An Intrinsic Calculation For Kratos Defense & Security Solutions, Inc. (NASDAQ:KTOS) Suggests It's 22% Undervalued

Simply Wall St · 10/15 16:00

Key Insights

  • Using the 2 Stage Free Cash Flow to Equity, Kratos Defense & Security Solutions fair value estimate is US$32.43
  • Kratos Defense & Security Solutions is estimated to be 22% undervalued based on current share price of US$25.35
  • The US$25.82 analyst price target for KTOS is 20% less than our estimate of fair value

Does the October share price for Kratos Defense & Security Solutions, Inc. (NASDAQ:KTOS) reflect what it's really worth? Today, we will estimate the stock's intrinsic value by taking the expected future cash flows and discounting them to their present value. One way to achieve this is by employing the Discounted Cash Flow (DCF) model. Before you think you won't be able to understand it, just read on! It's actually much less complex than you'd imagine.

Companies can be valued in a lot of ways, so we would point out that a DCF is not perfect for every situation. 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 Kratos Defense & Security Solutions

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. To start off with, we need to estimate the next ten years of cash flows. 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

2025 2026 2027 2028 2029 2030 2031 2032 2033 2034
Levered FCF ($, Millions) US$35.9m US$67.7m US$95.1m US$122.8m US$148.6m US$171.7m US$191.6m US$208.6m US$223.1m US$235.7m
Growth Rate Estimate Source Analyst x6 Analyst x2 Est @ 40.42% Est @ 29.05% Est @ 21.08% Est @ 15.51% Est @ 11.61% Est @ 8.87% Est @ 6.96% Est @ 5.62%
Present Value ($, Millions) Discounted @ 6.0% US$33.8 US$60.3 US$79.9 US$97.3 US$111 US$121 US$128 US$131 US$132 US$132

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$1.0b

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 (2.5%) 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 6.0%.

Terminal Value (TV)= FCF2034 × (1 + g) ÷ (r – g) = US$236m× (1 + 2.5%) ÷ (6.0%– 2.5%) = US$6.9b

Present Value of Terminal Value (PVTV)= TV / (1 + r)10= US$6.9b÷ ( 1 + 6.0%)10= US$3.9b

The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is US$4.9b. The last step is to then divide the equity value by the number of shares outstanding. Relative to the current share price of US$25.4, the company appears a touch undervalued at a 22% 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
NasdaqGS:KTOS Discounted Cash Flow October 15th 2024

The Assumptions

Now the most important inputs to a discounted cash flow are the discount rate, and of course, the actual 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 Kratos Defense & Security Solutions 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 6.0%, which is based on a levered beta of 0.847. 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 Kratos Defense & Security Solutions

Strength
  • Debt is not viewed as a risk.
Weakness
  • Shareholders have been diluted in the past year.
Opportunity
  • Annual earnings are forecast to grow faster than the American market.
  • Trading below our estimate of fair value by more than 20%.
  • Significant insider buying over the past 3 months.
Threat
  • Annual revenue is forecast to grow slower than the American market.

Looking Ahead:

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. Why is the intrinsic value higher than the current share price? For Kratos Defense & Security Solutions, we've put together three further items you should consider:

  1. Risks: For example, we've discovered 1 warning sign for Kratos Defense & Security Solutions that you should be aware of before investing here.
  2. Future Earnings: How does KTOS'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 High Quality Alternatives: Do you like a good all-rounder? Explore our interactive list of high quality stocks to get an idea of what else is out there you may be missing!

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.