Air France-KLM SA (EPA:AF) Shares Could Be 40% Below Their Intrinsic Value Estimate

Key Insights

• Using the 2 Stage Free Cash Flow to Equity, Air France-KLM fair value estimate is €2.95
• Current share price of €1.78 suggests Air France-KLM is potentially 40% undervalued
• Analyst price target for AF is €1.67 which is 43% below our fair value estimate

Today we'll do a simple run through of a valuation method used to estimate the attractiveness of Air France-KLM SA (EPA:AF) as an investment opportunity by taking the expected future cash flows and discounting them to today's value. One way to achieve this is by employing the Discounted Cash Flow (DCF) model. Believe it or not, it's not too difficult to follow, as you'll see from our example!

Remember though, that there are many ways to estimate a company's value, and a DCF is just one method. Anyone interested in learning a bit more about intrinsic value should have a read of the Simply Wall St analysis model.

View our latest analysis for Air France-KLM

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.

Generally we assume that a dollar today is more valuable than a dollar in the future, so we discount the value of these future cash flows to their estimated value in today's dollars:

10-year free cash flow (FCF) forecast

	2023	2024	2025	2026	2027	2028	2029	2030	2031	2032
Levered FCF (€, Millions)	€70.9m	€665.8m	€1.47b	€1.36b	€1.30b	€1.26b	€1.23b	€1.21b	€1.21b	€1.20b
Growth Rate Estimate Source	Analyst x5	Analyst x5	Analyst x2	Analyst x1	Est @ -4.74%	Est @ -3.16%	Est @ -2.06%	Est @ -1.28%	Est @ -0.74%	Est @ -0.36%
Present Value (€, Millions) Discounted @ 14%	€62.1	€511	€989	€804	€671	€569	€489	€423	€368	€321

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = €5.2b

The second stage is also known as Terminal Value, this is the business's cash flow after the first stage. 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 have used the 5-year average of the 10-year government bond yield (0.5%) to estimate future growth. In the same way as with the 10-year 'growth' period, we discount future cash flows to today's value, using a cost of equity of 14%.

Terminal Value (TV)= FCF₂₀₃₂ × (1 + g) ÷ (r – g) = €1.2b× (1 + 0.5%) ÷ (14%– 0.5%) = €8.9b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= €8.9b÷ ( 1 + 14%)¹⁰= €2.4b

The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is €7.6b. To get the intrinsic value per share, we divide this by the total number of shares outstanding. Compared to the current share price of €1.8, the company appears quite undervalued at a 40% 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.

Important Assumptions

The calculation above is very dependent on two assumptions. The first is the discount rate and the other is the cash flows. You don't have to agree with these inputs, I recommend redoing the calculations yourself and playing with them. 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 Air France-KLM 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 14%, which is based on a levered beta of 2.000. 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.

SWOT Analysis for Air France-KLM

Next Steps:

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 company. DCF models are not the be-all and end-all of investment valuation. Instead the best use for a DCF model is to test certain assumptions and theories to see if they would lead to the company being undervalued or overvalued. For example, changes in the company's cost of equity or the risk free rate can significantly impact the valuation. Can we work out why the company is trading at a discount to intrinsic value? For Air France-KLM, there are three pertinent aspects you should explore:

1. Risks: For example, we've discovered 3 warning signs for Air France-KLM that you should be aware of before investing here.
2. Future Earnings: How does AF'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. The Simply Wall St app conducts a discounted cash flow valuation for every stock on the ENXTPA every day. If you want to find the calculation for other stocks just search here.

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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. 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.