Estimating The Fair Value Of Kratos Defense & Security Solutions, Inc. (NASDAQ:KTOS)

Key Insights

• The projected fair value for Kratos Defense & Security Solutions is US$18.97 based on 2 Stage Free Cash Flow to Equity

• Kratos Defense & Security Solutions' US$18.21 share price indicates it is trading at similar levels as its fair value estimate

• Our fair value estimate is 12% lower than Kratos Defense & Security Solutions' analyst price target of US$21.60

How far off is Kratos Defense & Security Solutions, Inc. (NASDAQ:KTOS) from its intrinsic value? Using the most recent financial data, we'll take a look at whether the stock is fairly priced by projecting its future cash flows and then discounting them to today's value. Our analysis will employ the Discounted Cash Flow (DCF) model. There's really not all that much to it, even though it might appear quite complex.

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 want to learn more about discounted cash flow, the rationale behind this calculation can be read in detail in the Simply Wall St analysis model.

Check out our latest analysis for Kratos Defense & Security Solutions

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.

A DCF is all about the idea that a dollar in the future is less valuable than a dollar today, 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

	2024	2025	2026	2027	2028	2029	2030	2031	2032	2033
Levered FCF ($, Millions)	-US$22.9m	US$29.7m	US$46.3m	US$71.0m	US$90.7m	US$109.0m	US$125.1m	US$138.9m	US$150.5m	US$160.4m
Growth Rate Estimate Source	Analyst x5	Analyst x5	Analyst x2	Analyst x1	Est @ 27.77%	Est @ 20.12%	Est @ 14.77%	Est @ 11.03%	Est @ 8.41%	Est @ 6.57%
Present Value ($, Millions) Discounted @ 6.2%	-US$21.6	US$26.3	US$38.6	US$55.7	US$67.0	US$75.7	US$81.8	US$85.5	US$87.2	US$87.5

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$584m

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 (2.3%) 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 6.2%.

Terminal Value (TV)= FCF₂₀₃₃ × (1 + g) ÷ (r – g) = US$160m× (1 + 2.3%) ÷ (6.2%– 2.3%) = US$4.1b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= US$4.1b÷ ( 1 + 6.2%)¹⁰= US$2.3b

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$2.8b. 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$18.2, the company appears about fair value at a 4.0% 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.

dcf

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. If you don't agree with these result, have a go at the calculation yourself and play with the 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 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 6.2%, which is based on a levered beta of 0.861. 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 Kratos Defense & Security Solutions

Strength

• Debt is well covered by cash flow.

Weakness

• Interest payments on debt are not well covered.

• Shareholders have been diluted in the past year.

Opportunity

• Expected to breakeven next year.

• Has sufficient cash runway for more than 3 years based on current free cash flows.

• Current share price is below our estimate of fair value.

Threat

• No apparent threats visible for KTOS.

Next Steps:

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. 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. For Kratos Defense & Security Solutions, we've put together three relevant aspects you should further examine:

1. Risks: For example, we've discovered 1 warning sign for Kratos Defense & Security Solutions that you should be aware of before investing here.

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 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. 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.