Woolworths Group Limited (ASX:WOW) Shares Could Be 33% Below Their Intrinsic Value Estimate

In this article we are going to estimate the intrinsic value of Woolworths Group Limited (ASX:WOW) by taking the forecast future cash flows of the company and discounting them back to today's value. Our analysis will employ the Discounted Cash Flow (DCF) model. Believe it or not, it's not too difficult to follow, as you'll see from our example!

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 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.

Check out our latest analysis for Woolworths Group

Is Woolworths Group fairly valued?

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, so we discount the value of these future cash flows to their estimated value in today's dollars:

10-year free cash flow (FCF) estimate

	2022	2023	2024	2025	2026	2027	2028	2029	2030	2031
Levered FCF (A$, Millions)	AU$1.42b	AU$1.83b	AU$2.06b	AU$2.23b	AU$2.37b	AU$2.49b	AU$2.59b	AU$2.68b	AU$2.75b	AU$2.83b
Growth Rate Estimate Source	Analyst x2	Analyst x3	Analyst x3	Est @ 8.3%	Est @ 6.35%	Est @ 4.98%	Est @ 4.03%	Est @ 3.36%	Est @ 2.89%	Est @ 2.56%
Present Value (A$, Millions) Discounted @ 5.2%	AU$1.3k	AU$1.6k	AU$1.8k	AU$1.8k	AU$1.8k	AU$1.8k	AU$1.8k	AU$1.8k	AU$1.7k	AU$1.7k

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = AU$17b

We now need to calculate the Terminal Value, which accounts for all the future cash flows after this ten year period. 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 (1.8%) 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 5.2%.

Terminal Value (TV)= FCF₂₀₃₁ × (1 + g) ÷ (r – g) = AU$2.8b× (1 + 1.8%) ÷ (5.2%– 1.8%) = AU$84b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= AU$84b÷ ( 1 + 5.2%)¹⁰= AU$51b

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 AU$68b. The last step is to then divide the equity value by the number of shares outstanding. Compared to the current share price of AU$37.8, the company appears quite good value at a 33% discount to where the stock price trades currently. The assumptions in any calculation have a big impact on the valuation, so it is better to view this as a rough estimate, not precise down to the last cent.

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 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 5.2%, which is based on a levered beta of 0.807. 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.

Looking Ahead:

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. 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. Can we work out why the company is trading at a discount to intrinsic value? For Woolworths Group, there are three additional elements you should assess:

1. Risks: Take risks, for example - Woolworths Group has 3 warning signs (and 1 which is a bit unpleasant) we think you should know about.
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 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.