Is Kenmare Resources plc (LON:KMR) Trading At A 43% Discount?

Key Insights

• The projected fair value for Kenmare Resources is UK£5.88 based on 2 Stage Free Cash Flow to Equity

• Kenmare Resources is estimated to be 43% undervalued based on current share price of UK£3.33

• Our fair value estimate is similar to Kenmare Resources' analyst price target of US$5.90

How far off is Kenmare Resources plc (LON:KMR) from its intrinsic value? Using the most recent financial data, we'll take a look at whether the stock is fairly priced by taking the forecast future cash flows of the company and discounting them back to today's value. This will be done using the Discounted Cash Flow (DCF) model. There's really not all that much to it, even though it might appear quite complex.

Remember though, that there are many ways to estimate a company's value, and a DCF is just one method. 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 Kenmare Resources

The Calculation

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 begin with, we have to get estimates of 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

	2024	2025	2026	2027	2028	2029	2030	2031	2032	2033
Levered FCF ($, Millions)	-US$32.0m	-US$35.2m	US$72.1m	US$66.6m	US$63.3m	US$61.4m	US$60.5m	US$60.1m	US$60.2m	US$60.5m
Growth Rate Estimate Source	Analyst x4	Analyst x4	Analyst x5	Est @ -7.71%	Est @ -4.91%	Est @ -2.94%	Est @ -1.57%	Est @ -0.61%	Est @ 0.07%	Est @ 0.54%
Present Value ($, Millions) Discounted @ 8.4%	-US$29.6	-US$30.0	US$56.6	US$48.2	US$42.3	US$37.9	US$34.4	US$31.5	US$29.1	US$27.0

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$247m

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 1.6%. We discount the terminal cash flows to today's value at a cost of equity of 8.4%.

Terminal Value (TV)= FCF₂₀₃₃ × (1 + g) ÷ (r – g) = US$60m× (1 + 1.6%) ÷ (8.4%– 1.6%) = US$909m

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= US$909m÷ ( 1 + 8.4%)¹⁰= US$405m

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 US$653m. To get the intrinsic value per share, we divide this by the total number of shares outstanding. Compared to the current share price of UK£3.3, the company appears quite undervalued at a 43% discount to where the stock price trades currently. Valuations are imprecise instruments though, rather like a telescope - move a few degrees and end up in a different galaxy. Do keep this in mind.

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 Kenmare Resources 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 8.4%, which is based on a levered beta of 1.235. 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 Kenmare Resources

Strength

• Debt is not viewed as a risk.

• Dividends are covered by earnings and cash flows.

• Dividend is in the top 25% of dividend payers in the market.

Weakness

• Earnings declined over the past year.

Opportunity

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

• Significant insider buying over the past 3 months.

Threat

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

Looking Ahead:

Whilst important, the DCF calculation is only one of many factors that you need to assess for a company. It's not possible to obtain a foolproof valuation with a DCF model. Rather it should be seen as a guide to "what assumptions need to be true for this stock to be under/overvalued?" For example, changes in the company's cost of equity or the risk free rate can significantly impact the valuation. Why is the intrinsic value higher than the current share price? For Kenmare Resources, there are three relevant factors you should further examine:

1. Risks: Consider for instance, the ever-present spectre of investment risk. We've identified 2 warning signs with Kenmare Resources (at least 1 which is concerning) , and understanding these should be part of your investment process.

2. Future Earnings: How does KMR'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. The Simply Wall St app conducts a discounted cash flow valuation for every stock on the LSE every day. If you want to find the calculation for other stocks 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.