Does This Valuation Of Wesfarmers Limited (ASX:WES) Imply Investors Are Overpaying?

Key Insights

• Using the 2 Stage Free Cash Flow to Equity, Wesfarmers fair value estimate is AU$53.76

• Wesfarmers is estimated to be 31% overvalued based on current share price of AU$70.58

• The AU$63.49 analyst price target for WES is 18% more than our estimate of fair value

Today we'll do a simple run through of a valuation method used to estimate the attractiveness of Wesfarmers Limited (ASX:WES) as an investment opportunity by taking the expected future cash flows and discounting them to their present value. Our analysis will employ the Discounted Cash Flow (DCF) model. 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. Anyone interested in learning a bit more about intrinsic value should have a read of the Simply Wall St analysis model.

See our latest analysis for Wesfarmers

Is Wesfarmers Fairly Valued?

We're using the 2-stage growth model, which simply means we take in account two stages of company's growth. In the initial period the company may have a higher growth rate and the second stage is usually assumed to have a stable growth rate. 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.

Generally we assume that a dollar today is more valuable than a dollar in the future, 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) estimate

	2025	2026	2027	2028	2029	2030	2031	2032	2033	2034
Levered FCF (A$, Millions)	AU$2.85b	AU$3.09b	AU$3.51b	AU$3.04b	AU$3.08b	AU$3.06b	AU$3.08b	AU$3.11b	AU$3.15b	AU$3.21b
Growth Rate Estimate Source	Analyst x6	Analyst x6	Analyst x6	Analyst x2	Analyst x1	Est @ -0.40%	Est @ 0.44%	Est @ 1.03%	Est @ 1.45%	Est @ 1.74%
Present Value (A$, Millions) Discounted @ 6.8%	AU$2.7k	AU$2.7k	AU$2.9k	AU$2.3k	AU$2.2k	AU$2.1k	AU$1.9k	AU$1.8k	AU$1.7k	AU$1.7k

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = AU$22b

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 (2.4%) 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 6.8%.

Terminal Value (TV)= FCF₂₀₃₄ × (1 + g) ÷ (r – g) = AU$3.2b× (1 + 2.4%) ÷ (6.8%– 2.4%) = AU$75b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= AU$75b÷ ( 1 + 6.8%)¹⁰= AU$39b

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$61b. In the final step we divide the equity value by the number of shares outstanding. Compared to the current share price of AU$70.6, the company appears reasonably expensive at the time of writing. Valuations are imprecise instruments though, rather like a telescope - move a few degrees and end up in a different galaxy. Do keep this in mind.

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. You don't have to agree with these inputs, I recommend redoing the calculations yourself and playing with them. 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 6.8%, which is based on a levered beta of 1.062. 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 the industry.

• Debt is well covered by earnings and cashflows.

• Dividends are covered by earnings and cash flows.

Weakness

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

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

• Expensive based on P/E ratio and estimated fair value.

Opportunity

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

Threat

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

Moving On:

Valuation is only one side of the coin in terms of building your investment thesis, and it is only one of many factors that you need to assess for a company. The DCF model is not a perfect stock valuation tool. Preferably you'd apply different cases and assumptions and see how they would impact the company's valuation. 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. What is the reason for the share price exceeding the intrinsic value? For Wesfarmers, we've put together three important aspects you should look at:

1. Risks: Be aware that Wesfarmers is showing 2 warning signs in our investment analysis , you should know about...

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. 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.