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Are Investors Undervaluing Kratos Defense & Security Solutions, Inc. (NASDAQ:KTOS) By 29%?

Does the January 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. This is done using the Discounted Cash Flow (DCF) model. It may sound complicated, but actually it is quite simple!

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.

See our latest analysis for Kratos Defense & Security Solutions

The method

We're using the 2-stage growth model, which simply means we take in account two stages of company's growth. In the initial period the company may have a higher growth rate and the second stage is usually assumed to have a stable growth rate. 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

2020

2021

2022

2023

2024

2025

2026

2027

2028

2029

Levered FCF ($, Millions)

US$32.4m

US$57.5m

US$89.0m

US$114.1m

US$137.2m

US$157.4m

US$174.4m

US$188.6m

US$200.2m

US$210.0m

Growth Rate Estimate Source

Analyst x5

Analyst x3

Analyst x1

Est @ 28.21%

Est @ 20.27%

Est @ 14.71%

Est @ 10.82%

Est @ 8.09%

Est @ 6.19%

Est @ 4.85%

Present Value ($, Millions) Discounted @ 7.2%

US$30.2

US$50.1

US$72.3

US$86.5

US$97.1

US$104

US$107

US$108

US$107

US$105

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$868m

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 10-year government bond rate of 1.7%. We discount the terminal cash flows to today's value at a cost of equity of 7.2%.

Terminal Value (TV)= FCF2029 × (1 + g) ÷ (r – g) = US$210m× (1 + 1.7%) ÷ 7.2%– 1.7%) = US$3.9b

Present Value of Terminal Value (PVTV)= TV / (1 + r)10= US$3.9b÷ ( 1 + 7.2%)10= US$2.0b

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$2.8b. The last step is to then divide the equity value by the number of shares outstanding. Compared to the current share price of US$18.8, the company appears a touch undervalued at a 29% 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.

NasdaqGS:KTOS Intrinsic value, January 28th 2020
NasdaqGS:KTOS Intrinsic value, January 28th 2020

The assumptions

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. 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 7.2%, which is based on a levered beta of 0.999. 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.

Next Steps:

Although the valuation of a company is important, it shouldn’t be the only metric you look at when researching a company. The DCF model is not a perfect stock valuation tool. Rather it should be seen as a guide to "what assumptions need to be true for this stock to be under/overvalued?" If a company grows at a different rate, or if its cost of equity or risk free rate changes sharply, the output can look very different. What is the reason for the share price to differ from the intrinsic value? For Kratos Defense & Security Solutions, There are three fundamental factors you should look at:

  1. Financial Health: Does KTOS 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 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: Are there other high quality stocks you could be holding instead of KTOS? 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 US stock every day, so if you want to find the intrinsic value of any other stock just search here.

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.

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. Thank you for reading.

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