Is there an opportunity with The Coca-Cola Company’s 32% undervaluation (NYSE: KO)?

In this article, we’ll estimate the intrinsic value of The Coca-Cola Company (NYSE: KO) by taking the company’s future cash flow forecasts and discounting them to today’s value. This will be done using the Discounted Cash Flow (DCF) model. Believe it or not, it’s not too hard to follow, as you will see in our example!

We draw your attention to the fact that there are many ways to assess a business and, like DCF, each technique has advantages and disadvantages in certain scenarios. If you want to know more about discounted cash flow, the rationale for this calculation can be read in detail in the Simply Wall St.

See our latest analysis for Coca-Cola

The method

We use what is called a two-step model, which simply means that we have two different periods of growth rate for the cash flow of the business. Usually, the first stage is higher growth, and the second stage is a lower growth stage. In the first step, 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 stated value. We assume that companies with decreasing free cash flow will slow their rate of contraction, and companies with increasing free cash flow will see their growth rate slow during this period. We do this to reflect the fact that growth tends to slow down more in the early years than in subsequent years.

A DCF is based on the idea that a dollar in the future is worth less than a dollar today, so we need to discount the sum of these future cash flows to arrive at an estimate of the present value:

10-year free cash flow (FCF) forecast

2022 2023 2024 2025 2026 2027 2028 2029 2030 2031
Leverage FCF ($, Millions) US $ 9.84 billion US $ 10.6 billion US $ 11.7 billion US $ 12.5 billion US $ 13.2 billion US $ 13.7 billion US $ 14.2 billion US $ 14.6 billion US $ 15.0 billion US $ 15.4 billion
Source of estimated growth rate Analyst x8 Analyst x6 Analyst x1 Analyst x1 Is 5.03% Est @ 4.11% East @ 3.47% East @ 3.01% Is 2.7% East @ 2.48%
Present value (in millions of dollars) discounted at 5.6% US $ 9.3k $ 9.5,000 $ 9.9,000 US $ 10.1k US $ 10,000 $ 9.9,000 US $ 9.7k $ 9.5,000 US $ 9.2,000 $ 8.9,000

(“East” = FCF growth rate estimated by Simply Wall St)
10-year present value of cash flows (PVCF) = US $ 96 billion

It is now a matter of calculating the Terminal Value, which takes into account all future cash flows after this ten-year period. The Gordon growth formula is used to calculate the terminal value at a future annual growth rate equal to the 5-year average of the 10-year government bond yield of 2.0%. We discount the terminal cash flows to their present value at a cost of equity of 5.6%.

Terminal value (TV)= FCF2031 × (1 + g) ÷ (r – g) = US $ 15B × (1 + 2.0%) ÷ (5.6% – 2.0%) = US $ 433B

Present value of terminal value (PVTV)= TV / (1 + r)ten= US $ 433 billion ÷ (1 + 5.6%)ten= US $ 251 billion

The total value is the sum of the cash flows for the next ten years plus the final present value, which gives the total value of equity, which in this case is US $ 347 billion. In the last step, we divide the equity value by the number of shares outstanding. Compared to the current share price of US $ 54.6, the company looks fairly good value with a 32% 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.

NYSE: KO Discounted Cash Flow October 21, 2021

Important assumptions

The above calculation is very dependent on two assumptions. One is the discount rate and the other is cash flow. You don’t have to agree with these entries, I recommend that you redo the calculations yourself and play with them. 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 full picture of a company’s potential performance. Since we view Coca-Cola as a potential shareholder, 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 into account debt. In this calculation, we used 5.6%, which is based on a leveraged beta of 0.828. Beta is a measure of the volatility of a stock relative to the market as a whole. We get our average beta from the industry beta of comparable companies globally, with an imposed limit between 0.8 and 2.0, which is a reasonable range for a stable company.

Looking forward:

Valuation is only one side of the coin in terms of building your investment thesis, and it shouldn’t be the only metric you look at when researching a business. DCF models are not the alpha and omega of investment valuation. Preferably, you would apply different cases and assumptions and see their impact on the valuation of the business. For example, changes in the company’s cost of equity or the risk-free rate can have a significant impact on valuation. Can we understand why the company trades at a discount to its intrinsic value? For Coca-Cola, we’ve put together three relevant factors you should explore:

  1. Risks: Be aware that Coca-Cola displays 2 warning signs in our investment analysis , you must know…
  2. Management: Have insiders increased their stocks to take advantage of market sentiment about KO’s future prospects? Check out our management and board analysis with information on CEO compensation and governance factors.
  3. Other high quality alternatives: Do you like a good all-rounder? Explore our interactive list of high-quality stocks to get a feel for what else you might be missing!

PS. Simply Wall St updates its DCF calculation for every US stock every day, so if you want to find the intrinsic value of any other stock just search here.

This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts using only unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell shares and does not take into account your goals or your financial situation. Our aim is 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 material. Simply Wall St has no position in the mentioned stocks.

Do you have any feedback on this item? Are you worried about the content? Get in touch with us directly. You can also send an email to the editorial team (at) simplywallst.com.

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About Myra R.

Myra R.

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