Last week Domino’s Pizza Enterprises [ASX:DMP] provided the market with a ‘trading update’.
The share price cratered 30%.
The company said that pre-tax profit would likely come in around $88 million for the six months to 31 December 2023. That’s down 16% on the same period last year.
Prior to the profit warning, the stock traded on a hefty P/E multiple of 40 times expected FY24 earnings.
Hence, there was a savage share price reaction when the news hit that earnings would shrink in FY24…instead of growing as expected.
That begs the question, is Domino’s good value now it’s fallen nearly 50% over the past 12 months? Not to mention its near 80% fall from the COVID mania peaks?
Now, just because a rational assessment suggests the absence of value at these levels doesn’t mean the share price won’t recover from here. Mr Market is prone to all sorts of delusions. Some can last for years.
But if the share price does head north, it will be due to speculative demand and a misplaced idea of what constitutes a ‘growth stock’.
The quality premium
I’ve noticed a theme of late – and the stock price performance of many quality companies confirms this view – that it’s all about earnings growth…and valuations be damned.
In other words, the market is putting a big premium on quality earnings growth…to the point where the future returns from this point look thin indeed.
No one worries about this in a hot market like we’ve had over the past few months. But it leaves investors open to short-term losses should they feel the urge to chase these stocks higher.
Getting back to Domino’s though…
As I said, for many ‘investors’ it’s earnings growth that counts. In Domino’s case, consensus estimates suggest growth will resume in FY25 and FY26, with EPS growth 53% and 25% forecast respectively.
Let’s assume Domino’s experiences no more hiccups and hits these (lofty) growth expectations. What is the company worth?
I focus on return on equity (ROE) as a key valuation metric.
If Domino’s hits consensus forecasts, ROE will come in at 28.3% in FY25 and 31.5% in FY26.
Let’s be generous and assume a 30% sustainable ROE. (However, I view this as unlikely).
But for the purposes of providing an estimate of value, let’s go with it. It’s a very healthy return on equity capital. In this event, you want the company reinvesting the bulk of its earnings back into the business. That way the reinvested earnings compound at a high rate and generate lots of wealth for shareholders.
So is Domino’s doing this?
The answer is no.
In fact, Domino’s pays out around 80% of its earnings as a dividend! It only retains 20% of its earnings.
How is that a growth stock?
A company that has a high ROE and a high dividend payout ratio is a lot less valuable than a company with a high ROE that retains most of its profits.
Common sense tells you that.
With this in mind, I estimate fair value (based on FY25 numbers) at around $29.50 per share.
Yet the current share price is around $40!
And remember, I’m assuming a very optimistic sustainable ROE 30%.
However…there’s one important input I haven’t yet mentioned. The discount rate, or required rate of return. Whenever someone gives you a valuation you absolutely must ask what discount rate they use in their models. It’s one of the most important numbers.
What is the discount rate? This is the return you as an owner of the business require to part with your capital.
The discount rate, at a minimum, should be the ‘risk free rate’ (the usual proxy is the 10-year government bond yield) plus a premium for the risk of investing in equities.
At a minimum I use 8%. But in the case of Domino’s I use 10%.
That’s because I see this is a higher risk proposition relative to other high quality businesses and want compensation for that risk.
The risk I see is not only about the potential to miss growth forecasts.
Poor capital management
It’s just as much about the capital management/capital allocation decisions made over the past few years.
Let me explain…
In 2019, net debt was around $550 million. As at 2 July 2023 ((the last balance sheet date available) it was around $825 million.
(As an aside, included in this are bank loans totalling nearly $1 billion, on an average interest rate of just over 2%. But the loans mature in ‘1-5 years’ (according to the notes buried on page 237 of the annual report). A higher cost of capital is coming for Domino’s.
In 2019, Domino’s had retained earnings of around $200 million. What are ‘retained earnings’? As the name suggests, they represent the portion of earnings that the business ‘retains’ for growth. You can find it at the bottom of the balance sheet.
Retained earnings were $216 million as at 2 July, 2023. That’s growth of just $16 million over four years, or $4 million a year.
Again, how is this a growth company?
Meanwhile, ‘issued capital’ (equity capital raised from issuing new shares) increased from around $200 million in 2019 to $430 million now.
What does all this mean?
Put simply, Domino’s funds its growth by issuing debt and new equity (around $500 million over the past four years) rather than retaining earnings and letting those earnings compound at high rates.
To the rational investor, this makes no sense.
As such, it doesn’t make sense to invest in this enterprise either. The business itself is a sound one. But the capital management policy is poor. Someone should tell them!
My conclusion is that Domino’s isn’t a ‘growth’ company, so it shouldn’t trade on a growth multiple.
Right now, the market doesn’t care for this type of analysis. The company still has robust earnings per share growth, so ‘investors’ are willing to pay a high price for that growth.
Unless something changes on the capital management front, I think they’ll ultimately be disappointed…
