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Dollar General

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    Valuation and Analysis of Dollar General as of June 1, 2007

    Ravi Patel [email protected]

    Thai Tran [email protected] Jackee Otieno [email protected]

    Nathan Johnson [email protected] Lauren Kirkland [email protected]

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    Table of Contents

    Executive Summary1

    Overview of Dollar General6 Five Forces Model................................................9

    Rivalry among Existing Firms................................9 Industry Growth.10


    Differentiation and Switching costs13

    Scale Economies and Fixed/Variable Costs..13

    Excess Capacity and Exit Barriers14

    Threat of New Entrants..15

    Economies of Scale.15

    Channels of Distribution and Relationships..16

    Legal Barriers17

    Threat of Substitute products.17

    Buyers willingness to switch17

    Bargaining Power..18

    Bargaining Power of the Customer...............................18

    Switching Cost.18

    Product Cost and Quality..19

    Number of Buyers..19

    Volume per Buyer..19

    Bargaining Power of the Suppliers...20

    Switching Cost...............................................20

    Product Cost and Quality..20

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    Number of Suppliers....20

    Value Chain Analysis...21

    Efficient Production22

    Simpler Product Design.22

    Lower Input Costs....22

    Low-cost Distribution...22

    Minimal Brand Image Cost..23

    Tight Cost Control..23

    Firm Competitive Advantage Analysis....23

    Efficient Production..24

    Simpler Product Design.24

    Lower Input Costs....24

    Low-cost Distribution25

    Minimal Brand Image Cost..25

    Tight Cost Control..25


    Accounting Analysis.......27

    Key Accounting Policies.28

    Degrees of accounting flexibility..30

    Accounting Strategy...32

    Quality of Disclosure..34 Identify Potential Red Flags...44

    Undo Accounting Distortions.45

    Financial Analysis.48

    Trend and Cross Sectional Analysis48

    Financial Ratio Analysis.49

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    Liquidity Ratios..49

    Current Ratio...............................................50

    Acid Test..50

    Quick Asset Ratio.52

    Inventory Turnover...53

    Profitability Ratios...57

    Gross Profit Margin....57 Operating Profit Margin...58

    Net Profit Margin....59

    Asset Turnover.60

    Return on Assets.61

    Return on Equity.62

    Capital Structure Ratios..63

    Debt to Equity..64

    Times Interest Earned.65

    Debt Service Margin.66

    IGR/SGR Ratios67

    Forecasting Financial Statements..70

    Income Statement....70

    Balance Sheet.72

    Statement of Cash Flows..75

    Cost of Capital Estimation.76

    WACC estimation....78

    Valuation analysis.79

    Method of comparables80

    Intrinsic Value Models.85

    Discounted Dividends Model.85

    Free Cash Flow.87

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    Residual Income..88

    Long Run Residual Income...90

    Abnormal Earnings Growth...91


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    Executive Summary

    Investment Recommendation: Overvalued, Sell 6-1-07

    DG----NYSE (6/1/07) $21.63 EPS Forecast 52 Week Range $12.10-$21.85 2008 2009 2010 2011 2012 Revenue (2/2/07) $9,169,822 .44 .46 .48 .50 .55 Market Capitalization $6.86 Bill Shares Outstanding 314.88 Mill Ratio comp. DG DLTR FDO 3-Month Avg. Daily Trading Volume: Trailing P/E 9.53 22.19 22.75 Institutional Ownership 66% Forward P/E 7.62 17.78 18.98 Book Value per Share $5.706 PEG .065 1.27 1.61 ROE: 20% P/B 11.8 3.87 3.95 ROA: 12% Cost of Capital Est. R2 Beta Ke Valuation Estimates: 3-Month .19 1.19 Actual Price (6/1/07): $21.63 6-Month .19 1.19 Trailing P/E $9.57 2-Year .19 1.19 Forward P/E $7.80 5-Year .19 1.19 PEG $2.92 10-Year .18 1.18 P/B $54.00 P/EBITDA $28.24 Ke 12.09% P/FCF $123.39 Kd 5.19% EV/EBITDA $3.54 WACC 10.99% Altman Z-Score Intrinsic Valuations Actual 2003 2004 2005 2006 2007 Discounted Dividend $18.40 7.48 7.88 7.74 6.43 7.33 Free Cash $29.71 Residual Income $3.22 Revised Z-Score 2007: 2.847 LR ROE $7.21 AEG $8.79

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    Recommendation: Sell-Overvalued

    Industry Analysis

    Dollar General was founded in Scottsville, Kentucky in 1939 and was

    originally called J.L. Turner and Son Wholesale, then Turners Department Store,

    and then in 1955 it was converted to Dollar General and did not sell any item

    over $1. Dollar General was the originator of the dollar store concept and in 1968

    it became a publicly traded company. Dollar General is a Fortune 500

    company and the leader in the dollar store segment, with more than 8,000

    stores and $9.2 billion in fiscal 2006 sales (www.dollargeneral.com).

    Dollar General is in the discount retail store industry and focuses on cost

    leadership. Its direct competitors are Family Dollar Stores, Freds Inc., and Dollar

    Tree. In this industry, maintaining low costs are crucial to generating profits,

    since the merchandise is already being sold at a discount and there is such high

    competition between companies. The competition is high due to the threat of

    substitute products: the products being sold are extremely similar, if not identical

    and pose no switching costs to customers.

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    Accounting Analysis

    A major part of analyzing and valuing a firm is analyzing its methods of

    accounting. The information needed to do this can be found in the companys

    annual 10-K report. First the key accounting policies are analyzed to ensure that

    they correspond with the key success factors as defined by the five forces model.

    Then the degree of flexibility allowed by GAAP is determined, as well as the

    actual accounting strategy used by the firm. The quality of disclosure is how

    transparent the companys reports are and how believable their numbers are and

    is determined though screening ratios. These ratios alert us of any red flags in

    their accounting, and finally any distortions found are corrected to show the

    company more accurately.

    After our analysis, the only area in which Dollar General uses flexibility is

    in the reporting of leases, which is allowed by GAAP, but greatly alters their

    financial statements. While the footnotes were very clear in disclosing

    information, the consolidation of the financial statements makes it difficult to

    actually see what they are disclosing. After computing all of the revenue and

    expense manipulation ratios we did not find any red flags so the only distortion

    to undo was the reporting of the leases.

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    Ratio Analysis, Forecast Financials, & Cost of Capital


    Ratio analysis is done to evaluate a company and to find out how it ranks

    with its competitors. There are three sets of ratios used in this part of the

    analysis; liquidity ratios, profitability ratios, and capital structure ratios. All the

    information needed to compute these can be found in a companys financial

    statements. In our analysis of the past five years, Dollar General has performed

    about average with the industry and in a few cases has out-performed the

    industry. Once these ratios have been calculated they can be used to forecast

    the companys future performance. By using the CAPM model, a Beta for the

    company can be estimated; then using the estimated Beta, the companies

    estimated cost of equity can be determined through regression analysis. Finally

    the estimated cost of equity can be computed by using the WACC formula.


    The main focus for valuation models are to show whether the companies

    estimated value is worth what the market implies. To derive such prices, you

    must estimate the firms cost of capital and equity, the growth rate, and the

    WACC and use them to determine how well the companys stock is priced. There

    are five different valuation models the discounted dividends, free cash flows,

    residual income, long-run residual income, and the abnormal growth earnings.

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    These models use different factors in deriving the estimated share price, in which

    some are more accurate than others.

    We began with the method of comparables, which uses the current

    financials of Dollar General and also the financials of industry competitors. This

    method includes using the P/B ratio, PEG ratio, DPS, and trailing/forecasted P/E

    ratio. We believe this is a good benchmark to where firms should stand when

    compared to the industry.

    For our valuation models, we based our valuations using our ten

    year forecasted financials. The models indicated that Dollar General is highly

    overvalued compared to our intrinsic valuations. The free cash flow model

    shows that Dollar General is undervalued; we believe this valuation is doubtful

    based on the uncertainty of our forecasted cash flow. After using all five models,

    our overall decision is that Dollar General is highly overvalued and investors

    should sell.

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