Is there an opportunity with the 22% undervaluation of Costco Wholesale Corporation (NASDAQ: COST)?
In this article, we’ll estimate the intrinsic value of Costco Wholesale Corporation (NASDAQ: COST) by taking expected future cash flows and discounting them to their present value. To this end, we will take advantage of the Discounted Cash Flow (DCF) model. Believe it or not, it’s not too hard to follow, as you will see in our example!
There are many ways that businesses can be assessed, so we would like to point out that a DCF is not perfect for all situations. If you still have burning questions about this type of valuation, take a look at the Simply Wall St.
Is Costco Wholesale properly valued?
We use the 2-step growth model, which simply means that we take into account two stages of business growth. During the initial period, the business can have a higher growth rate, and the second stage is usually assumed to have a stable growth rate. To begin with, we need to get cash flow estimates for the next ten years. Where possible, we use analyst estimates, but when these are not available, we extrapolate the previous free cash flow (FCF) from the last estimate or stated value. We assume that companies with decreasing free cash flow will slow their rate of contraction, and companies with increasing free cash flow will see their growth rate slow during this period. We do this to reflect the fact that growth tends to slow down more in the early years than in subsequent years.
A DCF is based on the idea that a dollar in the future is worth less than a dollar today, so we need to discount the sum of these future cash flows to arrive at an estimate of the present value:
10-year Free Cash Flow (FCF) estimate
2022 | 2023 | 2024 | 2025 | 2026 | 2027 | 2028 | 2029 | 2030 | 2031 | |
Leverage FCF ($, Millions) | 4.79 billion US dollars | 5.81 billion US dollars | 6.89 billion US dollars | US $ 8.13 billion | US $ 9.92 billion | US $ 11.2 billion | US $ 12.3 billion | US $ 13.2 billion | US $ 13.9 billion | US $ 14.6 billion |
Source of estimated growth rate | Analyst x9 | Analyst x8 | Analyst x5 | Analyst x3 | Analyst x2 | Est @ 12.95% | East @ 9.65% | East @ 7.35% | Est @ 5.73% | East @ 4.6% |
Present value (in millions of dollars) discounted at 5.5% | $ 4.5,000 | US $ 5.2k | US $ 5.9,000 | US $ 6.6k | $ 7.6,000 | US $ 8.1,000 | 8.5,000 USD | US $ 8.6k | US $ 8.6k | US $ 8.6k |
(“East” = FCF growth rate estimated by Simply Wall St)
10-year present value of cash flows (PVCF) = US $ 72 billion
We now need to calculate the Terminal Value, which takes into account all 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 used the 5-year average of the 10-year government bond yield (2.0%) to estimate future growth. Similar to the 10-year “growth” period, we discount future cash flows to their present value, using a cost of equity of 5.5%.
Terminal value (TV)= FCF_{2031} × (1 + g) ÷ (r – g) = US $ 15B × (1 + 2.0%) ÷ (5.5% – 2.0%) = US $ 425B
Present value of terminal value (PVTV)= TV / (1 + r)^{ten}= US $ 425 billion ÷ (1 + 5.5%)^{ten}= US $ 249 billion
The total value is the sum of the cash flows for the next ten years plus the final present value, which gives the total value of equity, which in this case is $ 322 billion. To get the intrinsic value per share, we divide it by the total number of shares outstanding. From the current share price of US $ 568, the company appears to be slightly undervalued at a 22% discount from the current share price. Remember, however, that this is only a rough estimate, and like any complex formula – trash in, trash out.
NasdaqGS: COST Discounted Cash Flow December 30, 2021
Important assumptions
The above calculation is very dependent on two assumptions. One is the discount rate and the other is the cash flow. You don’t have to agree with these entries, I recommend that you redo the calculations yourself and play around with them. The DCF also does not take into account the possible cyclicality of an industry or the future capital needs of a company, so it does not give a full picture of a company’s potential performance. Since we view Costco Wholesale as a potential shareholder, the cost of equity is used as the discount rate, rather than the cost of capital (or weighted average cost of capital, WACC) which takes into account debt. In this calculation, we have used 5.5%, which is based on a leverage beta of 0.800. Beta is a measure of the volatility of a stock relative to the market as a whole. We get our beta from the industry average beta from globally comparable companies, with an imposed limit between 0.8 and 2.0, which is a reasonable range for a stable business.
Next steps:
While important, calculating DCF ideally won’t be the only piece of analysis you’ll look at for a business. The DCF model is not a perfect equity valuation tool. Instead, the best use of a DCF model is to test certain assumptions and theories to see if they would lead to undervaluation or overvaluation of the company. For example, if the terminal value growth rate is adjusted slightly, it can dramatically change the overall result. Why is intrinsic value greater than the current share price? For Costco Wholesale, we’ve compiled three more things you should dig into:
- Risks: As an example, we have found 1 warning sign for Costco Wholesale that you need to consider before investing here.
- Management: Have insiders increased their stocks to take advantage of market sentiment about COST’s future prospects? Check out our management and board analysis with information on CEO compensation and governance factors.
- Other strong companies: 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 trading fundamentals to see if there are other companies you may not have considered!
PS. The Simply Wall St app performs a daily discounted cash flow assessment for each NASDAQGS share. If you want to find the calculation for other actions, just search here.
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This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts using only 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 into account your goals or your financial situation. Our aim is to bring you long-term, targeted analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price sensitive companies or qualitative documents. Simply Wall St has no position in any of the stocks mentioned.
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