3.10) DCF Analysis - More Advanced Features Flashcards
- Why do you use the mid-year convention in a DCF analysis?
You use it because a company’s cash flows do not arrive 100% at the end of each year – the company generates cash flow throughout each year. Using 1, 2, 3, 4 for the discount periods implies that the first year’s cash flow arrives after one entire year has passed. If you use 0.5, 1.5, 2.5, 3.5 instead, you assume that only half a year passes before the first cash flow is generated, which is closer to real life.
- How does the mid-year convention affect the output of a DCF?
A DCF that uses the mid-year convention will produce higher Implied Values because the discount periods are lower. For example, a formula like this:
Present Value = $100 / ((1 + 10%) ^ Year#)
Will produce higher values because the Year # of the first period would be 1.0 without the mid-year convention but 0.5 with the mid-year convention.
- Why might you include a “stub period” in a DCF, and what does it mean?
You might include a “stub period” if you’re valuing a company midway through the year, and it has already reported some of its financial results for the year. A DCF is based on expected future cash flow, so you should subtract these previously reported results and adjust the discount periods as well. For example, maybe it’s September 30th, and the company’s fiscal year ends on December 31st. The company’s future cash flow for this year will be generated between September 30th and December 31st. Therefore, you should exclude the cash flow from January 1st to September 30th in your projections since that part of the year has already passed. So, in the first year, you would include only the projected FCF from September 30th to December 31st. To discount the FCF in those 3 months, you would use 0.25 for the discount period because 3 months is 25% of the year. You would then use 1.25 for the discount period of the next year, 2.25 for the year after that, and so on.
- You’re valuing a company on April 30th, and you want to use both stub periods and the mid-year convention in your analysis. How would you change the company’s Free Cash Flow, and which discount periods would you use?
For the FCF, you would exclude everything generated between January 1st and April 30th and include only the projected FCF generated between April 30th and December 31st. Since most companies report only quarterly results, you would probably exclude the first quarter, not exactly the first 4 months. To reflect both the stub period and the mid-year convention, you would divide the stub period of the first year by 2. In each year after that, you would subtract 0.5 from the “normal” discount period.
In this case, April 30th is 1/3 through the year. Two-thirds of the year remains, so the “normal” stub discount period is 0.67. You would divide that by 2 to get 0.34. You would then use that 0.34 period to discount the company’s FCF from April 30th to December 31st. The “normal” discount period of the next year is 0.67 + 1.00, or 1.67. So, you would take the 1.67 and subtract 0.50 to get 1.17. For the next year after that, the “normal” discount period is 0.67 + 2.00, or 2.67, so you would subtract 0.50 to get 2.17. You would continue that for the rest of the years in the forecast.
- Continuing with the same example, how would the Terminal Value and the PV of the Terminal Value change with this April 30th valuation?
It depends on how you calculate the Terminal Value. With the Multiples Method, the Terminal Value calculation stays the same since it’s based on the company’s EBITDA (or another metric) in the final projected year times an appropriate multiple. When you discount the Terminal Value, the stub period affects the discount period, but the mid-year convention does not because the Terminal Value via the Multiples Method is as of the END of the last projected year. So, if the valuation date is April 30th, and there are 10 years in the projection period, you would use 9.67 for the discount period to calculate the PV of the Terminal Value. With the Perpetuity Growth Method, the initial Terminal Value calculation stays the same and represents the company’s PV as of the end of Year 10 into the future. But since you’re using the mid-year convention, and this version of Terminal Value is based on cash flows assumed to arrive midway through each year, the discount period should be half a year earlier: 9.17 rather than 9.67. As a result, the PV of Terminal Value will be higher as well.
- Why might you create a “Normalized Terminal Year” in a DCF?
You might create a Normalized Terminal Year if something about the company’s revenue growth, margins, Working Capital, or CapEx is expected to change in a major way in the Terminal Period.
As a result of this change, multiplying Final Year FCF by (1 + Terminal FCF Growth Rate) won’t produce accurate results in the Terminal Value formula. For example, a key drug patent might expire in Year 9 or 10, or the company might have a huge Intangibles balance that gets completely amortized in Year 10. The first scenario would make a huge impact on the company’s revenue, growth rates, and margins, and the second would affect the company’s margins and non-cash add-backs. You use the FCF in this Normalized Year for the numerator in the Terminal Value calculation rather than multiplying Final Year FCF by (1 + Terminal FCF Growth Rate).
- What impact does the Normalized Terminal Year make?
In most cases, the Normalized Terminal Year will reduce a company’s Implied Value because you usually adjust down the company’s growth rates and margins in this year (and remove non-cash adjustments that might have benefited the company in previous periods).
