What is the distance between Costco Wholesale Corporation (NASDAQ:COST) and its inherent value? We’ll predict the stock’s future cash flows and discount them to its current value using the most recent financial data to see if it is reasonably valued. This time, we’ll apply the Discounted Cash Flow (DCF) model. You’ll see from our example that it’s not too hard to follow, believe it or not!
We would warn that, similar to the DCF, there are other methods for valuing a firm, and each method has benefits and drawbacks depending on the situation.
We employ a 2-stage model, which essentially implies the company’s cash flows rise at two distinct rates throughout various times. In general, there is a stronger growth phase in the first stage and a lower growth phase in the second. We must first project the cash flows for the next ten years. We utilise analyst estimates wherever feasible, but in the absence of them we extrapolate the prior free cash flow (FCF) from the most recent estimate or reported number. During this time, we predict that firms with declining free cash flow will slow down their rate of decline and companies with increasing free cash flow will slow down their pace of growth.
The business’s cash flow following the first stage is referred to as the second stage, or terminal value. For several reasons, a very cautious growth rate that is limited to the GDP growth of a nation is employed. In this instance, we have estimated future growth using the 5-year average of the 10-year government bond rate, which is 2.2%. We use a cost of equity of 6.2% to discount future cash flows to today’s value, just as we did for the 10-year ‘growth’ period.
The discounted terminal value plus the entire cash flows for the next 10 years equals the total value, which is US$260 billion, or the total equity value. The equity value is then divided by the total number of outstanding shares as the last stage. The business seems to be trading at a 1.9% discount to fair value when compared to the current share price of US$577. However, valuations are not exact tools; they can drift a few degrees and find themselves in a new galaxy, much like a telescope. Remember this, please.
It is noteworthy to mention that the discount rate and the actual cash flows are the two most crucial inputs in a discounted cash flow. Try doing the computation yourself and adjusting the assumptions if you disagree with the results. The DCF does not provide a complete picture of a company’s potential performance since it does not account for an industry’s potential for cyclicality or a company’s future capital requirements. Instead of using the cost of capital, or weighted average cost of capital, or WACC, which takes debt into consideration, the cost of equity is utilised as the discount rate as we are considering becoming shareholders in Costco Wholesale.
We utilised 6.2% in this estimate, based on a 0.800 levered beta. A stock’s volatility is measured by its beta in relation to the market at large. Our beta is determined by averaging the betas of internationally comparable firms in the industry, with a limit set between 0.8 and 2.0—a sensible range for a stable company.
When developing your investing thesis, valuation is just one aspect of the story and shouldn’t be the only statistic you consider when looking into a firm. DCF models are not the gold standard for valuing investments. The optimum use of a DCF model is to evaluate hypotheses and assumptions to see if they result in an undervalued or overpriced organisation. The results may fluctuate significantly if a firm expands at a different rate or if there are significant fluctuations in its cost of equity or risk-free rate. You should take into account three important factors regarding Costco Wholesale: