Are Investors Undervaluing Keros Therapeutics, Inc. (NASDAQ:KROS) By 37%?

Key Insights

• Keros Therapeutics' estimated fair value is US$93.42 based on 2 Stage Free Cash Flow to Equity

• Current share price of US$58.61 suggests Keros Therapeutics is potentially 37% undervalued

• The US$88.11 analyst price target for KROS is 5.7% less than our estimate of fair value

How far off is Keros Therapeutics, Inc. (NASDAQ:KROS) 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. It may sound complicated, but actually it is quite simple!

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.

View our latest analysis for Keros Therapeutics

The Model

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.

Generally we assume that a dollar today is more valuable than a dollar in the future, and so the sum of these future cash flows is then discounted to today's value:

10-year free cash flow (FCF) estimate

	2024	2025	2026	2027	2028	2029	2030	2031	2032	2033
Levered FCF ($, Millions)	-US$179.6m	-US$184.1m	-US$157.5m	-US$70.0m	US$65.9m	US$98.6m	US$133.7m	US$167.9m	US$199.1m	US$226.3m
Growth Rate Estimate Source	Analyst x1	Analyst x3	Analyst x3	Analyst x3	Analyst x3	Est @ 49.79%	Est @ 35.54%	Est @ 25.56%	Est @ 18.58%	Est @ 13.69%
Present Value ($, Millions) Discounted @ 6.1%	-US$169	-US$163	-US$132	-US$55.2	US$48.9	US$69.0	US$88.2	US$104	US$117	US$125

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$32m

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 6.1%.

Terminal Value (TV)= FCF₂₀₃₃ × (1 + g) ÷ (r – g) = US$226m× (1 + 2.3%) ÷ (6.1%– 2.3%) = US$6.0b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= US$6.0b÷ ( 1 + 6.1%)¹⁰= US$3.3b

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$3.4b. The last step is to then divide the equity value by the number of shares outstanding. Compared to the current share price of US$58.6, the company appears quite undervalued at a 37% 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

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 Keros Therapeutics 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 6.1%, which is based on a levered beta of 0.834. 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 Keros Therapeutics

Strength

• Currently debt free.

Weakness

• Shareholders have been diluted in the past year.

Opportunity

• Trading below our estimate of fair value by more than 20%.

Threat

• Has less than 3 years of cash runway based on current free cash flow.

• Not expected to become profitable over the next 3 years.

Looking Ahead:

Valuation is only one side of the coin in terms of building your investment thesis, and it ideally won't be the sole piece of analysis you scrutinize for 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. What is the reason for the share price sitting below the intrinsic value? For Keros Therapeutics, there are three fundamental elements you should further research:

1. Risks: We feel that you should assess the 3 warning signs for Keros Therapeutics (1 shouldn't be ignored!) we've flagged before making an investment in the company.

2. Future Earnings: How does KROS'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 NASDAQGM 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.