According to this valuation model, the Woolworths Limited (ASX: WOW) share price should be just $21!
Woolworths share price
As can be seen, it's been a rollercoaster ride for Woolworths shareholders over the past five years. From almost $38 to a low of $20.70, there have been some jaw-dropping moments. Ouch!
Since 2015, its yearly dividends have fallen from $1.39 per share to $0.67. Double-ouch!
Buy, Hold or Sell
No doubt, shrewd investors are running their rulers over Woolies shares. After all, it's not every day one of Australia's biggest and most well-known companies falls from grace – although, Telstra Corporation Ltd (ASX: TLS) might not be far behind (it's down 21% over the past year).
At any time successful investing often comes back to the difference between price and value. Value is what something — in this case, Woolworths shares — is worth.
For example, the current Woolworths share price is $26.55. By itself, that says nothing important to us other than what it would cost to buy one share in a supermarket operator.
Knowing what a company's shares are worth and comparing it to the current price is the only way many investors know whether to buy, hold or sell.
That doesn't mean you need to be an investing guru with 15 years of finance experience to invest successfully — after all, do you need a degree in 'shopping' to buy a t-shirt?
But by doing some research, leaving your emotional biases at the door, and asking yourself what you should pay for a company's shares, you can make an informed decision when your hard-earned cashola is on the line.
Dividend valuation
One way to value a company's shares is to use its dividends and assume a growth rate for those dividends into the future.
For example, Woolies shares are forecast to pay 77 cents per share in dividends and I estimate they can grow their dividends at 2.5% per year.
I think 2.5% growth is fair because although Woolworths is one of Australia's leading companies it is facing plenty of risks.
With a rate of return of 6.25% (which is calculated using Woolworths' historical 'risk'), its current valuation is $21.04.
Here's the formula:
Or, ($0.77 x 1.02) / (6.25% – 2.5%) = $21.04.
If that looks like finance gobbledygook (it is, believe me) just know that you can use that formula for just about any company with a very stable business.
However, please note that it will take you all of five seconds to use that valuation technique on most blue chip shares — so don't risk your life savings on it.
Indeed, if finance was that easy I wouldn't have a job!
You should use that formula with other valuation techniques like discounted cash flow analysis (DCF), comparable sales and book value analysis — and only after you have done plenty of reading and research on the company's future.
Foolish Takeaway
I cannot guarantee that Woolworths shares are worth $21 but that's what the theory of the Gordon Growth Model says. In fact, I wouldn't rely on that valuation. So iIn future articles, I'll show you how to value Woolworths ina few other ways.
But for now, I'm not buying Woolies shares.
