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Are Woolworths Limited shares expensive?

Credit: AS 1979

Woolworths Limited (ASX: WOW) shares might not be a standout buy.

What makes a standout buy?

Last week I questioned how much Woolworths shares are really worth. Based on an incomplete valuation I surmised that Woolworths shares may be worth just $21, which compares to their current share price of $25.

I have said before that value investors target shares that are priced at least 30% less than their valuation would suggest. For example, a value investor would buy shares in Woolworths if they were priced around $15 (30% below the valuation).

Having updated my analysis since last week I can tell you that a value investor may be waiting some time to get a hold of Woolworths.

What are Woolworths shares really worth?

Having completed the second half of my valuations, including a discounted cash flow (DCF) analysis and two dividend discount models (DDM), I can say confidently that Woolworths shares are not a buy in my book.

My valuation places the true worth of Woolworths shares materially below the current market price.

How low?

Well, based on the assumption of falling profit margins in supermarkets (some people may disagree with me about the margins) to 3% by 2021, Woolworths is valued close to $17.60. In other words, it may be overvalued.

The purpose of valuation

The purpose of valuation is to identify undervalued investment opportunities. However, valuing a business also allows an investor to understand what is required for the business to be a good investment, or which parts of the business are important drivers of profits.

For example, if you believe Woolworths will be able to fight off competition from Coles, owned by Wesfarmers Ltd (ASX: WES), Aldi and Amazon, then your valuation will be materially higher than mine.

That’s because Woolworths’ Australian supermarkets are volume businesses. Meaning, they sell many products for a small profit, so even a small change to profit margins can have a significant impact on the valuation.

Over in the UK, Tesco has been hurt by competition and online rivals like Amazon. It has profit margins of 2.3%, which compares to Woolworths supermarkets current 4.4%.

Admittedly, it will be harder for Amazon to uproot Woolworths. But I think it is conservative to forecast Woolworths being even modestly affected over time.

Foolish Takeaway

At current market prices, Woolworths needs to widen its profit margins and grow its sales above inflation. It may exceed my conservative estimates and justify its valuation in time, but it’s not a bet I’m willing to take. Especially when there are hundreds of other companies listed on the stock exchange.

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Owen Raszkiewicz owns shares of Amazon. You can follow Owen on Twitter @OwenRask.

The Motley Fool Australia's parent company Motley Fool Holdings Inc. owns shares of Amazon. The Motley Fool Australia owns shares of Wesfarmers Limited. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

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