Stock Analysis

Calculating The Fair Value Of Kennametal Inc. (NYSE:KMT)

NYSE:KMT
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Key Insights

  • The projected fair value for Kennametal is US$28.62 based on 2 Stage Free Cash Flow to Equity
  • With US$27.90 share price, Kennametal appears to be trading close to its estimated fair value
  • Analyst price target for KMT is US$26.44 which is 7.6% below our fair value estimate

Today we will run through one way of estimating the intrinsic value of Kennametal Inc. (NYSE:KMT) by taking the forecast future cash flows of the company and discounting them back to today's value. We will take advantage of the Discounted Cash Flow (DCF) model for this purpose. Before you think you won't be able to understand it, just read on! It's actually much less complex than you'd imagine.

We would caution that there are many ways of valuing a company and, like the DCF, each technique has advantages and disadvantages in certain scenarios. 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.

Check out our latest analysis for Kennametal

The Calculation

We use what is known as a 2-stage model, which simply means we have two different periods of growth rates for the company's cash flows. Generally the first stage is higher growth, and the second stage is a lower growth phase. 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, and so the sum of these future cash flows is then discounted to today's value:

10-year free cash flow (FCF) estimate

2023 2024 2025 2026 2027 2028 2029 2030 2031 2032
Levered FCF ($, Millions) US$133.0m US$146.5m US$157.0m US$165.0m US$171.9m US$178.0m US$183.5m US$188.6m US$193.5m US$198.2m
Growth Rate Estimate Source Analyst x2 Analyst x2 Analyst x2 Est @ 5.08% Est @ 4.18% Est @ 3.54% Est @ 3.10% Est @ 2.79% Est @ 2.58% Est @ 2.42%
Present Value ($, Millions) Discounted @ 9.0% US$122 US$123 US$121 US$117 US$112 US$106 US$100 US$94.7 US$89.1 US$83.8

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$1.1b

After calculating the present value of future cash flows in the initial 10-year period, we need to calculate the Terminal Value, which accounts for all future cash flows beyond 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 (2.1%) 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 9.0%.

Terminal Value (TV)= FCF2032 × (1 + g) ÷ (r – g) = US$198m× (1 + 2.1%) ÷ (9.0%– 2.1%) = US$2.9b

Present Value of Terminal Value (PVTV)= TV / (1 + r)10= US$2.9b÷ ( 1 + 9.0%)10= US$1.2b

The total value is the sum of cash flows for the next ten years plus the discounted terminal value, which results in the Total Equity Value, which in this case is US$2.3b. In the final step we divide the equity value by the number of shares outstanding. Compared to the current share price of US$27.9, the company appears about fair value at a 2.5% discount to where the stock price trades currently. Valuations are imprecise instruments though, rather like a telescope - move a few degrees and end up in a different galaxy. Do keep this in mind.

dcf
NYSE:KMT Discounted Cash Flow February 23rd 2023

The Assumptions

Now the most important inputs to a discounted cash flow are the discount rate, and of course, the actual 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 Kennametal 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 9.0%, which is based on a levered beta of 1.165. 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 Kennametal

Strength
  • Earnings growth over the past year exceeded its 5-year average.
  • Debt is well covered by earnings and cashflows.
Weakness
  • Earnings growth over the past year underperformed the Machinery industry.
  • Dividend is low compared to the top 25% of dividend payers in the Machinery market.
Opportunity
  • Annual earnings are forecast to grow for the next 3 years.
  • Good value based on P/E ratio and estimated fair value.
Threat
  • Dividends are not covered by cash flow.
  • Annual earnings are forecast to grow slower than the American market.

Looking Ahead:

Whilst important, the DCF calculation ideally won't be the sole piece of analysis you scrutinize for a company. It's not possible to obtain a foolproof valuation with a DCF model. 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 instance, if the terminal value growth rate is adjusted slightly, it can dramatically alter the overall result. For Kennametal, we've compiled three fundamental factors you should consider:

  1. Risks: As an example, we've found 2 warning signs for Kennametal that you need to consider before investing here.
  2. Management:Have insiders been ramping up their shares to take advantage of the market's sentiment for KMT's future outlook? Check out our management and board analysis with insights on CEO compensation and governance factors.
  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 NYSE every day. If you want to find the calculation for other stocks just search here.

Valuation is complex, but we're here to simplify it.

Discover if Kennametal might be undervalued or overvalued with our detailed analysis, featuring fair value estimates, potential risks, dividends, insider trades, and its financial condition.

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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.