Estimating The Intrinsic Value Of Coles Group Limited (ASX:COL)

Key Insights

• Coles Group's estimated fair value is AU$21.21 based on 2 Stage Free Cash Flow to Equity
• Current share price of AU$21.44 suggests Coles Group is potentially trading close to its fair value
• Analyst price target for COL is AU$21.17 which is similar to our fair value estimate

Today we will run through one way of estimating the intrinsic value of Coles Group Limited (ASX:COL) 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.

Remember though, that there are many ways to estimate a company's value, and a DCF is just one method. Anyone interested in learning a bit more about intrinsic value should have a read of the Simply Wall St analysis model.

Our free stock report includes 2 warning signs investors should be aware of before investing in Coles Group. Read for free now.

Crunching The Numbers

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.

Generally we assume that a dollar today is more valuable than a dollar in the future, 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

	2025	2026	2027	2028	2029	2030	2031	2032	2033	2034
Levered FCF (A$, Millions)	AU$1.34b	AU$1.44b	AU$1.62b	AU$1.36b	AU$1.34b	AU$1.34b	AU$1.35b	AU$1.37b	AU$1.39b	AU$1.42b
Growth Rate Estimate Source	Analyst x6	Analyst x6	Analyst x6	Analyst x2	Est @ -1.26%	Est @ -0.06%	Est @ 0.78%	Est @ 1.37%	Est @ 1.78%	Est @ 2.07%
Present Value (A$, Millions) Discounted @ 6.8%	AU$1.3k	AU$1.3k	AU$1.3k	AU$1.0k	AU$962	AU$900	AU$849	AU$806	AU$768	AU$733

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = AU$9.9b

We now need to calculate the Terminal Value, which accounts for all the future cash flows after this ten year period. 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 2.7%. We discount the terminal cash flows to today's value at a cost of equity of 6.8%.

Terminal Value (TV)= FCF₂₀₃₄ × (1 + g) ÷ (r – g) = AU$1.4b× (1 + 2.7%) ÷ (6.8%– 2.7%) = AU$36b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= AU$36b÷ ( 1 + 6.8%)¹⁰= AU$18b

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$28b. To get the intrinsic value per share, we divide this by the total number of shares outstanding. Relative to the current share price of AU$21.4, the company appears around fair value at the time of writing. Remember though, that this is just an approximate valuation, and like any complex formula - garbage in, garbage out.

The Assumptions

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 Coles 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 6.8%, which is based on a levered beta of 0.943. 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.

View our latest analysis for Coles Group

SWOT Analysis for Coles Group

Moving On:

Whilst important, the DCF calculation shouldn't be the only metric you look at when researching a company. It's not possible to obtain a foolproof valuation with a DCF model. 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 Coles Group, there are three fundamental aspects you should consider:

1. Risks: Case in point, we've spotted 2 warning signs for Coles Group you should be aware of.
2. Future Earnings: How does COL'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 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. 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.