What is stock analysis? Well, there are some that only look at charts. There are others that think analyst estimate misses (notice how this is equivalent to companies' earnings beats) are a way to gauge the trajectory of a stock. We, as investors, need to move beyond these individual frameworks and start taking a holistic view - from value through technical/momentum assessments. Let's take a look at what we mean as it relates to our analysis of Whole Foods (WFM).
But first, a little background to help with the understanding of the article. 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, which ranks stocks on a scale from 1 to 10, with 10 being the best. If a company is undervalued both on a DCF and on a relative valuation basis and has solid technical/momentum indicators, it scores high on our scale.
Whole Foods posts a VBI score of 3 on our scale, reflecting our "fairly valued" DCF assessment of the firm and its unattractive relative valuation versus peers. Though we note that the following firms aren't direct competitors, we compare Whole Foods to peers Target (TGT), Costco (COST) and Wal-Mart (WMT) to help financial advisors gain perspective on the potential valuation opportunities across the industry. In the spirit of transparency, we show how the performance of our VBI has stacked up per underlying score:
• Whole Foods earns a ValueCreation™ rating of EXCELLENT, the highest possible mark on our scale. The firm has been generating economic value for shareholders for the past few years, a track record we view very positively. We expect the firm's return on invested capital (excluding goodwill) to expand to 36% from 30.8% during the next two years.
• Whole Foods is a leading retailer of natural and organic foods in North America. The company seeks out the finest natural and organic foods available and maintains the strictest quality standards in the industry.
• Whole Foods has an excellent combination of strong free cash flow generation and low financial leverage. We expect the firm's free cash flow margin to average about 5.5% in coming years. Total debt-to-EBITDA was 0 last year, while debt-to-book capitalization stood at 0.8%.
• The company dominates its niche within the food retailing industry and is well-positioned to capture future growth related to healthier eating habits and lifestyles.
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 - WACC. The gap or difference between ROIC and WACC is called the firm's economic profit spread. Whole Foods' 3-year historical return on invested capital (without goodwill) is 24.8%, which is above the estimate of its cost of capital of 10.8%. 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 gray 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. Whole Foods' free cash flow margin has averaged about 5.8% during the past three years. As such, we think the firm's cash flow generation is relatively STRONG. 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. At Whole Foods, cash flow from operations increased about 54% from levels registered two years ago, while capital expenditures fell about 24% over the same time period.
The estimated fair value of $48 per share represents a price-to-earnings (P/E) ratio of about 16.3 times last year's earnings and an implied EV/EBITDA multiple of about 15.6 times last year's EBITDA. Shares are currently trading at $54 each. Our model reflects a compound annual revenue growth rate of 12.1% during the next five years, a pace that is higher than the firm's 3-year historical compound annual growth rate of 9.1%. Our model reflects a 5-year projected average operating margin of 6.5%, which is above Whole Foods' trailing 3-year average. Beyond year 5, we assume free cash flow will grow at an annual rate of 5.9% for the next 15 years and 3% in perpetuity. For Whole Foods, we use a 10.8% weighted average cost of capital to discount future free cash flows.
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 $48 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 Whole Foods. We think the firm is attractive below $36 per share (the green line), but quite expensive above $60 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 Whole Foods' fair value at this point in time to be about $48 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 Whole Foods' 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 $64 per share in Year 3 represents our existing fair value per share of $48 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