Is There An Opportunity With Krones AG's (ETR:KRN) 23% Undervaluation?

In this article we are going to estimate the intrinsic value of Krones AG (ETR:KRN) by estimating the company's future cash flows and discounting them to their present value. This will be done using the Discounted Cash Flow (DCF) model. There's really not all that much to it, even though it might appear quite complex.

Remember though, that there are many ways to estimate a company's value, and a DCF is just one method. If you want to learn more about discounted cash flow, the rationale behind this calculation can be read in detail in the Simply Wall St analysis model.

View our latest analysis for Krones

The method

We are going to use a two-stage DCF model, which, as the name states, takes into account two stages of growth. The first stage is generally a higher growth period which levels off heading towards the terminal value, captured in the second 'steady growth' period. In the first stage we need to estimate the cash flows to the business over the next ten years. Where possible we use analyst estimates, but when these aren't available we extrapolate the previous free cash flow (FCF) from the last estimate or reported value. We assume companies with shrinking free cash flow will slow their rate of shrinkage, and that companies with growing free cash flow will see their growth rate slow, over this period. We do this to reflect that growth tends to slow more in the early years than it does in later years.

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

10-year free cash flow (FCF) forecast

	2022	2023	2024	2025	2026	2027	2028	2029	2030	2031
Levered FCF (€, Millions)	€124.7m	€159.3m	€190.0m	€185.0m	€181.8m	€179.6m	€178.1m	€177.1m	€176.4m	€175.9m
Growth Rate Estimate Source	Analyst x5	Analyst x4	Analyst x1	Analyst x1	Est @ -1.72%	Est @ -1.2%	Est @ -0.84%	Est @ -0.58%	Est @ -0.4%	Est @ -0.28%
Present Value (€, Millions) Discounted @ 5.1%	€119	€144	€164	€152	€142	€133	€126	€119	€113	€107

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = €1.3b

We now need to calculate the Terminal Value, which accounts for all the future cash flows after this ten year period. The Gordon Growth formula is used to calculate Terminal Value at a future annual growth rate equal to the 5-year average of the 10-year government bond yield of 0.01%. We discount the terminal cash flows to today's value at a cost of equity of 5.1%.

Terminal Value (TV)= FCF₂₀₃₁ × (1 + g) ÷ (r – g) = €176m× (1 + 0.01%) ÷ (5.1%– 0.01%) = €3.5b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= €3.5b÷ ( 1 + 5.1%)¹⁰= €2.1b

The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is €3.4b. The last step is to then divide the equity value by the number of shares outstanding. Relative to the current share price of €82.9, the company appears a touch undervalued at a 23% discount to where the stock price trades currently. The assumptions in any calculation have a big impact on the valuation, so it is better to view this as a rough estimate, not precise down to the last cent.

The assumptions

The calculation above is very dependent on two assumptions. The first is the discount rate and the other is the cash flows. Part of investing is coming up with your own evaluation of a company's future performance, so try the calculation yourself and check your own assumptions. The DCF also does not consider the possible cyclicality of an industry, or a company's future capital requirements, so it does not give a full picture of a company's potential performance. Given that we are looking at Krones 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 accounts for debt. In this calculation we've used 5.1%, which is based on a levered beta of 1.079. Beta is a measure of a stock's volatility, compared 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.

Moving On:

Although the valuation of a company is important, it ideally won't be the sole piece of analysis you scrutinize for a company. DCF models are not the be-all and end-all of investment valuation. Preferably you'd apply different cases and assumptions and see how they would impact the company's valuation. If a company grows at a different rate, or if its cost of equity or risk free rate changes sharply, the output can look very different. Can we work out why the company is trading at a discount to intrinsic value? For Krones, we've compiled three important items you should assess:

1. Financial Health: Does KRN have a healthy balance sheet? Take a look at our free balance sheet analysis with six simple checks on key factors like leverage and risk.
2. Future Earnings: How does KRN's growth rate compare to its peers and the wider market? Dig deeper into the analyst consensus number for the upcoming years by interacting with our free analyst growth expectation chart.
3. Other Solid Businesses: Low debt, high returns on equity and good past performance are fundamental to a strong business. Why not explore our interactive list of stocks with solid business fundamentals to see if there are other companies you may not have considered!

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

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This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.
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