A Look at Darden Valuation

Darden Restaurants (DRI, Financial) shares were climbing after the open Monday, along with the market. The stock was up almost a dollar at $89.66 at 11:28 a.m. (ET). The shares reached a one-month high of almost $93 in mid-June but are up about 19% in the past five years. This way, the stock yields 2.5% if the share price stays at current levels.

Dividends have been paid since 1995, which demonstrates Darden's commitment to returning capital to shareholders. Darden has raised its cash dividend in the past. Thanks to GuruFocus we know that during the past 13 years, Darden's highest trailing annual dividend yield was 5.94%, the lowest was 1.02%, and the median was 3.19%.

Nowadays, the dividend yield is close to a five-year low. What makes possible the dividend hike is the solid financial position. Also, Darden's Piotroski F-Score of 7 indicates the company's financial situation is very healthy.

The company is trading at a price-earnings (P/E) ratio of 22.96x, which is ranked higher than
57% of the 235 companies in the Restaurants industry. Moreover, its price is close to a 10-year high, as well as its price-sales (P/S) ratio of 1.6x.

Despite sales falling in the industry, Darden has a well-known brand and good traffic on its locations, achieving higher levels of productivity. In the past, Darden had a track record of being a leader in operating margins, but now it has a minus 6% decline in a five-year period. Certain operating cost reductions should help the company restore profitability.

The past few months, it completes the acquisition of Cheddar's Scratch Kitchen for $780 million from private equity firms L Catterton and Oak Investment Partners. The investment was financed with cash and liabilities in the form of long-term senior notes. Needless to say, Olive Garden and Longhorn Steakhouse have helped the company beat expectations in recent quarters.

Now, let´s try to find the intrinsic value of the stock and compare it with its trading price. The Yahoo (YHOO, Financial) Finance consensus price target is $87, representing a downside potential of 3%. Let´s try to estimate the fair value of Darden. For that purpose I will use the Dividend Discount Model (DDM). In stock valuation models, DDM defines cash flow as the dividends to be received by the shareholders. The model requires forecasting dividends for many periods so we can use some growth models like Gordon (constant) growth model, the Two or Three stage growth model or the H-Model (which is a special case of a two-stage model).

Once the appropriate model has been selected, we can forecast dividends up to the end of the investment horizon where we no longer have confidence in the forecasts and then forecast a terminal value based on some other method, such as a multiple of book value or earnings.

Let´s estimate the inputs for modeling:

First, we need to calculate the different discount rates – i.e., the cost of equity (from CAPM). The capital asset pricing model (CAPM) estimates the required return on equity using the following formula: required return on stock j = risk-free rate + beta of j x equity risk premium

Risk-Free Rate: Rate of return on long-term government debt: RF = 3.03%. I think this is a very low rate. Since 1900, yields have ranged from a little less than 2% to 15%; with an average rate of 4.9%. It is more appropriate to use this rate.

Gordon Growth Model Equity Risk Premium = (1-year forecasted dividend yield on market index) + (consensus long-term earnings growth rate) – (long-term government bond yield) = 2.13% + 11.97% - 2.67% = 11.43%

Beta: From Yahoo! Finance we obtain a β = -0.16

The result given by the CAPM is a cost of equity of: rDRI = RF + βDRI [GGM ERP] = 4.9% + 1.49 [11.43%] = 21.93%

Dividend growth rate (g)

The sustainable growth rate is the rate at which earnings and dividends can grow indefinitely assuming that the firm's debt-to-equity ratio is unchanged, and it doesn´t issue new equity.

g = b x ROE

b = retention rate

ROE = (Net Income)/Equity= ((Net Income)/Sales).(Sales/(Total Assets)).((Total Assets)/Equity)

The “PRAT” Model:

g= ((Net Income-Dividends)/(Net Income)).((Net Income)/Sales).(Sales/(Total Assets)).((Total Assets)/Equity)

Collecting the financial information for the last three years, each ratio was calculated, then to have a better approximation I proceeded to find the three-year average:

Now it is easy to find the g = Retention rate × Profit margin × Asset turnover × Financial leverage = 4.31%

Because for most companies, the GGM is unrealistic, let´s consider the H-Model which assumes a growth rate that starts high and then declines linearly over the high growth stage until it reverts to the long-run rate. In other words, a smoother transition to the mature phase growth rate that is more realistic.

Dividend growth rate (g) implied by Gordon growth model (long-run rate)

With the GGM formula and simple math:

g = (P0.r - D0)/(P0+D0)

= ($89.6 × 3.07% – $2.24) ÷ ($89.6 + $2.24) = 0.56%.

The growth rates are:

G(2), g(3) and g(4) are calculated using linear interpolation between g(1) and g(5).

Now that we have all the inputs, let's discount the cash flows to find the intrinsic value:

Final comment

Intrinsic value is above the trading price by 9% so according to the model and assumptions, the stock is undervalued, especially considering a margin of safety (usually a 20%). However, we must keep in mind that the model is a valuation method and investors should not be relied on alone in order to determine a fair (over/under) value for a potential investment.

Several hedge fund gurus like Jim Simons (Trades, Portfolio), Paul Tudor Jones (Trades, Portfolio) and Steven Cohen (Trades, Portfolio) closed out their positions in the stock. Moreover, Joel Greenblatt (Trades, Portfolio) and Ray Dalio (Trades, Portfolio) also reduced their positions.

Disclosure: Author holds no positions in any stocksmentioned.