BEST BUY VALUATION
David Enriquez
Chris Gonsalves
Rohit Kapai
Patrick Nigro
Two-Stage Dividend Discount/ P/E Model
Assumptions
•
Payout ratio = 17%
•
Short-term dividend growth rate= 17%
•
Cost of equity = 12%
•
Beta = 1.4
•
P/E ratio at t(5) = 10.01
Model Analysis
Supplemental Information
Best Buy is one of the country’s largest
specialty
retailers
of
consumer
electronics, personal computers, and
appliances. The company’s Domestic
segment operates in the United States
as Best Buy (consumer electronics),
Best Buy Mobile (cell phones and
accessories), Geek Squad (product
repair, support, and installation),
Magnolia Audio Video (high-end
audio/video products), Napster (digital
music), Pacific Sales (high-end home
improvements),
and
Speakeasy
(broadband, voice, data, information
services to small businesses).
The
International segment operates in
Canada as Best Buy, Best Buy Mobile,
Future Shop, and Geek Squad; in
Europe as The Carphone Warehouse,
The Phone House and Geek Squad; in
China as Best Buy, Geek Squad, and
Five Star; in Mexico as Best Buy and
Geek Squad.
In Fiscal Year 2009 the company
recorded revenue in excess of $45
billion with just over $1 billion in net
income. Best Buy has a strong market
presence that it continuously reinforces
with key acquisitions. Best Buy has
been able to differentiate itself by
offering services such as
First, our analysts found the company’s Beta by using the historical four- year monthly
stock return of Best Buy as compared to the S&P 500’s returns. We then used the federal
government’s 10-year T-bill yield as the risk-free rate and adjusted the returns of the
equities for that.
The resulting graph of these points and slope of the trend line
determined Best Buy’s beta. Using CAPM with a market risk premium of 8%, we were then
able to determine that Best Buy’s cost of equity should be 11.94%, which we rounded up
to 12%.
Once cost of equity was calculated, the next step was to plug the annual dividend rate of
$0.56 per share, the share price of $28.82 as of 2/2/2009, the average short-term growth
rate of 17%, and the required rate of 12% into our 5-year DDM model. The 17% shortterm dividend growth rate was calculated by averaging the dividend growth rate of the
previous four years. Although the growth was at 19%, we chose 17% to be conservative.
To get the terminal value after year 5 we used a P/E valuation using the trailing P/E ratio
of 10.01 and the implied EPS at year 5, which we used under the assumption that Best Buy
will maintain their three-year average payout rate for dividends of 17%. The summation of
present values for these two valuations gave us a value of $44.34 per share. So, with this
Best Buy is largely undervalued in the market right now at $28.82.
The two-stage DDM/ P/E ratio valuation was the best method to use for Best Buy because
the company pays a consistent dividend that has a stable payout ratio. Unfortunately, we
do not believe that the dividend growth rate will remain at 17% past five years. After five
years, the P/E ratio valuation was used because it takes into account the market’s
expectation of growth of the company, which is safer to use than our estimated long-term
growth rate. As a result, we felt that combining the DDM and P/E ratio valuations would
give us the most accurate intrinsic value of Best Buy.
installation of home theater equipment
and other electronics. Its “Geek Squad”
unit, offering computer repair and
support services, has been successful
and is now available in all U.S. stores as
well as seven stand-alone stores.
One of Best Buy’s biggest weaknesses is
its lack of supplier diversity. The
company’s 20 largest suppliers account
for half of the merchandise purchased.
Some of these top suppliers have also
started to integrate vertically and open
their own stores. Competition amongst
electronic specialty retailers has led to
the demise of three former powerhouses
of the industry in the last few years:
Tweeter Home Entertainment Group,
CompUSA, and Circuit City. Aside from
traditional
competitors
such
as
Radioshack and hhgregg, the industry
has faced considerable pressure from
large discount retailers Wal-Mart and
Costco Wholesale, both of which have
expanded their selection of consumer
electronics and continue to offer less
expensive products. Amazon.com has
also become a strong competitor as its
online sales of electronics continue to
thrive.
Globally, the computer and electronic
retail sector had a compound annual
growth rate (CAGR) of 6.3% for the
period 2004-2008.
That figure is
forecasted to drop to 4.5% over 20082013.
Two-Stage Discounted Cash Flow Model
Assumptions
•
Cost of Equity = 12% (using CAPM)
•
Market Value of Equity = $11.989B
•
Pretax Cost of Debt = 8%
•
WACC = 11.4%
•
5 year short-term growth = 8%; Long-term growth = 3%
Model Analysis
Cost of Equity was determined using CAPM, which gave a required return of 12%.
Next, the Market Value of Equity was determined as of February 2009, which came
out to $11.989B. We used 02/2009 because that is the date of the most recent 10K.
Using the Book Value of Debt from the same time frame, WACC came out to be
11.4%. Best Buy has experienced an average growth in sales over the past four years
of 13%. By comparing the calculated Free Cash Flow to Equity to Sales for the
previous four years, FCFE was consistently around 4% of Sales. It is our belief that
Best Buy cannot grow sales at 13% for the next five years, so we used a more
reasonable 8% growth rate. Based on projected sales, we grew out FCFE at 4% of
sales. Once FCFE was forecasted for 5 years, the Terminal Value needed to be
determined using the perpetuity growth rate of 3%. Terminal Value was found taking
the FCFE for year 6 and dividing it by the difference of WACC and the perpetuity
growth rate. After discounting the five-year FCFE forecast and the Terminal Value
forecast, we arrived at an intrinsic value of Best Buy at $60.21.
The reason our company used a DCF model is because Best Buy showed consistent,
positive Free Cash Flows. FCFE was used because Best Buy has a stable capital
structure with consistent debt. FCFE also showed consistent growth for the past four
years when compared to Net Sales, so we felt it was appropriate to grow this and use
it as our indicator of intrinsic value. The outer five years was grown at an 8% rate
because we wanted to be conservative with our growth. Knowing that even 8% was
unsustainable, we decided to use a two-stage, so that we could grow the Terminal
Value at a more reasonable rate, which we assumed to be fair at 3%.
ACCOUNTING PRINCIPLES OVERVIEW
Best Buy's accounting policies are not significantly different from its
competitors.
Revenue is recognized when the sales price is fixed or determinable,
collectability is reasonably assured and the customer takes possession of
the merchandise or the service is provided. Revenue is recognized for
store sales when the customer receives and pays for merchandise. For
online sales, revenue is recognized at the time the customer receives the
product. The company sells service contracts as well as extended
warranties that have terms that range from 3 months to 5 years. In
instances where the company is deemed to be the obligor on the
contract, service revenue is recognized in revenue ratably over the term
of the service contract. In instances where the company sells service
contracts or extended warranties on behalf of an unrelated third party,
where it is not deemed to be the obligor, commissions are recognized in
revenue at the time of sale.
Inventory is recorded at the lower of cost using either the average cost or
first-in first-out method or market.
Property and equipment are recorded at cost. Depreciation is computed
using the straight-line method over the estimated useful lives of the
assets. When property is fully depreciated, retired, or disposed of, the
cost and accumulated depreciation are removed from the accounts and
any resulting gain or loss is reflected in the income statement.
The company owns 22 distribution centers, of which 3.2 million square
feet are owned and 7.0 million square feet are leased. Almost all stores
are leased. Out of 1,200 stores, the company owns 24 store locations and
operates 34 stores for which they own the building and the land is leased.
SUMMARY
In conclusion, our firm believes that Best Buy is currently undervalued.
Using the two-stage Dividend Discount model and the two-stage
Discounted Cash Flow model, we calculated intrinsic prices of the
company that are higher than what it was being traded at as of
February 2009.
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