Disney Stock: Time to Revisit Valuation
Disney may be a cash cow, but that doesn't mean its growth has slowed. Excluding items that affect comparability, EPS for the company's second quarter of 2013 increased 36% from the year-ago quarter. That is an impressive number for a company that has been publicly traded for more than five decades. But with shares nearly doubling the return of the S&P 500 in the trailing 12 months, it's time to revisit its valuation.
Riding the recovery
In any valuation, it's important to play the role of devil's advocate, especially when you're facing meaningful, double-digit growth rates. In that spirit, it's useful to keep in mind that Disney is not immune to tough times. When consumers face tough times, so does Disney.
Case in point, Disney's operating margin and free cash flow during the recession.
On the other hand, of course, this means that Disney benefits enormously when consumers begin to open up their wallets. During the recovery from the recession, Disney has improved both its operating margin and its free cash flow.
With this in mind, it's reasonable to expect Disney's growth rates in important metrics like EPS, free cash flow, and operating margin to decelerate in the future.
Let's cut through the gibberish. Forget earnings. Forget revenue. We should be looking at free cash flow. Free cash flow is our best friend. It's the cold, hard cash after all expenses are covered and capital expenditures are made. It's the cash used to build shareholder value by paying out dividends and repurchasing shares or to stash away for future capital expenditures.
Though Disney's free cash flow is notably at an all-time high, it's only 3.6% higher than the $4.8 billion it generated in 2006. In other words, when we examine Disney's free cash flow, there really is no major growth trend that resembles the 36% EPS growth the company achieved in its second quarter.
In fact, over the past 10 years, Disney has averaged a compound growth rate in free cash flow of just 10.3%.
Disney's stock price isn't reflective of a stock that's grown free cash flow at just 10% per annum over the past five years. To understand the market's enthusiasm about the stock, investors need to recognize the power of the company's acquisitions.
Between 2003 and 2007, Disney's net acquisitions reported on the cash flow statement amounted to $155 million per year, on average on acquisitions. During the next five years, the company's net acquisitions per year increased to $838 million. Finally, during the trailing 12 months alone, Disney's reported net acquisitions equals $2.3 billion.
And contrary to the doubtful attitudes investors often have toward Wall Street acquisitions, the market seems to nod in agreement with most of Disney's major acquisitions. In 2006, Disney acquired Pixar Animation Studios for $7.4 billion. Then, in 2009, Disney acquired Marvel Entertainment for $4.24 billion. And in 2012, Disney snapped up Lucasfilm and the Star Wars franchise for $4.05 billion. Pixar and Marvel are already paying off handsomely for Disney, and the Lucasfilm acquisition will likely too. These acquisitions come with powerful intangible assets that will add value to Disney for years to come.
And then there is ESPN, which accounts for approximately 65% of Disney's operating profit each year. The segment continues to hold dominant positions in both college and pro football -- both central to the success of sports programming. Even better news, no formidable competitor to ESPN has yet made headways significant enough to worry Disney investors.
A conservative estimate
Given these growth drivers, it wouldn't be fair to estimate future free cash flow growth in line with historical estimates. Massive spending on acquisitions that are arguably great investments has weighed on free cash flow. But in the future, they should pay off handsomely.
Analysts' average estimate for 12.4% EPS growth per annum for the next five years seems to reflect reasonably realistic assumptions for this stalwart. Applying this to the company's current levels of free cash flow, with expectations for this growth rate to inevitably slow over time, a likely scenario for Disney's free cash flow growth rates over the next 10 years, could look like this:
Using a 10% discount rate, a discounted cash flow valuation suggests that Disney shares are fairly valued at $68.50. In other words, at a price of about $63, the stock has a nearly 9% margin of safety.
Though a 9% margin of safety isn't substantial, it's not bad for a well-diversified media powerhouse with a handful of influential franchises that will likely contribute annuity, like operating income, for years to come.
Can I count on a discounted cash flow valuation?
No, but it's a starting point that gives us an objective look at the stock. For long-term investors, Disney stock is priced conservatively enough to at least earn a spot on their watchlist and possibly merit a deeper look. But long term is the key word here -- especially given the business's reliance on consumers. Another recession could send investors on a scary roller-coaster ride.
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The article Disney Stock: Time to Revisit Valuation originally appeared on Fool.com.Fool contributor Daniel Sparks has no position in any stocks mentioned. The Motley Fool recommends and owns shares of Walt Disney. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.
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