A Look At The Fair Value Of Loblaw Companies Limited (TSE:L)

Key Insights

• Using the 2 Stage Free Cash Flow to Equity, Loblaw Companies fair value estimate is CA$134

• With CA$154 share price, Loblaw Companies appears to be trading close to its estimated fair value

• Our fair value estimate is 17% lower than Loblaw Companies' analyst price target of CA$161

Today we'll do a simple run through of a valuation method used to estimate the attractiveness of Loblaw Companies Limited (TSE:L) as an investment opportunity by projecting its future cash flows and then discounting them to today's value. The Discounted Cash Flow (DCF) model is the tool we will apply to do this. 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. If you still have some burning questions about this type of valuation, take a look at the Simply Wall St analysis model.

See our latest analysis for Loblaw Companies

The Method

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. To begin with, we have to get estimates of 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, so we need to discount the sum of these future cash flows to arrive at a present value estimate:

10-year free cash flow (FCF) forecast

	2024	2025	2026	2027	2028	2029	2030	2031	2032	2033
Levered FCF (CA$, Millions)	CA$2.19b	CA$2.29b	CA$2.06b	CA$1.93b	CA$1.85b	CA$1.82b	CA$1.80b	CA$1.80b	CA$1.81b	CA$1.83b
Growth Rate Estimate Source	Analyst x2	Analyst x2	Est @ -9.99%	Est @ -6.37%	Est @ -3.83%	Est @ -2.06%	Est @ -0.82%	Est @ 0.05%	Est @ 0.66%	Est @ 1.09%
Present Value (CA$, Millions) Discounted @ 6.0%	CA$2.1k	CA$2.0k	CA$1.7k	CA$1.5k	CA$1.4k	CA$1.3k	CA$1.2k	CA$1.1k	CA$1.1k	CA$1.0k

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = CA$14b

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 2.1%. We discount the terminal cash flows to today's value at a cost of equity of 6.0%.

Terminal Value (TV)= FCF₂₀₃₃ × (1 + g) ÷ (r – g) = CA$1.8b× (1 + 2.1%) ÷ (6.0%– 2.1%) = CA$48b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= CA$48b÷ ( 1 + 6.0%)¹⁰= CA$26b

The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is CA$41b. In the final step we divide the equity value by the number of shares outstanding. Relative to the current share price of CA$154, the company appears around fair value at the time of writing. 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

The Assumptions

The calculation above is very dependent on two assumptions. The first is the discount rate and the other is the cash flows. Part of investing is coming up with your own evaluation of a company's future performance, so try the calculation yourself and check your own 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 6.0%, which is based on a levered beta of 0.856. 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.

• Expensive based on P/E ratio and estimated fair value.

Opportunity

• L's financial characteristics indicate limited near-term opportunities for shareholders.

Threat

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

Moving On:

Whilst important, the DCF calculation is only one of many factors that you need to assess for a company. The DCF model is not a perfect stock valuation tool. Rather it should be seen as a guide to "what assumptions need to be true for this stock to be under/overvalued?" For instance, if the terminal value growth rate is adjusted slightly, it can dramatically alter the overall result. For Loblaw Companies, we've put together three important factors you should consider:

1. Risks: Be aware that Loblaw Companies is showing 2 warning signs in our investment analysis , and 1 of those makes us a bit uncomfortable...

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.

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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.

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