Dollar General Corp (NYSE: DG) shares currently trade at 15.8x trailing earnings which is lower than the Consumer Discretionary sector median of 18.4x. While this makes DG look like a stock to add to your portfolio, equity investors might change their mind after taking a closer look at the assumptions behind the P/E ratio. In this article, I define how to calculate a P/E multiple and what to keep an eye out for when applying it in a comparable companies analysis.
Dollar General Comparable Companies Analysis
A comparable companies analysis, also known as a multiples valuation, determines the value of a subject company by benchmarking its financial performance against similar public companies or peers. We can conclude if a company looks undervalued or overvalued relative to its peers by comparing metrics like growth, profit margin, and valuation ratios.
A P/E Ratio is a valuation metric that indicates the multiple of earnings investors are willing to pay for one share of a company:
P/E Ratio = Stock Price ÷ Earnings Per Share
The P/E ratio by itself is not very helpful at all. It is only useful when comparing it to other companies that are considered similar to the subject company. The basic idea is that companies with similar characteristics should trade at similar multiples, all other things being equal. Therefore, we can come to a conclusion about the stock if the ratios are different. In the chart below, I compare Dollar General’s P/E ratio to its peer group that includes Target Corporation (NYSE: TGT), Big Lots, Inc. (NYSE: BIG), Dollar Tree, Inc. (NASDAQ: DLTR) and Sears Holdings Corporation (NASDAQ: SHLD).
Since Dollar General’s P/E of 15.8x is higher than the median of its peers (11.3x), it means that investors are paying more than they should for each dollar of DG’s earnings. As such, our analysis shows that DG represents an overvalued stock. In fact, finbox.io’s P/E Multiple Modelcalculates a fair value of roughly $72.50 per share which implies around 21.0% downside.
I selected a fair multiple of 12.5x in my analysis by averaging Dollar General’s current P/E ratio with its peer group.
Are Peers Really Comparable?
Before concluding that Dollar General should be banished from your portfolio, it is important to understand that our conclusion rests on two important assumptions.
(1) the selected peer group actually contains companies that truly are similar to Dollar General, and
(2) the selected peer group stocks are being fairly valued by the market.
If the first assumption is not accurate, the difference in P/E ratios could be due to a variety of factors. For example, if you accidentally compare Dollar General with lower growth companies, then its P/E multiple would naturally be higher than its peers since investors reward high growth stocks with a higher price.
source: P/E model
However, if the second assumption does not hold true, Dollar General’s higher multiple may be because firms in our peer group are being undervalued by the market.
How This Impacts Shareholders
As a shareholder, you may have already conducted fundamental analysis on the stock so its current overvaluation could signal a potential selling opportunity to reduce your exposure to DG. However, keep in mind the limitations of the P/E ratio when making investment decisions. There are a variety of other fundamental factors that I have not taken into consideration in this article. If you have not done so already, I highly recommend that you complete your research on Dollar General by taking a look at the following:
Valuation Metrics: what is Dollar General’s free cash flow yield and how does it compare to its publicly traded peers? This metric measures the amount of free cash flow for each dollar of equity (market capitalization). Analyze the free cash flow yield here.
Risk Metrics: what is Dollar General’s cash ratio which is used to assess a company’s short-term liquidity. View the company’s cash ratio here.
Efficiency Metrics: return on equity is used to measure the return that a firm generates on the book value of common equity. View Dollar General’s return on equity here.
As of this writing, I did not hold a position in any of the aforementioned securities and this is not a buy or sell recommendation on any security mentioned.