Target Corp (NYSE:TGT) stock deserves a much higher valuation despite its 84% rise over this past year. In fact, even year-to-date, TGT stock is up more than 18% as of April 20, when it reached $207.27.
Moreover, as it has better free cash flow (FCF) margins than Walmart (NYSE:WMT), Target should be at a much higher price. I believe that TGT is worth $300 or 45% more than the April 20 price. This is based on both its higher FCF margins and also Walmart’s higher FCF yield valuation.
For example, in the 12 months to January 2021, the discount retailer generated $7.876 billion in FCF. With its sales of $93.56 billion, its FCF margin was 8.42%.
By comparison, Walmart made $25.81 billion in FCF over its last 12 months to January 2021, according to Seeking Alpha‘s figures). Compared to its sales of $559.15 billion, its FCF margin was just 4.61%.
In other words, Target’s FCF margins were almost twice as high as Walmart’s (8.42% versus 4.6%).
This should make all the difference in the valuation of TGT stock compared to WMT stock. But, still, it doesn’t. I pointed out this discrepancy in my article on Target last August. Since then TGT stock has risen 53.7% from Aug. 13 when it was at $134.81 per share. And this undervaluation is still there even though WMT stock has only climbed some 6% during that period.
What Target Stock Is Worth
Target has a market capitalization of $104.04 billion as of April 20. Since it made $7.876 billion in FCF in the last 12 months, its FCF yield is 7.57%.
This is much higher than Walmart’s FCF yield. This means Target has a lower valuation than Walmart.
Walmart’s FCF of $25.81 billion divided by its market cap of $393.57 billion makes an FCF yield of 6.558%. This means Walmart has a higher valuation than Target.
Another way to see this is to take the inverse of the FCF yield. To take the inverse of any number you divide 1 by the number. Here, we divide 1 by Target’s FCF yield (i.e., 1/0.0757). The result is 13.21, which represents Target’s price-to-FCF.
Doing the same for Walmart’s 6.558% FCF yield results in an FCF multiple of 15.25 times (i.e., 1 / 0.06558). In other words, WMT stock has a higher price-to-FCF multiple (i.e., Walmart’s 15.25 ratio > Target’s 13.21 ratio). This is the same thing, only inverted, as saying Walmart has a lower FCF yield. The net result is that WMT stock is 15.4% more highly valued than TGT stock (i.e., 15.25 / 13.21-1 =15.4%).
That implies that if we multiply Target’s FCF of $7.876 billion by Walmart’s price-to-FCF multiple of 15.25 we can derive its inherent value. That results in a market cap of $120.1 billion. This is 15.4% higher than its market value April 20 of $104.04 billion. It also means TGT stock should be 15.4% higher, or $239.19.
But that is not sufficient. We are simply looking back. The market looks forward. For example, according to Seeking Alpha, 2022 sales are forecast to be $95.54 billion. Using its 8.42% FCF margin, FCF for 2022 (year ending January 2023) will be $8.045 billion.
Then using WMT stock’s 15.25 price-to-FCF, Target should have a market cap of $122.67 billion. That implies a 17.9% higher stock price, or $244.39 per share.
What to Do With TGT Stock
But wait, there’s more. Remember that this price target is $244.39 just sets Target at parity with Walmart, in terms of its FCF yield, (or by inverse, its price-to-FCF multiple).
But, I showed above that we can expect that Target will make much more in FCF for every dollar in sales than Walmart will. Its 8.4% FCF margin is 83% higher than Walmart’s 4.6% FCF margins.
Granted, Walmart has more than three times the sales as Target. So, a fair valuation adjustment would be to take at least half of that 83% higher margin and apply it to the Target stock price.
As we know that $244.39 is a baseline with equal valuation, we can then multiply this by 1 plus half of 83% (i.e., $244.39 x 1.415). That results in a final price target of $345.81 for Target. This is 66.9% higher than the price of $207.21.
Even if it takes two years for TGT stock to rise to the final price target of $345.81, the average annual return will be 29.2% each year. That represents a very good return for most investors in Target stock.
On the date of publication, Mark R. Hake does not hold a long or short position in any security mentioned in this article.