Today we’ll do a simple run through of a valuation method used to estimate the attractiveness of Coca-Cola FEMSA, S.A.B. de C.V. (NYSE:KOF) as an investment opportunity by taking the expected future cash flows and discounting them to today’s value. We will take advantage of the Discounted Cash Flow (DCF) model for this purpose. Models like these may appear beyond the comprehension of a lay person, but they’re fairly easy to follow.
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.
See our latest analysis for Coca-Cola FEMSA. de
Crunching the numbers
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.
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) estimate
|Levered FCF (MX$, Millions)||Mex$16.3b||Mex$16.9b||Mex$21.4b||Mex$22.4b||Mex$23.5b||Mex$24.3b||Mex$25.1b||Mex$25.8b||Mex$26.5b||Mex$27.1b|
|Growth Rate Estimate Source||Analyst x5||Analyst x4||Analyst x2||Analyst x2||Analyst x2||Est @ 3.64%||Est @ 3.16%||Est @ 2.82%||Est @ 2.59%||Est @ 2.42%|
|Present Value (MX$, Millions) Discounted @ 8.8%||Mex$14.9k||Mex$14.3k||Mex$16.6k||Mex$16.0k||Mex$15.4k||Mex$14.7k||Mex$13.9k||Mex$13.1k||Mex$12.4k||Mex$11.6k|
(“Est” = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = Mex$143b
After calculating the present value of future cash flows in the initial 10-year period, we need to calculate the Terminal Value, which accounts for all future cash flows beyond 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 2.0%. We discount the terminal cash flows to today’s value at a cost of equity of 8.8%.
Terminal Value (TV)= FCF2030 × (1 + g) ÷ (r – g) = Mex$27b× (1 + 2.0%) ÷ (8.8%– 2.0%) = Mex$408b
Present Value of Terminal Value (PVTV)= TV / (1 + r)10= Mex$408b÷ ( 1 + 8.8%)10= Mex$175b
The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is Mex$318b. In the final step we divide the equity value by the number of shares outstanding. Compared to the current share price of US$46.4, the company appears quite undervalued at a 39% discount to where the stock price trades currently. Remember though, that this is just an approximate valuation, and like any complex formula – garbage in, garbage out.
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 Coca-Cola FEMSA. de 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 8.8%, which is based on a levered beta of 0.895. 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.
Although the valuation of a company is important, it shouldn’t be the only metric you look at when researching a company. It’s not possible to obtain a foolproof valuation with a DCF model. 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. 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. Why is the intrinsic value higher than the current share price? For Coca-Cola FEMSA. de, we’ve put together three pertinent factors you should further examine:
- Risks: As an example, we’ve found 2 warning signs for Coca-Cola FEMSA. de that you need to consider before investing here.
- Future Earnings: How does KOF’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.
- 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.
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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.
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