Key Insights

• Using the 2 Stage Free Cash Flow to Equity, Lululemon Athletica fair value estimate is US$383

• Lululemon Athletica's US$360 share price indicates it is trading at similar levels as its fair value estimate

• The US$466 analyst price target for LULU is 22% more than our estimate of fair value

Today we will run through one way of estimating the intrinsic value of Lululemon Athletica Inc. (NASDAQ:LULU) by estimating the company's future cash flows and discounting them to their present value.  We will take advantage of the Discounted Cash Flow (DCF) model for this purpose.  Don't get put off by the jargon, the math behind it is actually quite straightforward.

We would caution that there are many ways of valuing a company and, like the DCF, each technique has advantages and disadvantages in certain scenarios.  Anyone interested in learning a bit more about intrinsic value should have a read of the Simply Wall St analysis model.

The Calculation

We're using the 2-stage growth model, which simply means we take in account two stages of company's growth. In the initial period the company may have a higher growth rate and the second stage is usually assumed to have a stable growth rate.  In the first stage we need to estimate the cash flows to the business over the next ten years.   Where possible we use analyst estimates, but when these aren't available we extrapolate the previous free cash flow (FCF) from the last estimate or reported value. We assume companies with shrinking free cash flow will slow their rate of shrinkage, and that companies with growing free cash flow will see their growth rate slow, over this period. We do this to reflect that growth tends to slow more in the early years than it does in later years.  

Generally we assume that a dollar today is more valuable than a dollar in the future,  and so the sum of these future cash flows is then discounted to today's value:

10-year free cash flow (FCF) estimate

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$15b

After calculating the present value of future cash flows in the initial 10-year period, we need to calculate the Terminal Value, which accounts for all future cash flows beyond the first stage.  For a number of reasons a very conservative growth rate is used that cannot exceed that of a country's GDP growth. In this case we have used the 5-year average of the 10-year government bond yield (2.3%) to estimate future growth. In the same way as with the 10-year 'growth' period, we discount future cash flows to today's value, using a cost of equity of 7.4%.

Terminal Value (TV)= FCF2033 × (1 + g) ÷ (r – g) = US$3.4b× (1 + 2.3%) ÷ (7.4%– 2.3%) = US$68b

Present Value of Terminal Value (PVTV)= TV / (1 + r)10= US$68b÷ ( 1 + 7.4%)10= US$34b

The total value is the sum of cash flows for the next ten years plus the discounted terminal value, which results in the Total Equity Value,  which in this case is US$48b.  The last step is to then divide the equity value by the number of shares outstanding.  Compared to the current share price of US$360, the company appears   about fair value    at a 5.9% discount to where the stock price trades currently.   Valuations are imprecise instruments though, rather like a telescope - move a few degrees and end up in a different galaxy. Do keep this in mind.

NasdaqGS:LULU Discounted Cash Flow April 26th 2024

Important Assumptions

Now the most important inputs to a discounted cash flow are the discount rate, and of course, the actual cash flows.  If you don't agree with these result, have a go at the calculation yourself and play with the assumptions.  The DCF also does not consider the possible cyclicality of an industry, or a company's future capital requirements, so it does not give a full picture of a company's potential performance.  Given that we are looking at Lululemon Athletica as potential shareholders, the cost of equity is used as the discount rate, rather than the cost of capital (or weighted average cost of capital, WACC) which accounts for debt.  In this calculation we've used 7.4%, which is based on a levered beta of 1.101. Beta is a measure of a stock's volatility, compared to the market as a whole. We get our beta from the industry average beta of globally comparable companies, with an imposed limit between 0.8 and 2.0, which is a reasonable range for a stable business.

SWOT Analysis for Lululemon Athletica

Strength

• Earnings growth over the past year exceeded the industry.

• Currently debt free.

• Balance sheet summary for LULU.

Weakness

• No major weaknesses identified for LULU.

Opportunity

• Annual revenue is forecast to grow faster than the American market.

• Current share price is below our estimate of fair value.

• Significant insider buying over the past 3 months.

Threat

• Annual earnings are forecast to grow slower than the American market.

• What else are analysts forecasting for LULU?

Looking Ahead:

Whilst important, the DCF calculation  ideally won't be the sole piece of analysis you scrutinize for a company.  It's not possible to obtain a foolproof valuation with a DCF model.  Instead the best use for a DCF model is to test certain assumptions and theories to see if they would lead to the company being undervalued or overvalued.  For example, changes in the company's cost of equity or the risk free rate can significantly impact the valuation.  For Lululemon Athletica, we've compiled three  important  aspects  you should further research:

1. Financial Health: Does LULU have a healthy balance sheet? Take a look at our free balance sheet analysis with six simple checks on key factors like leverage and risk.

2. Future Earnings: How does LULU's growth rate compare to its peers and the wider market? Dig deeper into the analyst consensus number for the upcoming years by interacting with our free analyst growth expectation chart.

3. Other Solid Businesses: Low debt, high returns on equity and good past performance are fundamental to a strong business. Why not explore our interactive list of stocks with solid business fundamentals to see if there are other companies you may not have considered!

PS. The Simply Wall St app conducts a discounted cash flow valuation for every stock on the NASDAQGS every day. If you want to find the calculation for other stocks just search here.