Today we’re going to walk through one way to estimate Kitron ASA’s intrinsic value (OB: KIT) by projecting its future cash flows and then discounting them to present value. The DCF (Discounted Cash Flow) model is the tool we will apply to do this. Believe it or not, it’s not too hard to follow, as you will see in our example!
We generally believe that the value of a business is the present value of all the cash it will generate in the future. However, a DCF is only one evaluation measure among many, and it is not without its flaws. If you still have burning questions about this type of assessment, take a look at the Simply Wall St analysis model.
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What is the estimated valuation?
We use the 2-step growth model, which simply means that we take into account two stages of business growth. During the initial period, the business can have a higher growth rate and the second stage is usually assumed to have a stable growth rate. First, we need to estimate the cash flow of the business over the next ten years. Where possible, we use analyst estimates, but when these are not available, we extrapolate the previous free cash flow (FCF) from the last estimate or the last reported value. We assume that companies with decreasing free cash flow will slow their withdrawal rate, and companies with increasing free cash flow will see their growth rate slow down during this period. We do this to reflect that growth tends to slow down more in the early years than in the later years.
Typically, we assume that a dollar today is worth more than a dollar in the future, and so the sum of these future cash flows is then discounted to present value:
10-year free cash flow (FCF) estimate
|Leverage FCF (NOK, millions)||409.0 million kr||289.0 million kr||232.0 million kr||255.0 million kr||287.5 kr||290.0 million kr||292.8 million kr||295.9 million kr||299.2 million kr||302.6 kr|
|Source of estimated growth rate||Analyst x1||Analyst x2||Analyst x2||Analyst x2||Analyst x2||Is 0.86%||Is 0.97%||Is 1.05%||Is 1.11%||Is 1.15%|
|Present value (NOK, millions) discounted at 7.3%||kr381||kr251||kr188||kr192||kr202||kr190||kr178||kr168||kr158||kr149|
(“East” = FCF growth rate estimated by Simply Wall St)
10-year present value of cash flow (PVCF) = kr2.1b
Now we need to calculate the terminal value, which takes into account all future cash flows after that ten year period. For a number of reasons, a very conservative growth rate is used that cannot exceed that of a country’s GDP growth. In this case, we used the 5-year average of the 10-year government bond yield (1.2%) to estimate future growth. Similar to the 10-year “growth” period, we discount future cash flows to present value, using a cost of equity of 7.3%.
Terminal value (TV)= FCF2030 × (1 + g) ÷ (r – g) = kr303m × (1 + 1.2%) ÷ (7.3% – 1.2%) = kr5.0b
Present value of terminal value (PVTV)= TV / (1 + r)ten= kr5.0b ÷ (1 + 7.3%)ten= kr2.5b
The total value is the sum of the cash flows for the next ten years plus the present terminal value, which gives the total value of equity, which in this case is 4.5 billion kr. To get the intrinsic value per share, we divide it by the total number of shares outstanding. Compared to the current share price of 20kr, the company appears to be a bit undervalued with a 21% discount from the current share price. Ratings are imprecise instruments, however, much like a telescope – move a few degrees and end up in another galaxy. Keep this in mind.
Now the most important data for a discounted cash flow is the discount rate and, of course, the actual cash flow. You don’t have to agree with these entries, I recommend that you redo the math yourself and play around with it. The DCF also does not take into account the possible cyclicality of an industry or the future capital needs of a company, so it does not give a complete picture of a company’s potential performance. Since we view Kitron as potential shareholders, the cost of equity is used as the discount rate, rather than the cost of capital (or weighted average cost of capital, WACC) which takes debt into account. In this calculation, we used 7.3%, which is based on a leveraged beta of 1.290. Beta is a measure of the volatility of a stock, relative to the market as a whole. We get our beta from the industry average beta of globally comparable companies, with an imposed limit between 0.8 and 2.0, which is a reasonable range for a stable business.
Valuation is only one side of the coin in terms of building your investment thesis, and ideally it won’t be the only analysis you look at for a business. DCF models are not the alpha and omega of investment valuation. Rather, it should be seen as a guide to “what assumptions must be true for this stock to be under / overvalued?” For example, changes in the company’s cost of equity or the risk-free rate can have a significant impact on valuation. What is the reason why the stock price is lower than intrinsic value? For Kitron, there are three essential factors that you should consider in more detail:
- Risks: We think you should rate the 2 warning signs for Kitron we reported before making an investment in the business.
- Future income: How does KIT’s growth rate compare to its peers and to the market in general? Dig deeper into the analyst consensus count for years to come by interacting with our free analyst growth forecast chart.
- Other strong companies: Low debt, high return on equity, and good past performance are essential to a strong business. Why not explore our interactive list of stocks with solid trading fundamentals to see if there are other companies you may not have considered!
PS. The Simply Wall St app performs a daily discounted cash flow assessment for each stock in the OB. If you want to find the calculation for other actions, just search here.
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This Simply Wall St article is general in nature. It is not a recommendation to buy or sell any stock, and does not take into account your goals or your financial situation. We aim to bring you long-term, targeted analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price sensitive companies or qualitative information. Simply Wall St has no position in the mentioned stocks.
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