A Look At The Fair Value Of Woolworths Group Limited (ASX:WOW)

Key Insights

• Woolworths Group's estimated fair value is AU$28.57 based on 2 Stage Free Cash Flow to Equity

• Current share price of AU$32.47 suggests Woolworths Group is potentially trading close to its fair value

• The AU$35.46 analyst price target for WOW is 24% more than our estimate of fair value

Today we'll do a simple run through of a valuation method used to estimate the attractiveness of Woolworths Group Limited (ASX:WOW) as an investment opportunity by taking the expected future cash flows and discounting them to their present value. We will take advantage of the Discounted Cash Flow (DCF) model for this purpose. Believe it or not, it's not too difficult to follow, as you'll see from our example!

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. If you want to learn more about discounted cash flow, the rationale behind this calculation can be read in detail in the Simply Wall St analysis model.

View our latest analysis for Woolworths Group

The Model

We are going to use a two-stage DCF model, which, as the name states, takes into account two stages of growth. The first stage is generally a higher growth period which levels off heading towards the terminal value, captured in the second 'steady growth' period. 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.

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) estimate

	2024	2025	2026	2027	2028	2029	2030	2031	2032	2033
Levered FCF (A$, Millions)	AU$1.90b	AU$2.48b	AU$2.68b	AU$1.73b	AU$1.79b	AU$1.62b	AU$1.53b	AU$1.48b	AU$1.45b	AU$1.45b
Growth Rate Estimate Source	Analyst x3	Analyst x3	Analyst x3	Analyst x1	Analyst x1	Est @ -9.13%	Est @ -5.74%	Est @ -3.37%	Est @ -1.71%	Est @ -0.55%
Present Value (A$, Millions) Discounted @ 6.0%	AU$1.8k	AU$2.2k	AU$2.2k	AU$1.4k	AU$1.3k	AU$1.1k	AU$1.0k	AU$925	AU$858	AU$804

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

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. 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 2.2%. 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) = AU$1.4b× (1 + 2.2%) ÷ (6.0%– 2.2%) = AU$38b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= AU$38b÷ ( 1 + 6.0%)¹⁰= AU$21b

The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is AU$35b. To get the intrinsic value per share, we divide this by the total number of shares outstanding. Compared to the current share price of AU$32.5, 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

Important Assumptions

The calculation above is very dependent on two assumptions. The first is the discount rate and the other is the 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 Woolworths Group 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 0.843. 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 Woolworths Group

Strength

• Debt is well covered by cash flow.

Weakness

• Interest payments on debt are not well covered.

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

Opportunity

• Expected to breakeven next year.

• Has sufficient cash runway for more than 3 years based on current free cash flows.

• Good value based on P/S ratio compared to estimated Fair P/S ratio.

Threat

• Paying a dividend but company is unprofitable.

Next Steps:

Although the valuation of a company is important, it is only one of many factors that you need to assess for a company. The DCF model is not a perfect stock valuation tool. Preferably you'd apply different cases and assumptions and see how they would impact the company's valuation. 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. For Woolworths Group, we've put together three additional elements you should explore:

1. Risks: You should be aware of the 2 warning signs for Woolworths Group (1 is concerning!) we've uncovered before considering an investment in the company.

2. Future Earnings: How does WOW'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 ASX every day. If you want to find the calculation for other stocks 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.