A Look At The Fair Value Of Coles Group Limited (ASX:COL)

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11 hours ago

Coles Group's estimated fair value is AU$21.93 based on 2 Stage Free Cash Flow to Equity
Coles Group's AU$20.46 share price indicates it is trading at similar levels as its fair value estimate
Our fair value estimate is 2.9% higher than Coles Group's analyst price target of AU$21.31
Today we'll do a simple run through of a valuation method used to estimate the attractiveness of Coles Group Limited (ASX:COL) as an investment opportunity by taking the expected future cash flows and discounting them to their present value. We will take advantage of the Discounted Cash Flow (DCF) model for this purpose. Don't get put off by the jargon, the math behind it is actually quite straightforward.
Companies can be valued in a lot of ways, so we would point out that a DCF is not perfect for every situation. If you want to learn more about discounted cash flow, the rationale behind this calculation can be read in detail in the Simply Wall St analysis model.
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We use what is known as a 2-stage model, which simply means we have two different periods of growth rates for the company's cash flows. Generally the first stage is higher growth, and the second stage is a lower growth phase. To start off with, we need to estimate the next ten years of cash flows. Where possible we use analyst estimates, but when these aren't available we extrapolate the previous free cash flow (FCF) from the last estimate or reported value. We assume companies with shrinking free cash flow will slow their rate of shrinkage, and that companies with growing free cash flow will see their growth rate slow, over this period. We do this to reflect that growth tends to slow more in the early years than it does in later years.
A DCF is all about the idea that a dollar in the future is less valuable than a dollar today, and so the sum of these future cash flows is then discounted to today's value:
2026
2027
2028
2029
2030
2031
2032
2033
2034
2035
Levered FCF (A$, Millions)
AU$1.44b
AU$1.62b
AU$1.36b
AU$1.34b
AU$1.34b
AU$1.35b
AU$1.37b
AU$1.40b
AU$1.43b
AU$1.47b
Growth Rate Estimate Source
Analyst x6
Analyst x6
Analyst x2
Est @ -1.20%
Est @ 0.05%
Est @ 0.92%
Est @ 1.53%
Est @ 1.95%
Est @ 2.25%
Est @ 2.46%
Present Value (A$, Millions) Discounted @ 6.9%
AU$1.3k
AU$1.4k
AU$1.1k
AU$1.0k
AU$958
AU$904
AU$858
AU$818
AU$782
AU$750
("Est" = FCF growth rate estimated by Simply Wall St)Present Value of 10-year Cash Flow (PVCF) = AU$10.0b
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. The Gordon Growth formula is used to calculate Terminal Value at a future annual growth rate equal to the 5-year average of the 10-year government bond yield of 2.9%. We discount the terminal cash flows to today's value at a cost of equity of 6.9%.
Terminal Value (TV)= FCF2035 × (1 + g) ÷ (r – g) = AU$1.5b× (1 + 2.9%) ÷ (6.9%– 2.9%) = AU$38b
Present Value of Terminal Value (PVTV)= TV / (1 + r)10= AU$38b÷ ( 1 + 6.9%)10= AU$19b
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$29b. In the final step we divide the equity value by the number of shares outstanding. Relative to the current share price of AU$20.5, the company appears about fair value at a 6.7% 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.
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 Coles Group 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 6.9%, which is based on a levered beta of 0.921. 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.
Check out our latest analysis for Coles Group
Strength
Earnings growth over the past year exceeded the industry.
Debt is well covered by earnings and cashflows.
Weakness
Dividend is low compared to the top 25% of dividend payers in the Consumer Retailing market.
Opportunity
Annual earnings are forecast to grow for the next 4 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.
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. It's not possible to obtain a foolproof valuation with a DCF model. Rather it should be seen as a guide to "what assumptions need to be true for this stock to be under/overvalued?" For instance, if the terminal value growth rate is adjusted slightly, it can dramatically alter the overall result. For Coles Group, there are three important items you should further research:
Risks: You should be aware of the 2 warning signs for Coles Group we've uncovered before considering an investment in the company.
Future Earnings: How does COL'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 Solid Businesses: 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 business fundamentals to see if there are other companies you may not have considered!
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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