【cetme c flat】Calculating The Intrinsic Value Of Costco Wholesale Corporation (NASDAQ:COST)

How far off is cetme c flatCostco Wholesale Corporation (

NASDAQ:COST

) from its intrinsic value? Using the most recent financial data, we'll take a look at whether the stock is fairly priced by taking the expected future cash flows and discounting them to today's value. We will take advantage of the Discounted Cash Flow (DCF) model for this purpose. It may sound complicated, but actually it is quite simple!

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 still have some burning questions about this type of valuation, take a look at the

Simply Wall St analysis model

.

Check out our latest analysis for Costco Wholesale

Step by step through the calculation

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.

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

2021

2022

2023

2024

2025

2026

2027

2028

2029

2030

Levered FCF ($, Millions)

US$4.76b

US$4.79b

US$6.14b

US$7.28b

US$8.26b

US$8.99b

US$9.59b

US$10.1b

US$10.5b

US$10.9b

Growth Rate Estimate Source

Analyst x10

Analyst x9

Analyst x5

Analyst x5

Analyst x4

Est @ 8.76%

Est @ 6.75%

Est @ 5.33%

Est @ 4.35%

Est @ 3.65%

Present Value ($, Millions) Discounted @ 6.2%

US$4.5k

US$4.2k

US$5.1k

US$5.7k

US$6.1k

US$6.3k

US$6.3k

US$6.2k

US$6.1k

US$6.0k

("Est" = FCF growth rate estimated by Simply Wall St)

Present Value of 10-year Cash Flow (PVCF)

= US$57b

After calculating the present value of future cash flows in the initial 10-year period, we need to calculate the Terminal Value, which accounts for all future cash flows beyond the first stage. 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 (2.0%) 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 6.2%.

Story continues

Terminal Value (TV)

= FCF

2030

× (1 + g) ÷ (r – g) = US$11b× (1 + 2.0%) ÷ (6.2%– 2.0%) = US$267b

Present Value of Terminal Value (PVTV)

= TV / (1 + r)

10

= US$267b÷ ( 1 + 6.2%)

10

= US$146b

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 US$202b. To get the intrinsic value per share, we divide this by the total number of shares outstanding. Compared to the current share price of US$377, the company appears about fair value at a 17% 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.

dcf

Important 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. 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 Costco Wholesale 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 6.2%, which is based on a levered beta of 0.800. 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:

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. DCF models are not the be-all and end-all of investment valuation. 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. For Costco Wholesale, we've put together three further items you should further research:

Risks

: Consider for instance, the ever-present spectre of investment risk.

We've identified 2 warning signs

with Costco Wholesale

, and understanding them should be part of your investment process.

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

: 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. Simply Wall St updates its DCF calculation for every American stock every day, so if you want to find the intrinsic value of any other stock just

search here

.

This article by Simply Wall St is general in nature. 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.

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