facing challenges due to inflation related reduced spending by their core customer base.
• Dollar General is more profitable and more efficiently run. They also have a higher quality of earnings than Dollar Tree.
• Only 10.29% of the current share price of Dollar General is attributed to growth while 51.22% of the current share price of Dollar Tree is attributed to growth.
• The market is undervaluing Dollar General's growth prospects relative to Dollar Tree, making it a favorable investment option.

Introduction

Dollar General ( DG ) and Dollar Tree ( DLTR ) are operating in a particularly difficult environment given their business model. Their core customers are the low- and fixed-income households in areas frequently underserved by other retailers. The impact of inflation on them has been magnified. For example, both businesses have reported seeing their customers switch their spending from high margin non-consumables to low margin consumables. Both also reported higher shrink levels. These developments paint a picture of customers that are stretched and have shifted their purchases to simply being able to afford household essentials. Exacerbating an already difficult situation was the lower than usual tax refunds this past filing season and a reduction in SNAP benefits which many of their customers rely on. These headwinds crimped spending habits which directly affected Dollar General and Dollar Tree's operating performance in the first quarter.

Source: Dollar General Q1 2023 Results and Conference Call. Dollar Tree Q1 2023 Results and Conference Call.

In this article, we evaluate the relative performance of Dollar General and Dollar Tree from 2016 to 2022 with particular emphasis on growth. We review the operating performance of each company during the time period and estimate their respective sustainable growth rates. We then calculate the growth that is inferred by their current share prices and compare that with the sustainable growth rate for each. We remark on the value that the market is placing on the growth prospects of one company versus the other and opine whether there is sufficient basis for such value to be assigned. We offer a view on the quality of growth for both firms and conclude with a favorable investment recommendation in one of the two stocks.

Sustainable Growth Rate

The sustainable growth rate of a company can be estimated to be the product of the retention ratio and the return on equity. For every dollar not paid out in dividends, it is reinvested in the business at the return on equity rate. The higher the percentage of earnings retained and the higher the return on equity, the higher the sustainable growth rate.

The return on equity can be further decomposed to three factors: the amount of leverage in the capital structure, how efficient the business is run as measured by the asset turnover, and the profitability of the business. The more profitable and efficient the business, the higher the return on equity. The more leverage in the capital structure, the higher the return on equity up to a point. After a certain point, the gains from leverage are not enough to offset the decline in profitability given the higher interest expense from the leverage employed.

Please take a look at Table 1 in which we present the retention ratio of Dollar General from 2016 to 2022.

Source: Dollar General's 10-K for 2016 to 2022 . Dollar General's fiscal year ends in January. Therefore, the year 2016 in the table is for the year that ended January 2017. DPS means dividends per share. EPS means earnings per share and CAGR means compound annual growth rate.

On average, from 2016 to 2022, Dollar General retained just over 81 cents for every dollar earned. Dollar Tree does not pay out any dividends and so they retain 100% of earnings. Please take a look at Table 2 for the earnings per share record from 2016 to 2022 for Dollar Tree.

Source: Dollar Tree's 10-K for 2016 to 2022 . Dollar Tree's fiscal year ends in January. Therefore, the year 2016 in the table above is for the fiscal year that ended in January 2017.

At the early innings of this study, it is worth making a note that Dollar Tree retains 100% of earnings and yet hasn't delivered the growth in earnings that Dollar General has in the time period presented.

The next statistic we use in estimating the sustainable growth rate is the asset turnover. Please take a look at Table 3 and 4 in which we present the asset turnover for Dollar General and Dollar Tree.

On average, Dollar General generates $1.64 in sales for every $1 in assets versus the $1.35 for every dollar of asset that Dollar Tree generates. Again, by this metric, Dollar General has the edge. The asset turnover ratio uses an income statement account in the numerator and a balance sheet account in the denominator. It is an efficiency ratio that indicates how efficiently assets are utilized. Related to this ratio are two ratios frequently used in retail: the sales per square foot and comparable store sales increase. Let us look at both these to see if it supports the asset turnover ratio. Please take a look at Table 4 and Table 5.

Both tables support the view that Dollar General is better generating revenue from the assets employed.

The next measure to consider in forming our sustainable growth rate estimate is the leverage ratio. The leverage ratio is a measure of how much of the firm's assets is supported by equity capital. The more assets supported by a dollar of equity implies that more leverage. For this measure, I have calculated the leverage ratio as per share value of the long-term debt and book value of equity for the numerator, and the book value of equity in the denominator. Please take a look at Table 6 and 7 for the leverage ratio of Dollar General and Dollar Tree.

As a measure of leverage, the leverage ratio is somewhat lacking. It doesn't directly show you the debt-paying capacity of the business. It also uses book values for equity which is often an inadequate measure of equity capital. Still, there is not a wide difference in the leverage ratio of the two firms and so, on a relative basis, it won't impact our sustainable growth rate estimate. A more informative measure for ascertaining leverage is the long-term debt to operating income ratio. The ratio sizes the debt relative to the ability to pay down the debt. Please take a look at Table 8 and 9.

On average, Dollar General can pay off their debt in over a year. It would take Dollar Tree about two and a half years to pay off their long-term debt with their operating profit. I have removed the negative year of 2018 in the calculation of the average which implies it would probably take them longer than two and a half years to pay off their long-term debt.

Dollar Tree's ability to pay off their long-term debt is substantially better in the recent years than in the early years presented. It is worth pointing out that Dollar Tree's ability to pay off their debt is improved because their debt is almost half in 2022 than it was in 2016. For Dollar General, their debt in 2022 is more than double than it was in 2016 and yet the long-term debt to operating income ratio still much less than Dollar Tree's was from 2016 to 2020. This is because the operating income for Dollar General is in 2022 double the figure in 2016. For Dollar Tree the operating income is 38.6% higher in 2022 than 2016.

The last input we need to estimate the sustainable growth rate is profitability of the business. Please take a look at Table 10 and 11.

Dollar General is more profitable, more efficiently run and as conservatively leveraged. It accomplishes this while paying a dividend.

Please take a look at Table 12 for the sustainable growth rate of the two companies.

The sustainable growth rate is simply the product of the four inputs discussed.

In Table 13 we compare the actual EPS growth with the sustainable growth rate calculation.

While both have outperformed their respective sustainable growth rates, there is ample evidence to point to Dollar General's earnings growth as being more consistent and perhaps better quality than Dollar Tree's. Dollar General's earnings does not show a deficit in the years presented and is on a steady trend upwards.

In the next section we calculate how much growth is assumed in the current share price of each company and opine whether it is reasonable given what we have reviewed thus far.

Present Value of Growth Opportunities

In valuation theory, we can divide the value of a company into two components:

• The value of a company assuming zero-growth.
• The present value of growth opportunities (PVGO). Or, less technically, the value of the growth prospects of the business.

If you have two companies that will both earn $15 next year, the company that is able to grow earnings in succeeding years at a higher rate will trade at a higher price, ceteris paribus. This can be observed by comparing tech stocks with utilities, for example. Profitable companies can exhibit zero-growth. Because they turn a profit, there is a positive value to these companies, albeit less than profitable companies with growth potential.

Furthermore, if a company does not have any profitable growth prospects, then the company should cease from retaining any portion of earnings and pay out all earnings in the form of dividends. If a company earns $15 per share and has no growth prospects, then, it should pay $15 worth of dividends and the value of the company is simply the discounted value of $15. In finance parlance, the value of the company can be calculated as the present value of a perpetuity paying $15. Our first step in estimating how much growth is priced in the current share price is to consider the forward earnings for Dollar General and Dollar Tree and assume that neither company will grow in future years. Their respective stock prices have unperformed for some time now and their disappointing first quarter performance certainly did not help. Instead of trying to figure out what catalyst would turn their fortunes around, we simply make the unreasonable assumption that neither firm will be able to grow their earnings from here on. If the stock is trading at or close to the zero-growth value, then any growth that is realized is a bonus. The margin of safety becomes the value of growth and if the investor has confidence that some growth will be realized then an allocation to one or the other stock may be justified at a zero-growth price.

Source: Equity Asset Valuation, Second Edition, by Jerald E. Pinto, CFA, Elaine Henry, CFA, Thomas R. Robinson, CFA and John D. Stowe, CFA. Copyright 2009 by CFA Institute.

Please take a look at Table 14 where we present the forward earnings estimate for Dollar General and Dollar Tree.

Source: Seeking Alpha

To estimate the zero-growth value, we will discount the forward earnings estimate with the cost of equity. To estimate the cost of equity, we use the Capital Asset Pricing Model (CAPM). CAPM essentially adds a spread to the risk-free rate and scales that spread by the volatility of the stock. Please take a look at Table 15 for the inputs used to calculate the cost of equity using CAPM for the two securities.

Source: The beta statistic is from Seeking Alpha. The risk-free rate is 10-year Treasury on August 8th, 2023 from Yahoo! Finance.

For Table 15, I use the 10-year treasury as a risk-free rate. I use an equity risk premium of 4.38% which is from Aswath Damodaran at NYU . The crucial statistic for this table is the beta statistic. Dollar General has a lower beta statistic than Dollar Tree which leads to a lower cost of equity. The beta statistic measures the stock's sensitivity to the market and a beta statistic of 0.63 implies that Dollar General moves less than the market in either direction. Conceptually, this is justified because Dollar General is more profitable and has been better able to pay down their debt historically. Also, Dollar General pays a quarterly dividend and therefore a portion of their earnings is less sensitive to interest rates which is an input in discounting future cash flows. Technically, the dividend reduces the duration of their earnings. Dollar Tree's beta of 1.00 implies that it moves in step with the market in either direction.

Please take a look at Table 16 in which we estimate the value of each company assuming zero growth.

Discounting their forward earnings with their cost of equity we find that Dollar General has a zero-growth value of $148.26 and Dollar Tree has a zero-growth value of $71.62.

In Table 17, I add three rows to the previous table.

Source: Share prices are closing prices on August 8th 2023 from Yahoo! Finance.

The first row added is the current share price and the second row is the difference between the current share price and the company's zero-growth value. The interpretation is that if the zero-growth value of Dollar General is $148.26 and the current share price is $165.27 then the difference of $17.01 is the value that the market is placing on the growth opportunities of Dollar General. By comparison, Dollar Tree has a zero-growth value of $71.62 and the current share price is $146.80 which implies that the market is valuing Dollar Tree's growth opportunities at $75.18. On a percentage basis, only 10.29% of Dollar General's share price is attributed to its growth prospects while 51.22% of Dollar Tree's share price is attributed to its growth prospects despite having similar business models.

There is nothing in our analysis that supports Dollar Tree's growth prospects being given a premium valuation relative to Dollar General. Moreover, in Dollar General's case, the stock is trading close to its zero-growth value suggesting that an adequate margin of safety exists for this stock.

Risks and Limitations of This Approach

There are some limitations to the approach I have employed for this article. I have used the book value of equity in calculating the leverage ratios which is an input in the sustainable growth rate. There is a rough approximation of the sustainable growth rate estimated and the actual realized growth in earnings per share but it should be treated with some caution.

Secondly, I have used Capital Asset Pricing Model in estimating the cost of equity. CAPM is widely used but evidence of its predictive value is mixed.

Finally, the health of Dollar General and Dollar Tree's business is directly related to the financial health of their customer base. It is difficult if not impossible to pinpoint exactly when they will resume spending habits that resemble habits prior to the recent inflationary period.

Conclusion

Dollar General is more profitable and more efficiently run than Dollar Tree. Dollar General's earnings per share has trended steadily upward with no deficit in recent years. Their operating income has kept some pace with their debt levels and their baseline sustainable growth rate exceeds that of Dollar Tree's materially. They accomplish this whilst rewarding shareholders with a growing dividend.

With respect to valuation, the market is underestimating the growth prospects of Dollar General relative to Dollar Tree. Only 10.29% of the current share price of Dollar General is attributed to growth while 51.22% of the current share price of Dollar Tree is attributed to growth. A key assumption in this analysis is the lower beta statistic for Dollar General. The lower beta statistic is justified as Dollar General has better margins and pays a dividend. Dividends tend to temper the volatility of a stock's price.

In conclusion, there is more than an adequate basis for investors to consider a meaningful allocation in Dollar General's stock.

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