A valuation of Dollar General
Last time we went through our first detailed step in the valuation process. Using Madison Square Garden Sports (MSGS) as an example we valued the assets of the business. We then compared that to the stock price. After doing that we came to the conclusion that the assets of MSGS were worth more than twice the stock price. We wouldn’t necessarily stop there. In our MSGS example we would continue to update that information as time goes on. At the point in time where MSGS stock reflects the value of the assets we might want to continue to own MSGS as a going concern or move on. Before buying or selling the stock we would do step 2 of our valuation model.
The 2nd step of the valuation process using our Columbia Business School model is Earnings Power Value or EPV. Understand that when we use earnings we are not using the numbers right off the financial statements. That earnings number that everyone talks about has a lot of noise in it. In other words there are all kinds of adjustments we make to that number. We are in essence converting our earnings number to free cash flow. We want to know the actual cash that the business generates. Earnings is just an accounting number. It’s probably easiest to use actual numbers so lets begin with our Dollar General example.
We have followed Dollar General for well over 20 years. In fact we have done valuations of the business on at least 6 different occasions but never got the chance to buy the stock at a discount. We’ve always felt that the stock price fully reflected the value of the business. We like the monopoly like characteristics of their stores most of which are located in communities that have little if any alternatives for shopping. Recently the company has had some challenges which sent the stock price stumbling and incented us to update our work and take another look.
Even as the stock price of DG fell 70% sales were still growing. In 2025 revenue grew about 5% to $41B annually. DG’s gross profit margins have been fairly stable at around 30%. As we move down the income statement one important metric is operating margin.
Operating margin is percentage of profit after cost of goods sold and all administrative and selling costs. This is identified on the financial statements as SG&A.
DG’s operating margins over the last couple of decades has been around 10%. However recently the company has incurred some problems that we believe are quite fixable. Operating margins fell from 10% to around 3-4% in 2024. 1-2% of this loss was due to shrink. Shrink is loss from theft due to self checkout and other management failures. Those are being addressed and it’s quite conceivable that margins will recover maybe not to the peak 10%, but 8% looks to be quite doable.
Multiplying gross revenue times our operating margin gives us operating income. So $41B times 8% gives us $3.28B in operating income. But that’s not all. Dollar General has around $900m a year in depreciation. in our valuation our goad is to isolate sustainable net operating profit. A small part of that depreciation is for growth of new stores. They bear no relation to the stores already operating. So in order to do that we would add back the part of depreciation that is for growth. It would be small but it is relevant. From my experience this would be around $200M.
We would also examine other expenditures that are written off in the current year but actually will create income in future years. Research and development expenses would be an example. These are just a couple of the handful of adjustments we would make to get to Sustainable net operating profit after tax (NOPAT). Companies like Meta and Google have large R&D expenses but for Dollar General these numbers aren’t relevant.
So we would add back $200M in depreciation to get to $3.5B in operating income. Subtract 20% for taxes get us to $2.8B in sustainable net operating profit after tax, (NOPAT).
From here we apply a discount rate or our cost of capital. Think of this as a required minimum rate of return. For a higher risk investment we might apply a higher required rate of return. For a stock many use the risk free rate plus a couple of percent for the risk of buying stock. So, for example today the risk free rate is 4.25%. That is what you would get from a risk free long term Treasury. Most companies know their cost of capital. It is their weighted cost of debt plus their weighted cost of equity. Dollar General is a lower risk business so a cost of equity of 7.5% seems reasonable. Applying the cost of capital rate gives us a valuation of the entire company. Our NOPAT divided by 7.5% gives us an Earniings Power Value of $37.33B.
To isolate the value of the equity we would subtract cash and add back debt. This gives us an EV or enterprise value of $32,633B (37.3+1B cash – 5.7B debt). if we divide this value by 220M shares gives us a value of $150 a share.
That’s todays value. The interesting thing about DG is that it’s profitably growing. I’ve done this valuation every year for at least 10 years and the numbers just continue to go up. But looking at it’s growth I believe it will take about a decade for its growth under the current system to stop. When we apply a conservative growth rate for the next 5 years and a return in margins to normal we get a valuation more than double the current stock price.
So we’ve calculated the value to replicate Dollar General’s assets. We’ve computed the Earnings Power Value which exceeds todays stock price and also exceeds the asset value. This tells us we have a business that has profitable growth or what we call franchise value.
Finding a business with franchise value is the key to long term compounding. In order to have value in the franchise we have to have a business with some sort of competitive advantage. Buffett called this a competitive moat.
Dollar General
Replication value of DG’s assets $ 100 a share
Earnings Power Value 150 a share
Stock price $ 110 a share
Stock is at a discount to EPV. Further EPV>Asset value indicating a profitable business with a competitive advantage. This tells us growth can add value. Further research is needed to assess sources and sustainability of competitive advantages.
in our next article we will discuss franchise value and sources of competitive advantages.
At CSH Investment Management we are professional investors. We invest all our own money alongside our clients. If your not getting this type of analysis from your “investment guy” and want a higher level of analysis and learn about investing principles along the way give us a try.
C Steve Henry