- Using the 2 Stage Free Cash Flow to Equity, Coca-Cola fair value estimate is US$64.03
- Coca-Cola's US$63.68 share price indicates it is trading at similar levels as its fair value estimate
- The US$69.01 analyst price target for KO is 7.8% more than our estimate of fair value
Does the April share price for The Coca-Cola Company (NYSE:KO) reflect what it's really worth? Today, we will estimate the stock's intrinsic value by estimating the company's future cash flows and discounting them to their present value. We will use the Discounted Cash Flow (DCF) model on this occasion. There's really not all that much to it, even though it might appear quite complex.
Companies can be valued in a lot of ways, so we would point out that a DCF is not perfect for every situation. Anyone interested in learning a bit more about intrinsic value should have a read of the Simply Wall St analysis model.
We are going to use a two-stage DCF model, which, as the name states, takes into account two stages of growth. The first stage is generally a higher growth period which levels off heading towards the terminal value, captured in the second 'steady growth' period. In the first stage we need to estimate the cash flows to the business over the next ten years. Where possible we use analyst estimates, but when these aren't available we extrapolate the previous free cash flow (FCF) from the last estimate or reported value. We assume companies with shrinking free cash flow will slow their rate of shrinkage, and that companies with growing free cash flow will see their growth rate slow, over this period. We do this to reflect that growth tends to slow more in the early years than it does in later years.
A DCF is all about the idea that a dollar in the future is less valuable than a dollar today, so we need to discount the sum of these future cash flows to arrive at a present value estimate:
10-year free cash flow (FCF) forecast
|Levered FCF ($, Millions)||US$9.54b||US$11.4b||US$12.3b||US$14.1b||US$14.5b||US$14.9b||US$15.2b||US$15.6b||US$15.9b||US$16.3b|
|Growth Rate Estimate Source||Analyst x6||Analyst x5||Analyst x4||Analyst x1||Analyst x1||Est @ 2.46%||Est @ 2.34%||Est @ 2.26%||Est @ 2.20%||Est @ 2.16%|
|Present Value ($, Millions) Discounted @ 6.8%||US$8.9k||US$10.0k||US$10.1k||US$10.8k||US$10.4k||US$10.0k||US$9.6k||US$9.2k||US$8.8k||US$8.4k|
("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$96b
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. 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 2.1%. We discount the terminal cash flows to today's value at a cost of equity of 6.8%.
Terminal Value (TV)= FCF2032 × (1 + g) ÷ (r – g) = US$16b× (1 + 2.1%) ÷ (6.8%– 2.1%) = US$349b
Present Value of Terminal Value (PVTV)= TV / (1 + r)10= US$349b÷ ( 1 + 6.8%)10= US$181b
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$277b. In the final step we divide the equity value by the number of shares outstanding. Compared to the current share price of US$63.7, the company appears about fair value at a 0.6% discount to where the stock price trades currently. Remember though, that this is just an approximate valuation, and like any complex formula - garbage in, garbage out.
We would point out that 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 Coca-Cola 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 6.8%, which is based on a levered beta of 0.800. 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 Coca-Cola
- Debt is well covered by earnings and cashflows.
- Dividends are covered by earnings and cash flows.
- Earnings declined over the past year.
- Dividend is low compared to the top 25% of dividend payers in the Beverage market.
- Annual earnings are forecast to grow for the next 3 years.
- Good value based on P/E ratio and estimated fair value.
- Annual earnings are forecast to grow slower than the American market.
Whilst important, the DCF calculation is only one of many factors that 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 need to be true for this stock to be under/overvalued?" For example, changes in the company's cost of equity or the risk free rate can significantly impact the valuation. For Coca-Cola, we've compiled three additional factors you should further research:
- Risks: We feel that you should assess the 2 warning signs for Coca-Cola we've flagged before making an investment in the company.
- Management:Have insiders been ramping up their shares to take advantage of the market's sentiment for KO's future outlook? Check out our management and board analysis with insights on CEO compensation and governance factors.
- 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 American 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. 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.