In this article we are going to estimate the intrinsic value of Costco Wholesale Corporation (NASDAQ:COST) by taking the expected future cash flows and discounting them to today’s value. This will be done using the Discounted Cash Flow (DCF) model. 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 still have some burning questions about this type of valuation, take a look at the Simply Wall St analysis 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, so we discount the value of these future cash flows to their estimated value in today’s dollars:
10-year free cash flow (FCF) forecast
|Levered FCF ($, Millions)||US$4.17b||US$4.66b||US$5.99b||US$7.39b||US$8.59b||US$9.47b||US$10.2b||US$10.8b||US$11.3b||US$11.8b|
|Growth Rate Estimate Source||Analyst x10||Analyst x9||Analyst x6||Analyst x5||Analyst x4||Est @ 10.24%||Est @ 7.76%||Est @ 6.03%||Est @ 4.82%||Est @ 3.97%|
|Present Value ($, Millions) Discounted @ 5.8%||US$3.9k||US$4.2k||US$5.1k||US$5.9k||US$6.5k||US$6.8k||US$6.9k||US$6.9k||US$6.8k||US$6.7k|
(“Est” = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$60b
The second stage is also known as Terminal Value, this is the business’s cash flow after the first stage. For a number of reasons a very conservative growth rate is used that cannot exceed that of a country’s GDP growth. In this case we have used the 5-year average of the 10-year government bond yield (2.0%) to estimate future growth. In the same way as with the 10-year ‘growth’ period, we discount future cash flows to today’s value, using a cost of equity of 5.8%.
Terminal Value (TV)= FCF2030 × (1 + g) ÷ (r – g) = US$12b× (1 + 2.0%) ÷ (5.8%– 2.0%) = US$318b
Present Value of Terminal Value (PVTV)= TV / (1 + r)10= US$318b÷ ( 1 + 5.8%)10= US$182b
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 US$242b. To get the intrinsic value per share, we divide this by the total number of shares outstanding. Relative to the current share price of US$385, the company appears a touch undervalued at a 30% 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.
NasdaqGS:COST Discounted Cash Flow June 18th 2021
We would point out that 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 Costco Wholesale 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 5.8%, which is based on a levered beta of 0.800. 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.
Valuation is only one side of the coin in terms of building your investment thesis, and it ideally won’t be the sole piece of analysis you scrutinize for a company. DCF models are not the be-all and end-all of investment valuation. Rather it should be seen as a guide to “what assumptions need to be true for this stock to be under/overvalued?” For example, changes in the company’s cost of equity or the risk free rate can significantly impact the valuation. What is the reason for the share price sitting below the intrinsic value? For Costco Wholesale, there are three fundamental elements you should explore:
- Risks: For instance, we’ve identified 2 warning signs for Costco Wholesale that you should be aware of.
- Management:Have insiders been ramping up their shares to take advantage of the market’s sentiment for COST’s future outlook? Check out our management and board analysis with insights on CEO compensation and governance factors.
- 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 NASDAQGS every day. If you want to find the calculation for other stocks just search here.
This article by Simply Wall St is general in nature. 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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