Estimating The Intrinsic Value Of Wesfarmers Limited (ASX:WES)

Does the September share price for Wesfarmers Limited (ASX:WES) reflect what it's really worth? Today, we will estimate the stock's intrinsic value by taking the expected future cash flows and discounting them to their present value. The Discounted Cash Flow (DCF) model is the tool we will apply to do this. 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. For those who are keen learners of equity analysis, the Simply Wall St analysis model here may be something of interest to you.

View our latest analysis for Wesfarmers

The Model

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. 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 need to discount the sum of these future cash flows to arrive at a present value estimate:

10-year free cash flow (FCF) forecast

	2023	2024	2025	2026	2027	2028	2029	2030	2031	2032
Levered FCF (A$, Millions)	AU$2.72b	AU$2.48b	AU$2.71b	AU$2.83b	AU$2.50b	AU$2.31b	AU$2.20b	AU$2.14b	AU$2.11b	AU$2.10b
Growth Rate Estimate Source	Analyst x6	Analyst x6	Analyst x6	Analyst x4	Analyst x1	Est @ -7.49%	Est @ -4.69%	Est @ -2.74%	Est @ -1.37%	Est @ -0.41%
Present Value (A$, Millions) Discounted @ 5.4%	AU$2.6k	AU$2.2k	AU$2.3k	AU$2.3k	AU$1.9k	AU$1.7k	AU$1.5k	AU$1.4k	AU$1.3k	AU$1.2k

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = AU$19b

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 1.8%. We discount the terminal cash flows to today's value at a cost of equity of 5.4%.

Terminal Value (TV)= FCF₂₀₃₂ × (1 + g) ÷ (r – g) = AU$2.1b× (1 + 1.8%) ÷ (5.4%– 1.8%) = AU$61b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= AU$61b÷ ( 1 + 5.4%)¹⁰= AU$36b

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$54b. The last step is to then divide the equity value by the number of shares outstanding. Relative to the current share price of AU$46.0, the company appears about fair value at a 4.0% discount to where the stock price trades currently. Remember though, that this is just an approximate valuation, and like any complex formula - garbage in, garbage out.

The Assumptions

Now 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 Wesfarmers 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 5.4%, which is based on a levered beta of 0.835. 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.

Moving On:

Whilst important, the DCF calculation ideally won't be the sole piece of analysis you scrutinize for a company. It's not possible to obtain a foolproof valuation with a DCF model. Instead the best use for a DCF model is to test certain assumptions and theories to see if they would lead to the company being undervalued or overvalued. 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 Wesfarmers, there are three pertinent elements you should further examine:

1. Risks: For example, we've discovered 2 warning signs for Wesfarmers that you should be aware of before investing here.
2. Management:Have insiders been ramping up their shares to take advantage of the market's sentiment for WES's future outlook? Check out our management and board analysis with insights on CEO compensation and governance factors.
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. Simply Wall St updates its DCF calculation for every Australian 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.