Is There An Opportunity With Keurig Dr Pepper Inc.'s (NASDAQ:KDP) 37% Undervaluation?

Key Insights

• The projected fair value for Keurig Dr Pepper is US$53.94 based on 2 Stage Free Cash Flow to Equity

• Current share price of US$34.03 suggests Keurig Dr Pepper is potentially 37% undervalued

• Analyst price target for KDP is US$36.26 which is 33% below our fair value estimate

Today we will run through one way of estimating the intrinsic value of Keurig Dr Pepper Inc. (NASDAQ:KDP) by taking the expected future cash flows and discounting them to their present value. The Discounted Cash Flow (DCF) model is the tool we will apply to do this. Models like these may appear beyond the comprehension of a lay person, but they're fairly easy to follow.

Companies can be valued in a lot of ways, so we would point out that a DCF is not perfect for every situation. 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.

View our latest analysis for Keurig Dr Pepper

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. 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 need to discount the sum of these future cash flows to arrive at a present value estimate:

10-year free cash flow (FCF) estimate

	2024	2025	2026	2027	2028	2029	2030	2031	2032	2033
Levered FCF ($, Millions)	US$1.99b	US$2.75b	US$3.10b	US$3.26b	US$3.25b	US$3.27b	US$3.30b	US$3.35b	US$3.41b	US$3.47b
Growth Rate Estimate Source	Analyst x4	Analyst x5	Analyst x2	Analyst x2	Analyst x2	Est @ 0.48%	Est @ 1.05%	Est @ 1.45%	Est @ 1.73%	Est @ 1.92%
Present Value ($, Millions) Discounted @ 6.2%	US$1.9k	US$2.4k	US$2.6k	US$2.6k	US$2.4k	US$2.3k	US$2.2k	US$2.1k	US$2.0k	US$1.9k

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$22b

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 (2.4%) 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$3.5b× (1 + 2.4%) ÷ (6.2%– 2.4%) = US$93b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= US$93b÷ ( 1 + 6.2%)¹⁰= US$51b

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$73b. In the final step we divide the equity value by the number of shares outstanding. Relative to the current share price of US$34.0, the company appears quite good value at a 37% 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

The 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 Keurig Dr Pepper 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 0.832. 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 Keurig Dr Pepper

Strength

• Earnings growth over the past year exceeded the industry.

• Debt is well covered by earnings.

Weakness

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

Opportunity

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

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

• Significant insider buying over the past 3 months.

Threat

• Debt is not well covered by operating cash flow.

• Dividends are not covered by cash flow.

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

Moving On:

Whilst important, the DCF calculation shouldn't be the only metric you look at when researching a company. DCF models are not the be-all and end-all of investment valuation. 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. 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 Keurig Dr Pepper, we've compiled three fundamental aspects you should explore:

1. Risks: As an example, we've found 2 warning signs for Keurig Dr Pepper (1 shouldn't be ignored!) that you need to consider before investing here.

2. Future Earnings: How does KDP'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.