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Is K-Bro Linen Inc. (TSE:KBL) Trading At A 33% Discount?

Simply Wall St
·6 min read

Today we'll do a simple run through of a valuation method used to estimate the attractiveness of K-Bro Linen Inc. (TSE:KBL) as an investment opportunity by taking the expected future cash flows and discounting them to their present value. The Discounted Cash Flow (DCF) model is the tool we will apply to do this. Models like these may appear beyond the comprehension of a lay person, but they're fairly easy to follow.

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 still have some burning questions about this type of valuation, take a look at the Simply Wall St analysis model.

Check out our latest analysis for K-Bro Linen

What's the estimated valuation?

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 need to discount the sum of these future cash flows to arrive at a present value estimate:

10-year free cash flow (FCF) forecast

2021

2022

2023

2024

2025

2026

2027

2028

2029

2030

Levered FCF (CA$, Millions)

CA$23.9m

CA$26.7m

CA$28.8m

CA$30.5m

CA$31.9m

CA$33.1m

CA$34.1m

CA$35.0m

CA$35.8m

CA$36.5m

Growth Rate Estimate Source

Analyst x5

Analyst x3

Est @ 7.77%

Est @ 5.9%

Est @ 4.59%

Est @ 3.68%

Est @ 3.04%

Est @ 2.59%

Est @ 2.27%

Est @ 2.05%

Present Value (CA$, Millions) Discounted @ 6.8%

CA$22.3

CA$23.4

CA$23.6

CA$23.4

CA$22.9

CA$22.3

CA$21.5

CA$20.6

CA$19.7

CA$18.9

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = CA$218m

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 1.5%. We discount the terminal cash flows to today's value at a cost of equity of 6.8%.

Terminal Value (TV)= FCF2030 × (1 + g) ÷ (r – g) = CA$37m× (1 + 1.5%) ÷ (6.8%– 1.5%) = CA$701m

Present Value of Terminal Value (PVTV)= TV / (1 + r)10= CA$701m÷ ( 1 + 6.8%)10= CA$362m

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 CA$580m. In the final step we divide the equity value by the number of shares outstanding. Relative to the current share price of CA$36.8, the company appears quite undervalued at a 33% discount to where the stock price trades currently. The assumptions in any calculation have a big impact on the valuation, so it is better to view this as a rough estimate, not precise down to the last cent.

dcf
dcf

Important 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 K-Bro Linen 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 1.012. 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.

Moving On:

Valuation is only one side of the coin in terms of building your investment thesis, and it 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. 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. Can we work out why the company is trading at a discount to intrinsic value? For K-Bro Linen, there are three further aspects you should look at:

  1. Risks: Take risks, for example - K-Bro Linen has 4 warning signs (and 1 which makes us a bit uncomfortable) we think you should know about.

  2. Future Earnings: How does KBL'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 TSX every day. If you want to find the calculation for other stocks just search here.

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. 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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team@simplywallst.com.