What’s the value?
I use what is known as a 2-stage model, which simply means we have two different periods of varying growth rates for the company’s cash flows. Generally the first stage is higher growth, and the second stage is a more stable growth phase. To start off with we need to estimate the next five years of cash flows. For this I used the consensus of the analysts covering the stock, as you can see below. I then discount the sum of these cash flows to arrive at a present value estimate.
5-year cash flow forecast
| 2018 | 2019 | 2020 | 2021 | 2022 | |
| Levered FCF ($, Millions) | $2.55k | $2.77k | $3.44k | $3.78k | $4.15k |
| Source | Analyst x8 | Analyst x9 | Analyst x3 | Analyst x3 | Analyst x3 |
| Present Value Discounted @ 8.59% | $2.35k | $2.35k | $2.68k | $2.72k | $2.75k |
Present Value of 5-year Cash Flow (PVCF)= $12.85k
We now need to calculate the Terminal Value, which accounts for all the future cash flows after the five years. For a number of reasons a very conservative growth rate is used that cannot exceed that of the GDP. In this case I have used the 10-year government bond rate (2.9%). In the same way as with the 5-year ‘growth’ period, we discount this to today’s value at a cost of equity of 8.6%.
Terminal Value (TV) = FCF2022 × (1 + g) ÷ (r – g) = $4.15k × (1 + 2.9%) ÷ (8.6% – 2.9%) = $75.70k
Present Value of Terminal Value (PVTV) = TV / (1 + r)5 = $75.70k / ( 1 + 8.6%)5 = $50.14k
The total value is the sum of cash flows for the next five years and the discounted terminal value, which results in the Total Equity Value, which in this case is $62.99k. In the final step we divide the equity value by the number of shares outstanding. If the stock is an depositary receipt (represents a specified number of shares in a foreign corporation) or ADR then we use the equivalent number. This results in an intrinsic value of $143.61. Relative to the current share price of $202.57, the stock is quite expensive and not available at a discount at this time.
Important assumptions
I’d like to point out that the most important inputs to a discounted cash flow are the discount rate and of course the actual cash flows. You don’t have to agree with my inputs, I recommend redoing the calculations yourself and playing with them. Because 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 weighed average cost of capital, WACC) which accounts for debt. In this calculation I’ve used 8.6%, which is based on a levered beta of 0.800. This is derived from the Bottom-Up Beta method based on comparable companies, with an imposed limit between 0.8 and 2.0, which is a reasonable range for a stable business.
Next Steps:
Valuation is only one side of the coin in terms of building your investment thesis, and it shouldn’t be the only metric you look at when researching a company. What is the reason for the share price to differ from the intrinsic value? For COST, there are three fundamental factors you should look at:
- Financial Health: Does COST have a healthy balance sheet? Take a look at our free balance sheet analysis with six simple checks on key factors like leverage and risk.
- Future Earnings: How does COST’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.
- Other High Quality Alternatives: Are there other high quality stocks you could be holding instead of COST? Explore our interactive list of high quality stocks to get an idea of what else is out there you may be missing!
PS. Simply Wall St does a DCF calculation for every US stock every 6 hours, so if you want to find the intrinsic value of any other stock just search here.