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Investors Are Undervaluing KB Home (NYSE:KBH) By 46.42%

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Today I will be providing a simple run through of a valuation method used to estimate the attractiveness of KB Home (NYSE:KBH) as an investment opportunity by projecting its future cash flows and then discounting them to todayâ€™s value. This is done using the discounted cash flows (DCF) model. It may sound complicated, but actually it is quite simple! Anyone interested in learning a bit more about intrinsic value should have a read of the Simply Wall St analysis model. Please also note that this article was written in February 2019 so be sure check out the updated calculation by following the link below.

Step by step through the calculation

I use what is known as a 2-stage model, which simply means we have two different periods of varying growth rates for the companyâ€™s cash flows. Generally the first stage is higher growth, and the second stage is a more stable growth phase. To start off with we need to estimate the next five years of cash flows. For this I used the consensus of the analysts covering the stock, as you can see below. I then discount the sum of these cash flows to arrive at a present value estimate.

5-year cash flow forecast

 2019 2020 2021 2022 2023 Levered FCF (\$, Millions) \$254.65 \$355.78 \$417.01 \$487.90 \$565.96 Source Analyst x2 Analyst x4 Est @ 17.21% Est @ 17%, capped from 17.21% Est @ 16%, capped from 17.21% Present Value Discounted @ 14.94% \$221.56 \$269.31 \$274.64 \$279.57 \$282.16

Present Value of 5-year Cash Flow (PVCF)= US\$1.3b

After calculating the present value of future cash flows in the intial 5-year period we need to calculate the Terminal Value, which accounts for all the future cash flows beyond the first stage. For a number of reasons a very conservative growth rate is used that cannot exceed that of the GDP. In this case I have used the 10-year government bond rate (2.7%). In the same way as with the 5-year â€˜growthâ€™ period, we discount this to todayâ€™s value at a cost of equity of 14.9%.

Terminal Value (TV) = FCF2023 Ã— (1 + g) Ã· (r â€“ g) = US\$566m Ã— (1 + 2.7%) Ã· (14.9% â€“ 2.7%) = US\$4.8b

Present Value of Terminal Value (PVTV) = TV / (1 + r)5 = US\$4.8b Ã· ( 1 + 14.9%)5 = US\$2.4b

The total value, or equity value, is then the sum of the present value of the cash flows, which in this case is US\$3.7b. In the final step we divide the equity value by the number of shares outstanding. If the stock is an depositary receipt (represents a specified number of shares in a foreign corporation) or ADR then we use the equivalent number. This results in an intrinsic value of \$42.59. Relative to the current share price of \$22.82, the stock is quite good value at a 46% discount to what it is available for right now.

Important assumptions

Iâ€™d like to point out that the most important inputs to a discounted cash flow are the discount rate and of course the actual cash flows. You donâ€™t have to agree with my inputs, I recommend redoing the calculations yourself and playing with them. Because we are looking at KB Home as potential shareholders, the cost of equity is used as the discount rate, rather than the cost of capital (or weighed average cost of capital, WACC) which accounts for debt. In this calculation Iâ€™ve used 14.9%, which is based on a levered beta of 1.679. This is derived from the Bottom-Up Beta method based on comparable companies, with an imposed limit between 0.8 and 2.0, which is a reasonable range for a stable business.

Next Steps:

Although the valuation of a company is important, it shouldnâ€™t be the only metric you look at when researching a company. What is the reason for the share price to differ from the intrinsic value? For KBH, Iâ€™ve put together three pertinent factors you should further research:

1. Financial Health: Does KBH have a healthy balance sheet? Take a look at our free balance sheet analysis with six simple checks on key factors like leverage and risk.
2. Future Earnings: How does KBHâ€™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: Are there other high quality stocks you could be holding instead of KBH? 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 for every stock on the NYSE every 6 hours. If you want to find the calculation for other stocks just search here.

We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.

If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.com. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned. On rare occasion, data errors may occur. Thank you for reading.