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

Key Insights

• Using the 2 Stage Free Cash Flow to Equity, Wesfarmers fair value estimate is AU$55.96

• With AU$51.83 share price, Wesfarmers appears to be trading close to its estimated fair value

• Our fair value estimate is 12% higher than Wesfarmers' analyst price target of AU$49.99

In this article we are going to estimate the intrinsic value of Wesfarmers Limited (ASX:WES) by taking the forecast future cash flows of the company and discounting them back to today's value. We will use the Discounted Cash Flow (DCF) model on this occasion. 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 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.

View our latest analysis for Wesfarmers

The Method

We are going to use a two-stage DCF model, which, as the name states, takes into account two stages of growth. The first stage is generally a higher growth period which levels off heading towards the terminal value, captured in the second 'steady growth' period. To begin with, we have to get estimates of 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

	2023	2024	2025	2026	2027	2028	2029	2030	2031	2032
Levered FCF (A$, Millions)	AU$2.82b	AU$2.83b	AU$3.09b	AU$3.39b	AU$4.12b	AU$4.50b	AU$4.82b	AU$5.08b	AU$5.31b	AU$5.51b
Growth Rate Estimate Source	Analyst x5	Analyst x5	Analyst x5	Analyst x3	Analyst x1	Est @ 9.28%	Est @ 7.08%	Est @ 5.55%	Est @ 4.47%	Est @ 3.72%
Present Value (A$, Millions) Discounted @ 8.5%	AU$2.6k	AU$2.4k	AU$2.4k	AU$2.4k	AU$2.7k	AU$2.8k	AU$2.7k	AU$2.6k	AU$2.5k	AU$2.4k

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = AU$26b

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 (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 8.5%.

Terminal Value (TV)= FCF₂₀₃₂ × (1 + g) ÷ (r – g) = AU$5.5b× (1 + 2.0%) ÷ (8.5%– 2.0%) = AU$86b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= AU$86b÷ ( 1 + 8.5%)¹⁰= AU$38b

The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is AU$63b. The last step is to then divide the equity value by the number of shares outstanding. Compared to the current share price of AU$51.8, the company appears about fair value at a 7.4% 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.

dcf

The Assumptions

The calculation above is very dependent on two assumptions. The first is the discount rate and the other is the 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 8.5%, which is based on a levered beta of 1.104. 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.

SWOT Analysis for Wesfarmers

Strength

• Earnings growth over the past year exceeded its 5-year average.

• Debt is well covered by earnings and cashflows.

Weakness

• Earnings growth over the past year underperformed the Multiline Retail industry.

• Dividend is low compared to the top 25% of dividend payers in the Multiline Retail market.

Opportunity

• Annual earnings are forecast to grow for the next 3 years.

• Current share price is below our estimate of fair value.

Threat

• Dividends are not covered by cash flow.

• Annual earnings are forecast to grow slower than the Australian market.

Next Steps:

Although the valuation of a company is important, it is only one of many factors that you need to assess for a company. It's not possible to obtain a foolproof valuation with a DCF model. Preferably you'd apply different cases and assumptions and see how they would impact the company's valuation. For example, changes in the company's cost of equity or the risk free rate can significantly impact the valuation. For Wesfarmers, we've compiled three relevant elements you should further examine:

1. Risks: As an example, we've found 3 warning signs for Wesfarmers that you need to consider before investing here.

2. Future Earnings: How does WES'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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.

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.

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