How much are Woolworths Limited shares REALLY worth?

If you're a regular reader of the free articles here at fool.com.au, you'll know a few of us writers are bullish on the prospects of Woolworths Limited (ASX: WOW).

After all, it's not everyday you are able to buy Australia's most profitable supermarket chain for a 26% discount to its price a year ago.

Personally, I'm on record as saying Woolworths accounts for 9.5% of my entire share portfolio, having recently topped up…twice!

1 BIG reason you need to consider it…

As the rapid falls in share price have taken place, Woolworths' forecast dividend yield has blossomed to over 5.1% — fully franked no less. Adjusted for franking credits its yield blows out to over 7.3%.

Given the reliability of Woolworths' dividend and the current low-interest rate environment, it makes sense to at least consider owning some shares in your portfolio.

Is it good value?

Before crunching the numbers on valuation, it's vital to know the business you're preparing to buy shares in and — most importantly — be cognisant of the risks.

You don't have to be an analyst with a flashy suit to identify risks and understand a business like Woolworths.

The risks

Woolworths shares have fallen because investors and analysts have grown concerned about competitive threats from key rival Coles – owned by Wesfarmers Ltd (ASX: WES) – as well as foreign giants Aldi, Lidl, and Costco Wholesale Corp.

However, Roy Morgan research from 2014 found that Woolworths and Coles control 74% of the local supermarket space.

It also said German giant, Aldi, controlled 10% of the market, having displaced Metcash Limited's (ASX: MTS) IGA stores with 9.5% share. The rest is made up by independents.

In financial year 2014, Woolworths' Australian Food, Liquor and Petrol division accounted for 79% of group revenues.

Historically, its EBIT margin has been quite robust too. EBIT, or earnings before interest and taxes, is a financial measure which essentially means profit, before taking into account how the business is funded.

EBIT is the best way to gauge the profitability of individual business lines (e.g. Home Improvement) because they're funding structures can vary.

For example, Masters is part-owned by Lowe's of America whereas BIGW is not. EBIT makes their returns comparable.

Before corporate costs and significant items, the Australian Food, Liquor and Petrol division achieved an EBIT margin of 7% in 2014. Meaning, it made $7 in divisional profit (before taxes, interest etc.) for every $100 spent in store.

This compares favourably to my calculations of Coles' EBIT margin of 4.4%.

Here's what the margins look like across the group, and what I expect in the future.

Obviously, any significant margin pressure across Woolworths' supermarkets will have a profound effect at the group level given that such a large proportion of profits stem from supermarkets.

You'll note from the above graph however I've forecast falling group margins until 2017. Around that time I believe we'll likely start to see the Home Improvement division — specifically Masters — start making a profit.

It doesn't really matter to me if it breaks even in 2017, 2018 or 2019 because I'm a long-term investor. Moreover, I'm confident it'll turn a profit sooner or later.

In its financial year 2013, the Australian Home Improvement market was estimated to be worth $45 billion, with the top three players controlling just 22%.

So what are Woolworths shares worth?

Well, that depends.

A conservative estimate

Based on modest, low-single digit, revenue growth across the group; a terminal growth rate of 2.5%; approximately $2.4 billion in annual capital expenditure; and a weighted discount rate of 8.3%; Woolworths shares are worth around $19.87 according to my discounted cash flow model.

A Fairer Estimate

However, adjusting my valuation to be accommodative of the current low-interest rate environment and using a terminal growth rate of 3% yields a value of $28.39.

A well-rounded valuation

We can provide a more robust valuation of Woolworths shares by incorporating the current market valuations of its peers and fellow ASX-listed stocks with similar traits. The market's implied valuations of Costco, Telstra Corporation Ltd (ASX: TLS), Wesfarmers and Woolworths can be found below.

Some financial commentators use the P/E Ratio to provide a relative valuation to shares.

Whilst this model has very limited credibility amongst value investors, from the above table we can see the average P/E amongst Woolworths and its rivals is 21x. At today's earnings per share of $1.92 that'd imply a valuation of $40.32 per share.

Using the Enterprise Value (EV) to earnings before interest, taxes, depreciation and amortisation (EBITDA) model provides a fairer estimate of the market value for Woolworths shares. As can be seen above, fair value for Woolworths shares should lie around $38.81, according to the EV/EBITDA model.

Incorporating all of the models together using a weighted proportion according to their theoretical robustness, is arguably the best way to value any company's shares.

If you don't understand each of the tools I used above, that's OK. You're certainly not alone.

Based on my somewhat arbitrary weightings of all of the valuation tools I used above, I believe fair value for Woolworths shares likely falls around $28.65.

Here's the kicker

Whilst my estimate of fair value might compare favourably with Woolworths' current market price of $26.90 per share, investors are reminded that valuations (no matter how many times you do them!) always prove to be wrong sooner or later.

There is no substitute for thorough qualitative research.

Indeed, this is just my estimate of fair value. And personally I would normally only buy shares which I'm able to purchase at a price which is 30% less than my estimate of their worth, so as to ensure a healthy margin of safety in the likely case my model is wrong.

Would I buy Woolworths shares today?

At today's prices, I think if you're looking to secure a reliable income stream above 5% you could comfortably add some Woolworths shares to your portfolio.

They're not a bargain by any means – and are therefore unlikely to smash the market over coming years – but the supermarket giant's ability to pay a generous fully franked dividend yield is undoubtedly attractive in this low-interest rate environment.