Is there an opportunity with the 47% undervaluation of Collins Foods Limited (ASX:CKF)?
In this article, we will estimate the intrinsic value of Collins Foods Limited (ASX:CKF) by projecting its future cash flows and then discounting them to present value. We will use the Discounted Cash Flow (DCF) model for this purpose. This may sound complicated, but it’s actually quite simple!
Remember though that there are many ways to estimate the value of a business and a DCF is just one method. 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 analysis template.
Check out our latest analysis for Collins Foods
crush numbers
We will use a two-stage DCF model which, as the name suggests, takes into account two stages of growth. The first stage is usually a period of higher growth which stabilizes towards the terminal value, captured in the second period of “sustained growth”. In the first step, we need to estimate the company’s cash flow over the next ten years. Wherever possible, we use analysts’ estimates, but where these are not available, we extrapolate the previous free cash flow (FCF) from the latest estimate or reported 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 more in early years than in later years.
Generally, 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 today’s value:
10-Year Free Cash Flow (FCF) Forecast
2022 | 2023 | 2024 | 2025 | 2026 | 2027 | 2028 | 2029 | 2030 | 2031 | |
Leveraged FCF (A$, Millions) | A$72.9 million | A$104.2 million | A$101.4 million | A$127.2 million | A$141.9 million | A$154.1 million | A$164.3 million | A$172.7 million | A$179.9 million | A$186.1 million |
Growth rate estimate Source | Analyst x3 | Analyst x3 | Analyst x2 | Analyst x1 | Is at 11.56% | Is at 8.64% | Is at 6.58% | Is at 5.15% | Is at 4.14% | Is at 3.44% |
Present value (A$, millions) discounted at 7.7% | AU$67.7 | AU$89.9 | AU$81.1 | AU$94.5 | AU$97.9 | AU$98.7 | AU$97.7 | AU$95.4 | AU$92.2 | AU$88.6 |
(“East” = FCF growth rate estimated by Simply Wall St)
10-year discounted cash flow (PVCF) = AU$903 million
The second stage is also known as the terminal value, it is the cash flow of the business after the first stage. The Gordon Growth formula is used to calculate the terminal value at a future annual growth rate equal to the 5-year average 10-year government bond yield of 1.8%. We discount terminal cash flows to present value at a cost of equity of 7.7%.
Terminal value (TV)= FCF_{2031} × (1 + g) ÷ (r – g) = AU$186 million × (1 + 1.8%) ÷ (7.7%–1.8%) = AU$3.2 billion
Present value of terminal value (PVTV)= TV / (1 + r)^{ten}= AU$3.2 billion÷ (1 + 7.7%)^{ten}= AU$1.5 billion
The total value is the sum of the cash flows for the next ten years plus the present terminal value, which gives the total equity value, which in this case is A$2.4 billion. In the last step, we divide the equity value by the number of shares outstanding. Compared to the current share price of AU$11.1, the company looks quite undervalued at a 47% discount to the current share price. Remember though that this is only a rough estimate, and like any complex formula – trash in, trash out.
Important assumptions
The above calculation is highly dependent on two assumptions. One is the discount rate and the other is the cash flows. Part of investing is coming up with your own assessment of a company’s future performance, so try the math yourself and check your own assumptions. 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 Collins Foods 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 factors in debt. In this calculation, we used 7.7%, which is based on a leveraged beta of 1.393. Beta is a measure of a stock’s volatility relative to the market as a whole. We derive our beta from the average industry beta of broadly comparable companies, with an imposed limit between 0.8 and 2.0, which is a reasonable range for a stable company.
Look forward:
Valuation is only one side of the coin in terms of building your investment thesis, and it’s just one of many factors you need to assess for a company. DCF models are not the be-all and end-all of investment valuation. Rather, it should be seen as a guide to “what assumptions must be true for this stock to be under/overvalued?” If a company grows at a different rate, or if its cost of equity or risk-free rate changes sharply, output may be very different. Can we understand why the company is trading at a discount to its intrinsic value? For Collins Foods, we’ve rounded up three important factors you should dig into:
- Risks: For example, we discovered 2 warning signs for Collins Foods which you should be aware of before investing here.
- Management:Did insiders increase their shares to take advantage of market sentiment about CKF’s future prospects? View our management and board analysis with insights into CEO compensation and governance factors.
- Other high-quality alternatives: Do you like a good all-rounder? Explore our interactive list of high-quality actions to get an idea of what you might be missing!
PS. The Simply Wall St app performs a discounted cash flow valuation for every stock on the ASX every day. If you want to find the calculation for other stocks, search here.
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This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts only using unbiased methodology and our articles are not intended to be financial advice. It is not a recommendation to buy or sell stocks and does not take into account your objectives or financial situation. Our goal is to bring you targeted long-term analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price-sensitive companies or qualitative materials. Simply Wall St has no position in the stocks mentioned.