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Savvy investors know the importance of knowing what a company is worth. After all, the stock market is just a market with buyers and sellers. If one doesn't know what the value of stocks he/she is buying, then how can one know if a bargain is to be had. As part of our process for all the companies in our coverage universe, we perform a rigorous discounted cash-flow methodology that dives into the true intrinsic worth of companies. Let's dig into what Costco (NASDAQ:COST) is worth on the basis of such a future free cash flow model.

We think a comprehensive analysis of a firm's discounted cash-flow valuation and relative valuation versus industry peers is the best way to identify the most attractive stocks at the best time to buy. This process culminates in what we call our Valuentum Buying Index (VBI), which ranks stocks on a scale from 1 to 10, with 10 being the best. Essentially, we're looking for firms that overlap investment methodologies, thereby revealing the greatest interest by investors (we like firms that fall in the center of the diagram below). Valuentum followers know that the cornerstone of any investment is an understanding of what a company is worth and what drives stock prices (such that one can identify the best time as to when a stock may coverage to intrinsic value).

If a company is undervalued both on a DCF and on a relative valuation basis, it scores high on our VBI scale. Costco posts a VBI score of 6 on our scale, reflecting our 'fairly valued' DCF assessment of the firm, its unattractive relative valuation versus peers, and bullish technicals. We compare Costco to peers Kroger (NYSE:KR), Target (NYSE:TGT), and Wal-Mart (NYSE:WMT). In the spirit of transparency, we show how our strategy has performed recently:

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Our Report on Costco

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Investment Considerations

Investment Highlights

• Costco's business quality (an evaluation of our ValueCreation™ and ValueRisk™ ratings) ranks among the best of the firms in our coverage universe. The firm has been generating economic value for shareholders with relatively stable operating results for the past few years, a combination we view very positively.

• Costco operates an international chain of warehouses, mainly under the 'Costco Wholesale' name. Costco is open only to members and offers three types of membership: Business, Gold Star (individual) and the Executive membership.

• Costco's cash flow generation and financial leverage aren't much to speak of. The firm's free cash flow margin has averaged about 2% during the past three years, lower than the mid-single-digit range we'd expect for cash cows. However, the firm's cash flow should be sufficient to handle its low financial leverage.

• Costco targets merchandise that produces high sales volumes and rapid inventory turnover. This turnover, when combined with efficiencies achieved by volume purchasing, efficient distribution and reduced handling of merchandise in no-frills, self-service warehouses, enables Costco to operate profitably at significantly lower gross margins than peers.

• The firm experienced a revenue CAGR of about 11.5% during the past 3 years. We expect its revenue growth to be better than its peer median during the next five years.

Business Quality

Economic Profit Analysis

The best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital (ROIC) with its weighted average cost of capital (OTC:WACC). The gap or difference between ROIC and WACC is called the firm's economic profit spread. Costco's 3-year historical return on invested capital (without goodwill) is 18.9%, which is above the estimate of its cost of capital of 9.7%. As such, we assign the firm a ValueCreation™ rating of EXCELLENT. In the chart below, we show the probable path of ROIC in the years ahead based on the estimated volatility of key drivers behind the measure. The solid grey line reflects the most likely outcome, in our opinion, and represents the scenario that results in our fair value estimate.

Cash Flow Analysis

Firms that generate a free cash flow margin (free cash flow divided by total revenue) above 5% are usually considered cash cows. Costco's free cash flow margin has averaged about 2% during the past 3 years. As such, we think the firm's cash flow generation is relatively MEDIUM. The free cash flow measure shown above is derived by taking cash flow from operations less capital expenditures and differs from enterprise free cash flow (FCFF), which we use in deriving our fair value estimate for the company. For more information on the differences between these two measures, please visit our website at Valuentum.com. At Costco, cash flow from operations increased about 10% from levels registered two years ago, while capital expenditures
expanded about 40% over the same time period.

Valuation Analysis

The estimated fair value of $95 per share represents a price-to earnings (P/E) ratio of about 24.4 times last year's earnings and an implied EV/EBITDA multiple of about 10.5 times last year's EBITDA. Our model reflects a compound annual revenue growth rate of 7.2% during the next five years, a pace that is lower than the firm's 3-year historical compound annual growth rate of 11.5%. Our model reflects a 5-year projected average operating margin of 3%, which is above Costco's trailing 3-year average. Beyond year 5, we assume free cash flow will grow at an annual rate of 2.9% for the next 15 years and 3% in perpetuity. For Costco, we use a 9.7% weighted average cost of capital to discount future free cash flows.

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Margin of Safety Analysis

Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate the firm's fair value at about $95 per share, every company has a range of probable fair values that's created by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After all, if the future was known with certainty, we wouldn't see much volatility in the markets as stocks would trade precisely at their known fair values. Our ValueRisk™ rating sets the margin of safety or the fair value range we assign to each stock. In the graph below, we show this probable range of fair values for Costco. We think the firm is attractive below $76 per share (the green line), but quite expensive above $114 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion.

Future Path of Fair Value

We estimate Costco's fair value at this point in time to be about $95 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart below compares the firm's current share price with the path of Costco's expected equity value per share over the next three years, assuming our long-term projections prove accurate. The range between the resulting downside fair value and upside fair value in Year 3 represents our best estimate of the value of the firm's shares three years hence. This range of potential outcomes is also subject to change over time, should our views on the firm's future cash flow potential change. The expected fair value of $122 per share in Year 3 represents our existing fair value per share of $95 increased at an annual rate of the firm's cost of equity less its dividend yield. The upside and downside ranges are derived in the same way, but from the upper and lower bounds of our fair value estimate range.

Pro Forma Financial Statements

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Source: Costco Through The Lens Of A DCF