Kadant Inc.'s (NYSE:KAI) Intrinsic Value Is Potentially 19% Below Its Share Price

Key Insights

• Using the 2 Stage Free Cash Flow to Equity, Kadant fair value estimate is US$151

• Current share price of US$186 suggests Kadant is potentially 23% overvalued

• Our fair value estimate is 30% lower than Kadant's analyst price target of US$216

Today we will run through one way of estimating the intrinsic value of Kadant Inc. (NYSE:KAI) by taking the expected future cash flows and discounting them 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!

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.

Check out our latest analysis for Kadant

The Method

We are going to use a two-stage DCF model, which, as the name states, takes into account two stages of growth. The first stage is generally a higher growth period which levels off heading towards the terminal value, captured in the second 'steady growth' period. In the first stage we need to estimate the cash flows to the business over the next ten years. 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

	2023	2024	2025	2026	2027	2028	2029	2030	2031	2032
Levered FCF ($, Millions)	US$130.4m	US$119.2m	US$117.6m	US$117.3m	US$117.8m	US$118.8m	US$120.3m	US$122.1m	US$124.2m	US$126.4m
Growth Rate Estimate Source	Analyst x3	Analyst x2	Est @ -1.31%	Est @ -0.30%	Est @ 0.41%	Est @ 0.91%	Est @ 1.26%	Est @ 1.50%	Est @ 1.67%	Est @ 1.79%
Present Value ($, Millions) Discounted @ 8.2%	US$121	US$102	US$92.9	US$85.6	US$79.4	US$74.1	US$69.3	US$65.0	US$61.1	US$57.5

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$807m

The second stage is also known as Terminal Value, this is the business's cash flow after 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 (2.1%) 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 8.2%.

Terminal Value (TV)= FCF₂₀₃₂ × (1 + g) ÷ (r – g) = US$126m× (1 + 2.1%) ÷ (8.2%– 2.1%) = US$2.1b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= US$2.1b÷ ( 1 + 8.2%)¹⁰= US$958m

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$1.8b. The last step is to then divide the equity value by the number of shares outstanding. Compared to the current share price of US$186, the company appears slightly overvalued at the time of writing. 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

Important 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 Kadant 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 8.2%, which is based on a levered beta of 1.031. 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 Kadant

Strength

• Earnings growth over the past year exceeded the industry.

• Debt is not viewed as a risk.

Weakness

• Dividend is low compared to the top 25% of dividend payers in the Machinery market.

• Expensive based on P/E ratio and estimated fair value.

Opportunity

• KAI's financial characteristics indicate limited near-term opportunities for shareholders.

Threat

• Annual earnings are forecast to decline for the next 2 years.

Moving On:

Whilst important, the DCF calculation 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. Preferably you'd apply different cases and assumptions and see how they would impact the company's valuation. For example, changes in the company's cost of equity or the risk free rate can significantly impact the valuation. What is the reason for the share price exceeding the intrinsic value? For Kadant, we've put together three important items you should further research:

1. Risks: To that end, you should learn about the 2 warning signs we've spotted with Kadant (including 1 which can't be ignored) .

2. Future Earnings: How does KAI'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 Solid Businesses: Low debt, high returns on equity and good past performance are fundamental to a strong business. Why not explore our interactive list of stocks with solid business fundamentals to see if there are other companies you may not have considered!

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.

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

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.

Join A Paid User Research Session
You’ll receive a US$30 Amazon Gift card for 1 hour of your time while helping us build better investing tools for the individual investors like yourself. Sign up here