Is There An Opportunity With LATAM Airlines Group S.A.'s (SNSE:LTM) 27% Undervaluation?

Key Insights

• LATAM Airlines Group's estimated fair value is CL$33.83 based on 2 Stage Free Cash Flow to Equity
• LATAM Airlines Group's CL$24.66 share price signals that it might be 27% undervalued
• The US$29.31 analyst price target for LTM is 13% less than our estimate of fair value

Today we will run through one way of estimating the intrinsic value of LATAM Airlines Group S.A. (SNSE:LTM) by taking the forecast future cash flows of the company and discounting them back to today's value. One way to achieve this is by employing the Discounted Cash Flow (DCF) model. It may sound complicated, but actually it is quite simple!

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. For those who are keen learners of equity analysis, the Simply Wall St analysis model here may be something of interest to you.

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Is LATAM Airlines Group Fairly Valued?

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 begin with, we have to get estimates of 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.

A DCF is all about the idea that a dollar in the future is less valuable than a dollar today, 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

	2026	2027	2028	2029	2030	2031	2032	2033	2034	2035
Levered FCF ($, Millions)	US$2.16b	US$1.86b	US$1.83b	US$1.85b	US$1.88b	US$1.94b	US$2.02b	US$2.11b	US$2.20b	US$2.31b
Growth Rate Estimate Source	Analyst x3	Analyst x2	Est @ -1.36%	Est @ 0.70%	Est @ 2.14%	Est @ 3.14%	Est @ 3.85%	Est @ 4.34%	Est @ 4.68%	Est @ 4.93%
Present Value ($, Millions) Discounted @ 12%	US$1.9k	US$1.5k	US$1.3k	US$1.2k	US$1.1k	US$966	US$893	US$829	US$773	US$721

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$11b

The second stage is also known as Terminal Value, this is the business's cash flow after 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 5.5%. We discount the terminal cash flows to today's value at a cost of equity of 12%.

Terminal Value (TV)= FCF₂₀₃₅ × (1 + g) ÷ (r – g) = US$2.3b× (1 + 5.5%) ÷ (12%– 5.5%) = US$36b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= US$36b÷ ( 1 + 12%)¹⁰= US$11b

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$22b. To get the intrinsic value per share, we divide this by the total number of shares outstanding. Compared to the current share price of CL$24.7, the company appears a touch undervalued at a 27% 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.

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 LATAM Airlines Group 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 12%, which is based on a levered beta of 1.258. 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.

Check out our latest analysis for LATAM Airlines Group

SWOT Analysis for LATAM Airlines Group

Next Steps:

Whilst important, the DCF calculation 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. 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. Can we work out why the company is trading at a discount to intrinsic value? For LATAM Airlines Group, there are three important aspects you should consider:

1. Risks: You should be aware of the 2 warning signs for LATAM Airlines Group we've uncovered before considering an investment in the company.
2. Future Earnings: How does LTM'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. The Simply Wall St app conducts a discounted cash flow valuation for every stock on the SNSE 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.