Kerry Group Plc Discounted Cash Flow (DCF) Analysis

Posted by Matthew Harvey on Aug-01-2022

1. Introduction

Discounted Cash Flow (DCF) valuation remains a fundamental value investing model. Using a DCF continues to be one of the best ways to calculate a company's intrinsic value. Using a DCF remains the main method analysts use throughout finance, and some think using this type of valuation remains far too complicated for them.

There are several ways to estimate FCF, but it is typically calculated over five years (Partnoy, 2022). Sector, stage of growth, and financial predictability all factor into how long a corporation may expect a projection to be accurate(Gaspars-Wieloch, 2019). The PV of free cash flows is calculated by discounting the cash flows at the WACC of the company. The terminal value and PV of cash flows are combined to calculate the company's total value. As a result, rather than looking at a single figure in a DCF report, we analyze the whole range of values. To understand how these assumptions impact the value, sensitivity analysis is utilized.

The application of the model is explained by taking Kerry Group Plc as an example. The historical financial data of Kerry Group Plc is used to project the cash flows for the next five years, and then the cash flows are discounted to calculate the company's intrinsic value.

2. Steps involved in DCF Analysis

Step-by-step instructions on how to design a DCF are provided in this section. DCF mastery is also provided, in the form of a collection of tools that allow one to build an in-depth examination of the objective and its main performance factors, as well as a rational set of assumptions.

2.1 Step 1: Understanding the Business Model:

A DCF begins with extensive study and data collection about the firm in question and the industry in which it operates. To construct a framework for valuation, one must have a firm grasp of the company profile, which can be done by performing the SWOT, PESTEL, and Porter's Five Forces analysis(Viswanadham, 2018). WACC and terminal value assumptions and realistic financial estimates must be developed (or supported) by the banker for the goal.

To understand the business model of Kerry Group Plc, we start with an overall macroeconomic analysis and then conduct the industry analysis to which the company belongs. Next, we conduct the individual company analysis and compare it with its competitors.

2.1.1 Key Drivers:

Identifying the most important aspects influencing the company's performance is the next step in creating a realistic set of FCF estimates. Some of these influences are internal (such as the expansion of the company's facilities or the development of its goods), while others are external(Matar & Eneizan, 2018).

Depending on its organizational structure and management team, a company's development profile may be quite different from its industry competitors. A broad variety of factors, such as management style, brand recognition, customer base, and operational focus, as well as product mix, sales/marketing strategy, size, and technological advancements, affect profitability for enterprises in a certain sector(Malagueno, Lopez-Valeiras, & Gomez-Conde, 2018).  

2.1.2 The Free Cash Flows are calculated using the following formula:

Free Cash Flow Calculation

Earnings before Interest and Taxes

Less: Taxes (at the Marginal Tax Rate)

2.1.3 Earnings before Interest after Taxes

Plus: Depreciation & Amortization

Less: Capital Expenditures

2.1.4 Less: Increase/ Decrease in Net Working Capital

Free Cash Flow

(Borad, 2022)

2.1.5 Historical Data:

Understanding previous performance allows for a more accurate estimation of FCF. For established firms operating in non-cyclical industries, a firm's previous financial success is a solid predictor of future financial performance(Jesus & Mira da Silva, 2014). When estimating future financials, it is usually considered good if the past financial data of at least 10 years is used; however, the past data of 3 years can also be used(Beach, 2019). The historical unlevered cash flows for Kerry Group Plc are as follows:

    (in million) Actual
  2018 2019 2020 2021
Sales 2,955 3,568 4,102 4,663
         
Total costs -2,511 -3,047 -3,524 -4,031
EBITDA 444 521 578 631
Depreciation & Amortization: -49 -63 -75 -84
EBIT 396 459 503 548
Taxes (30%) -119 -138 -151 -164
Capex   -79 -41 -169
Increase/Decrease in NWC

 

-145 -77 -18
Unlevered Free Cash Flow   159 309 281

 

2.1.6 Projection Period:

In most cases, the analyst can anticipate the company's FCF for a period of five years. Established businesses in mature industries may be able to attain a steady condition within five years. At least one business cycle should be included in a five-year projection period, which allows adequate time for current or planned actions to be realized (N.Kaplan & S.Ruback, 1995).

In the case of Kerry Group Plc, the financial data is projected for the next five years, i.e., 2022 to 2026, using the historical data of the past four years, i.e., 2018 to 2021.

2.2 Step 2: Projections of Free Cash Flows:

The unlevered FCF of a target is used to calculate the DCF. A company's "unlevered FCF" refers to the cash that has been generated after covering all the operating expenses incurred throughout the year and all the applicable taxes but before any interest expenses have been paid out by that company(Schueler, 2017).

Sales trend, margin ratios, and NWC all play a part in determining how much FCF the goal is projected to produce. The development of these assumptions is aided by past performance and direction from third parties and/or management. The most important factor in DCF valuation is the adoption of accurate FCF predictions(Januszewski, 2011).  

FCF projections aim to forecast the target's financial performance to a point in the future when it may be used as the foundation for calculating the target's terminal value. The actual and forecasted sales, costs, CAPEX, NWC, and free cash flows for Kerry Group Plc are indicated in the below figure.

Forecast period
    (in million) Actual CAGR
  2018 2019 2020 2021 (18- 21) 2022 2023 2024 2025 2026
Sales 2,955 3,568 4,102 4,663 16% 5,036 5,438 5,874 6,343 6,851
                     
Total costs -2,511 -3,047 -3,524 -4,031 17% -4,316 -4,661 -5,034 -5,436 -5,871
EBITDA 444 521 578 631 12% 720 778 840 907 980
Depreciation & Amortization: -49 -63 -75 -84   -91 -98 -106 -114 -123
EBIT 396 459 503 548 11% 629 680 734 793 856
Taxes (30%) -119 -138 -151 -164   -189 -204 -220 -238 -257
Capex   -79 -41 -169   -116 -125 -135 -146 -158
Increase/Decrease in NWC

 

-145 -77 -18   -14 -33 -35 -38 -41
Unlevered Free Cash Flow   159 309 281   402 416 449 485 524

2.3 Step 3: Calculation of Discount Rate:

The WACC is the discount rate used to find the PV of an organization's projected future cash flow (FCF) and terminal value (Visconti, 2022). It demonstrates the usual return on investment needed for a certain company. The "WACC" of an organization is calculated based on the projected capital structure of that organization. This is owing to the fact that debt and equity both come with their own unique sets of risks and repercussions for taxes.

To put it another way, the WACC might be regarded as the opportunity cost of capital for an investor, which is the return anticipated from an alternative investment with risk characteristics equivalent to those of the first investment.  

The cost of capital for a corporation could change based on its many different business lines. Therefore, it is possible that carrying out a Discounted Cash Flow analysis using the "sum of the parts" method, where each distinct corporate sector has its own WACC, would prove advantageous in several different contexts(Khudoykulov, 2021).

In the case of Kerry Group Plc, we use the data for debt, equity, past returns, tax rates and other economic variables like risk-free rate of returns and market returns to calculate the WACC for the company. WACC can be calculated as:

WACC = Re(E/V)+Rd (1-t) (D/V)

(Dikov, 2020)

Where:

Re = Cost of Equity

E = Total Market Value of Equity

V = Total value of Company i.e., Equity + Debt

Rd = Cost of Debt

T = Tax Rate

D = Market/ Book Value of Debt  

2.3.1 Capital Structure:

The company's target capital structure comprises the weightage of debt and equity. The valuation of a company increases with the introduction of debt in the capital structure but only up to a specific level. The reason for the increase is due to the tax savings that are resulted from the interest payments of the debt (Harris, 2019). The capital structure is used in the calculation of the WACC. The target capital structure for Kerry Group Plc is indicated in the below figure.

Target Capital Structure
Debt to Total Capitalization 29.10%
Equity to Total Capitalization 71%
Debt to Equity Ratio 41.80%

2.3.2 Equity:

The preferred method to determine the cost of equity is CAPM, which is universally recognized and frequently utilized. Based on an ERP and an alpha component that compares the volatility of stock returns to the general market's return, risk-free interest rates and beta factors are all included in this formula(Situm, 2020). A simple way to represent the CAPM model is:

Cost of Equity = Rf + beta x ERP

The cost of equity for Kerry Group Plc is indicated in the below table:


Cost of Equity
Risk-free rate 3.4%
Market risk Premium 4.6%
Levered Beta 1.22
    Cost of Equity 9.0%
2.3.2.1 RFR:

The return that is unaffected by default risk is known as the risk-free rate. It is most usual to utilize long-term US treasury bonds as an alternative to risk-free investments such as stocks and bonds. Long-term bonds offer greater yields than short-term ones because the holders of long-term bonds assume more risk.

2.3.2.2 Beta:

The asset's sensitivity to non-diversifiable risk is measured by its beta. It is calculated by comparing a public company's returns over time to the returns of a certain market. When the stock price moves in tandem with the market (e.g., a rise of 1% in the market corresponds to an increase of 1% in the price of the stock), it is known as having a beta of 1.0.

2.3.2.3 Equity Risk Premium:

The anticipated return on equity (ERP) is the difference between an asset's return on risk-free assets and an equity market's expected return on risky assets. Analyzing past performance is the most widely acknowledged approach to evaluating ERP.

2.3.3 Cost of Debt:

Leverage is a term used to describe a company's degree of debt. When individuals refer to their debt, they often imply both long-term interest-bearing debt and short-term interest-bearing debt, as well as other debt equivalents, such as term debt, bonds due, and mortgage payments.  

When a firm has debt, it is considered to be levered; however, when a company has no debt, it is said to be unlevered. The cash flow estimate may be impacted by a firm's status as a debtor, depending on how the DCF model was developed.

The cost of debt is calculated as:  

COD = Rf + debt risk premium.  

Rf, often known as the risk-free rate, has previously been discussed. For the relatively low risk of debt default, a premium of 40 to 120 basis points is levied(Teker, 2020). For big, high-quality enterprises with considerable interest cover, a debt risk premium that falls toward the lower end of this range is preferable, and vice versa. Divide the yearly interest expenditure by the total amount of the company's current debt to get the cost of debt using this technique. You can calculate the cost of debt using this. The cost of debt for Kerry Group Plc is indicated in the below figure.

Cost of Debt
Cost of Debt 6.0%
Taxes 30.0%
    After-Tax Cost of Debt 4.2%

One particular component of the cost of debt is the potential financial benefit of being able to deduct interest payments from taxable income to lessen the total tax burden that the taxpayer faces. This gives a tax advantage. The tax rate for Kerry Group Plc is 30% which is used in calculating the WACC.

Since the unlevered method only indirectly accounts for interest payments, this tax advantage is reflected in the discount rate as a decrease in the cost of debt and, as a result, the discount rate. Because interest may be written off for tax reasons to balance the income of each marginal dollar reported for tax purposes, the marginal tax rate is frequently the most relevant statistic to analyze the cost of debt after taxes have been considered.

The final WACC calculation for Kerry Group Plc is indicated in the figure below:


Wacc Calculation
Target Capital Structure
Debt to Total Capitalization 29.1%
Equity to Total Capitalization 71%
Debt to Equity Ratio 41.8%
   
Cost of Equity
Risk-free rate 3.4%
Market risk Premium 4.6%
Levered Beta 1.22
    Cost of Equity 9.0%
   
Cost of Debt
Cost of Debt 6.0%
Taxes 30.0%
    After Tax Cost of Debt 4.2%
   
WACC 7.6%

2.4 Step 4: Calculation of Terminal Value:

Analysts calculate the company's long-term value using the terminal value, which estimates the value of a business after its forecasting period has ended since FCF cannot be forecasted indefinitely. The designation "terminal value" refers to an estimate of a company's last year's free cash flows based on the projection period.

Its terminal value determines more than three-quarters of the value of a corporation in a DCF. The last year of a company's operations should reflect a consistent financial performance level rather than an extreme peak or low. In addition, the underlying assumptions that were utilized to generate the terminal value must be extensively evaluated and made more sensitive. The terminal value may be computed using the perpetual growth method.

The perpetual growth technique is used to find the company's terminal value after the projection period, which assumes that its terminal year FCF will continue to expand at an anticipated rate throughout time(Behr, Mielcarz, & Osiichuk, 2018). Based on the predicted WACC from Step III, the lender must expect the firm to expand at a sustainable long-term rate.  

For Kerry Group Plc, the terminal cash flow in the year 2026 is $524 million. The perpetual growth rate for Kerry Group Plc is assumed to be 3.0%. The terminal value is calculated using the following formula: FCF is the free cash flow for the year 2026, g is the perpetual growth rate, and d is the WACC.

Terminal Value (TV) = ((FCF * ( 1 + g )))/(( d - g ))

In the case of Kerry Group Plc, the terminal value is calculated to be $11,742 million.


Terminal Value  
Terminal Year Free Cash Flow 524
Perpetuity Growth Rate

3.0%

Terminal Value 11,742

2.5 Step 5: Discounting Cash Flows and Calculating Intrinsic Value:

Because a dollar is worth more now than it will be tomorrow, the temporal value of money is a crucial concept in present-value calculations. Because of the time value of money, a corporation's expected free cash flow and terminal value must be discounted to their present value using the company's WACC(Fernandez, 2020).

The predicted FCF and terminal value for each year by the appropriate discount factor are determined by multiplying the FCF and terminal value. Separate reductions are given to the FCF and terminal value for each year. The discount factor, which is a fractional number, represents the present value of a dollar that will be received later. This fractional value is calculated by applying a preset discount rate.  

For instance, if a corporation had a WACC of 10%, its predicted FCF would be worth $91 million today rather than the original $100 million. The present value of the free cash flows of Kerry Group Plc is shown below, where the free cash flows are discounted at the weighted average cost of capital of 7.6%. The total present value of free cash flows is $1,887 million.


DCF model
    (in million) Actual CAGR Forecast period
  2018 2019 2020 2021 (18- 21) 2022 2023 2024 2025 2026
Sales 2,955 3,568 4,102 4,663 16% 5,036 5,438 5,874 6,343 6,851
Total costs -2,511 -3,047 -3,524 -4,031 17% -4,316 -4,661 -5,034 -5,436 -5,871
                     
EBITDA 444 521 578 631 12% 720 778 840 907 980
Depreciation & Amortization: -49 -63 -75 -84   -91 -98 -106 -114 -123
EBIT 396 459 503 548 11% 629 680 734 793 856
Taxes (30%) -119 -138 -151 -164   -189 -204 -220 -238 -257
Capex   -79 -41 -169   -116 -125 -135 -146 -158
Increase/Decrease in NWC   -145 -77 -18   -14 -33 -35 -38 -41
Unlevered Free Cash Flow   159 309 281   402 416 449 485 524
                 
WACC 7.6%              
Discount Period       0.5 1.5 2.5 3.5 4.5
Discount Factor       0.96 0.90 0.83 0.77 0.72
Present value of free cash flow           387 373 374 376 377

The present value of terminal value for Kerry Group Plcis also calculated using the WACC of 7.6%. The PV of terminal value for Kerry Group Plcis calculated to be $8,142 million.


Terminal Value  
Terminal Year Free Cash Flow 524
Perpetuity Growth Rate

3.0%

Terminal Value 11,742
Discount Period 5.0
Discount Factor 0.7
   Present Value of Terminal Value 8,142

Finally, the enterprise value for Kerry Group Plc is calculated by adding the present value of cash flows and the present value of terminal value. The total enterprise value for Kerry Group Plc came out to be $10,029 million.  

The equity value of the Kerry Group Plc is calculated by subtracting the total debt and adding the cash and cash equivalents. The total equity value came out to be $10,229 million.  

Suppose we assume that the total outstanding shares of Kerry Group Plc are 1000 million. In that case, the share price of Kerry Group Plc can be calculated by dividing the total equity value by the total outstanding shares. The share price, in this case, is calculated to be $10.23 per share.  

This intrinsic value of Kerry Group Plc is then compared with the current share price of the company to determine if the company's share is undervalued or overvalued.

Enterprise value
Present value of Free Cash Flow 1,887
   
Terminal Value 11,742
Discount Factor 0.69
Present Value of Terminal Value 8,142
   
Enterprise value 10,029
Less: Total debt 100
Plus: Cash and Cash Equi. 300
Net Debt -200
   
Implied Equity Value 10,229
Outstanding shares 1,000
Implied share price 10.23

3. Sensitivity Analysis

Assumptions in the DCF have a substantial impact on a company's worth. Due to the various input assumptions, the DCF result is believed to be in a range instead of a single figure. Sensitivity analysis may determine a company's monetary worth range by adjusting crucial inputs. It is shown via sensitivity analysis, which shows that valuation is an art as much as it is a science. A DCF's most often sensitive inputs include important valuation metrics, including WACC, exit multiple, and perpetuity growth rate(Marchiono & Magni, 2018).

Similar businesses and past deals might provide useful comparisons when evaluating a DCF value range. If the outcome differs significantly from the assumptions, it's best to examine them and fine-tune them if required. WACC, terminal value assumptions, and inaccurate financial predictions are some of the most common DCF errors that may bias the DCF valuation. This does not imply, however, that the analysis is erroneous only because the DCF implies a significantly different value than the other methods.

The sensitivity analysis is performed to check the impact of perpetual growth rate and WACC on the enterprise value of the Kerry Group Plc. The following table shows the different enterprise values for different values of perpetual growth rate and WACC.

Sensitivity Analysis
    Perpetuity growth %
## 10,029 2.0% 2.5% 3.0% 3.5% 4.0%
WACC 6.1% 11,670 13,077 14,938 17,516 21,326
7.1% 9,360 10,211 11,271 12,625 14,417
8.1% 7,810 8,374 9,047 9,868 10,889
9.1% 6,700 7,096 7,556 8,099 8,749
10.1% 5,867 6,157 6,488 6,870 7,314

4. Conclusion

Using DCF, it is possible to arrive at values that are completely unbiased by market forces. It is said to be a more objective way of valuation than others since it does not rely on market emotion to determine worth.

The DCF model is applied to Kerry Group Plc to calculate the intrinsic share price, which helps in determining if Kerry Group Plc is undervalued or overvalued.

The DCF is unaffected by transient market distortions, although the market may frequently misprice firms. Consider the long-term worth of a possible investment when calculating DCF. A long-term return on investment is calculated by considering the time value of money and giving investors an idea of when they may expect to receive a specific amount of profit.  

There are certain advantages to using DCF over other valuation techniques, but there are also some drawbacks to be aware of. DCF analysis relies on the accuracy of the estimations used. Many assumptions go into DCF models, and if they're wrong, it may have a big effect on the investor. For example, an investor's overestimation of future cash flows may lead to an investment that does not pay off in the long run, resulting in lost revenue. Cash flow assumptions that are excessively high might lead to lost opportunities. This model demands a lot of information. It is difficult and time-consuming to gather and evaluate the financial data needed to build a DCF model.

5. References

Beach, R. (2019). Critical Assumptions for Financial Projections. Credit Analysis.

Behr, A., Mielcarz, P., & Osiichuk, D. (2018). Terminal value calculation in dcf valuation models: An empirical verification. e-Finanse: Financial Internet Quarterly, 27-38.

Borad, S. B. (2022). Free Cash Flow. Retrieved from Finance Management: https://efinancemanagement.com/working-capital-financing/free-cash-flow

Dikov, D. (2020, 02 21). Understanding the Weighted Average Cost of Capital (WACC). Retrieved from Medium: https://medium.com/magnimetrics/understanding-the-weighted-average-cost-of-capital-wacc-948182d97e6

Fernandez, P. (2020). Three Residual Income Valuation methods and Discounted Cash Flow Valuation.

Gaspars-Wieloch, H. (2019). Project Net Present Value estimation under uncertainty. Central European Journal of Operations Research, 179-197.

Harris, C. (2019). Cash flow risk and capital structure decisions. Finance Research Letters, 393-397.

Januszewski, S. (2011). HOW TO PERFORM DISCOUNTED CASH FLOW VALUATION? Foundations of Management, 81-95.

Jesus, D., & Mira da Silva, M. (2014). Financial Projections based on Business Model Canvas.

Khudoykulov, K. (2021). THE VALUATION OF THE COST OF CAPITAL THROUGH THE DCF MODEL.

Malagueno, R., Lopez-Valeiras, E., & Gomez-Conde, J. (2018). Balanced scorecard in SMEs: effects on innovation and financial performance. Small Business Economics, 221-244.

Marchiono, A., & Magni, C. A. (2018). Investment decisions and sensitivity analysis: NPV-consistency of rates of return. European Journal of Operational Research, 361-372.

Matar, A., & Eneizan, B. (2018). Determinants of Financial Performance in the Industrial Firms: Evidence from Jordan. Asian Journal of Agricultural Extension, Economics & Sociology , 1-10.

N.Kaplan, S., & S.Ruback, R. (1995). The Valuation of Cash Flow Forecasts: An Empirical Analysis. Journal of Finance, 50(4), 1059-1093.

Partnoy, F. (2022). Market Prices vs. Fundamental Value: The Case for Using Discounted Cash Flow Analysis in Securities Class Actions.

Schueler, A. (2017). A Tool Kit for Discounted Cash Flow Valuation: Consistent and Inconsistent Ways to Value Risky Cash Flows. Journal of Business Valuation and Economic Loss Analysis.

Situm, M. (2020). Determination of expected cost of equity with the CAPM. Managerial and Decision Economics, 77-84.

Teker, S. (2020). REVISITING DISCOUNTED CASH FLOWS MODEL AS A CAPITAL BUDGETING DECISION TOOL. PressAcademia Procedia, 60-63.

Visconti, R. M. (2022). DCF Metrics and the Cost of Capital: ESG Drivers and Sustainability Patterns. 18.

Viswanadham, N. (2018). Performance analysis and design of competitive business models. International Journal of Production Research, 983-999.

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