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Are Investors Undervaluing The Kroger Co. (NYSE:KR) By 48%?

Key Insights

  • Using the 2 Stage Free Cash Flow to Equity, Kroger fair value estimate is US$88.30

  • Kroger is estimated to be 48% undervalued based on current share price of US$46.07

  • The US$53.18 analyst price target for KR is 40% less than our estimate of fair value

In this article we are going to estimate the intrinsic value of The Kroger Co. (NYSE:KR) by taking the expected future cash flows and discounting them to today's value. The Discounted Cash Flow (DCF) model is the tool we will apply to do this. It may sound complicated, but actually it is quite simple!

We generally believe that a company's value is the present value of all of the cash it will generate in the future. However, a DCF is just one valuation metric among many, and it is not without flaws. If you still have some burning questions about this type of valuation, take a look at the Simply Wall St analysis model.

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View our latest analysis for Kroger

What's The Estimated Valuation?

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) estimate

2023

2024

2025

2026

2027

2028

2029

2030

2031

2032

Levered FCF ($, Millions)

US$2.75b

US$3.48b

US$3.26b

US$3.42b

US$3.65b

US$3.79b

US$3.90b

US$4.01b

US$4.11b

US$4.21b

Growth Rate Estimate Source

Analyst x5

Analyst x5

Analyst x4

Analyst x4

Analyst x3

Analyst x3

Est @ 2.99%

Est @ 2.73%

Est @ 2.54%

Est @ 2.41%

Present Value ($, Millions) Discounted @ 7.5%

US$2.6k

US$3.0k

US$2.6k

US$2.6k

US$2.5k

US$2.5k

US$2.4k

US$2.2k

US$2.1k

US$2.0k

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$25b

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. 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 7.5%.

Terminal Value (TV)= FCF2032 × (1 + g) ÷ (r – g) = US$4.2b× (1 + 2.1%) ÷ (7.5%– 2.1%) = US$80b

Present Value of Terminal Value (PVTV)= TV / (1 + r)10= US$80b÷ ( 1 + 7.5%)10= US$39b

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$63b. To get the intrinsic value per share, we divide this by the total number of shares outstanding. Compared to the current share price of US$46.1, the company appears quite good value at a 48% 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 Kroger 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 7.5%, which is based on a levered beta of 0.906. 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 Kroger

Strength

  • Earnings growth over the past year exceeded the industry.

  • Debt is well covered by earnings and cashflows.

  • Dividends are covered by earnings and cash flows.

Weakness

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

Opportunity

  • Annual earnings are forecast to grow for the next 3 years.

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

Threat

  • Annual earnings are forecast to grow slower than the American market.

Looking Ahead:

Although the valuation of a company is important, 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. Preferably you'd apply different cases and assumptions and see how they would impact the company's valuation. For instance, if the terminal value growth rate is adjusted slightly, it can dramatically alter the overall result. What is the reason for the share price sitting below the intrinsic value? For Kroger, we've compiled three pertinent items you should explore:

  1. Risks: You should be aware of the 3 warning signs for Kroger we've uncovered before considering an investment in the company.

  2. Management:Have insiders been ramping up their shares to take advantage of the market's sentiment for KR's future outlook? Check out our management and board analysis with insights on CEO compensation and governance factors.

  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 NYSE every day. If you want to find the calculation for other stocks 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.

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