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Are Investors Undervaluing Loblaw Companies Limited (TSE:L) By 32%?

Key Insights

  • Using the 2 Stage Free Cash Flow to Equity, Loblaw Companies fair value estimate is CA$186

  • Loblaw Companies' CA$126 share price signals that it might be 32% undervalued

  • Our fair value estimate is 36% higher than Loblaw Companies' analyst price target of CA$137

In this article we are going to estimate the intrinsic value of Loblaw Companies Limited (TSE:L) by taking the forecast future cash flows of the company and discounting them back to today's value. This will be done using the Discounted Cash Flow (DCF) model. Before you think you won't be able to understand it, just read on! It's actually much less complex than you'd imagine.

Companies can be valued in a lot of ways, so we would point out that a DCF is not perfect for every situation. For those who are keen learners of equity analysis, the Simply Wall St analysis model here may be something of interest to you.

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Check out our latest analysis for Loblaw Companies

What's The Estimated Valuation?

We use what is known as a 2-stage model, which simply means we have two different periods of growth rates for the company's cash flows. Generally the first stage is higher growth, and the second stage is a lower growth phase. To start off with, we need to estimate the next ten years of cash flows. 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.

A DCF is all about the idea that a dollar in the future is less valuable than a dollar today, and so the sum of these future cash flows is then discounted to today's value:

10-year free cash flow (FCF) forecast

2023

2024

2025

2026

2027

2028

2029

2030

2031

2032

Levered FCF (CA$, Millions)

CA$2.30b

CA$2.46b

CA$3.61b

CA$3.54b

CA$3.45b

CA$3.40b

CA$3.39b

CA$3.40b

CA$3.43b

CA$3.46b

Growth Rate Estimate Source

Analyst x4

Analyst x4

Analyst x1

Analyst x1

Analyst x1

Est @ -1.24%

Est @ -0.34%

Est @ 0.29%

Est @ 0.73%

Est @ 1.04%

Present Value (CA$, Millions) Discounted @ 6.7%

CA$2.2k

CA$2.2k

CA$3.0k

CA$2.7k

CA$2.5k

CA$2.3k

CA$2.2k

CA$2.0k

CA$1.9k

CA$1.8k

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = CA$23b

The second stage is also known as Terminal Value, this is the business's cash flow after the first stage. The Gordon Growth formula is used to calculate Terminal Value at a future annual growth rate equal to the 5-year average of the 10-year government bond yield of 1.8%. We discount the terminal cash flows to today's value at a cost of equity of 6.7%.

Terminal Value (TV)= FCF2032 × (1 + g) ÷ (r – g) = CA$3.5b× (1 + 1.8%) ÷ (6.7%– 1.8%) = CA$71b

Present Value of Terminal Value (PVTV)= TV / (1 + r)10= CA$71b÷ ( 1 + 6.7%)10= CA$37b

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 CA$60b. To get the intrinsic value per share, we divide this by the total number of shares outstanding. Compared to the current share price of CA$126, the company appears quite undervalued at a 32% 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.

dcf
dcf

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 Loblaw Companies 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 6.7%, which is based on a levered beta of 0.836. 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 Loblaw Companies

Strength

  • Earnings growth over the past year exceeded the industry.

  • Debt is well covered by earnings and cashflows.

  • Dividends are covered by earnings and cash flows.

Weakness

  • Earnings growth over the past year is below its 5-year average.

  • Dividend is low compared to the top 25% of dividend payers in the Consumer Retailing market.

Opportunity

  • Annual earnings are forecast to grow for the next 3 years.

  • Trading below our estimate of fair value by more than 20%.

Threat

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

Next Steps:

Valuation is only one side of the coin in terms of building your investment thesis, and it shouldn't be the only metric you look at when researching a company. DCF models are not the be-all and end-all of investment valuation. 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. If a company grows at a different rate, or if its cost of equity or risk free rate changes sharply, the output can look very different. Why is the intrinsic value higher than the current share price? For Loblaw Companies, we've compiled three relevant aspects you should look at:

  1. Risks: You should be aware of the 2 warning signs for Loblaw Companies we've uncovered before considering an investment in the company.

  2. Management:Have insiders been ramping up their shares to take advantage of the market's sentiment for L's future outlook? Check out our management and board analysis with insights on CEO compensation and governance factors.

  3. Other High Quality Alternatives: Do you like a good all-rounder? Explore our interactive list of high quality stocks to get an idea of what else is out there you may be missing!

PS. Simply Wall St updates its DCF calculation for every Canadian stock every day, so if you want to find the intrinsic value of any other stock just search here.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.

This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.

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