Normalized Terminal Year in a DCF Question that came in the other - - PowerPoint PPT Presentation

• Question that came in the other day…
• “In a DCF model, how do you normalize the FCF for

the firm in the last year of the projection period? I thought you just had to remove non-recurring charges to normalize it, but the interviewer seemed to want something more.”

• “So how do you normalize Free Cash Flow in a DCF?”

Normalized Terminal Year in a DCF

• Terminal Value: Represents the PV of the company’s

FCFs beyond the end of the last year into infinity…

• Often based on the Final Year FCF and a Growth Rate:

Final Year FCF * (1 + FCF Growth Rate) (Discount Rate – FCF Growth Rate)

• Growth Rate: Often linked to GDP growth, inflation, etc.

Normalized Terminal Year in a DCF

• PROBLEM: What if a company’s Free Cash Flows in

the projection period are not consistent with what it looks like in a “steady state”?

Normalized Terminal Year in a DCF

• Admittedly: Yes, that is an extreme example, but there

are plenty of other issues that might come up for “normal” (i.e., non-biotech/pharma) companies:

• Issue #1: Does the revenue growth rate make sense?
• Issue #2: Are the margins reasonable?
• Issue #3: Do CapEx and D&A make sense?
• Issue #4: Are the WC req’s similar to historical #s?
• Issue #5: Is the tax rate free of the impact of NOLs,

tax credits, and other items that expire?

Normalized Terminal Year in a DCF

• Application #1: We’re assuming a lower revenue growth

rate of ~5% because the company’s key product patent expires 1-2 years before  will probably grow at a much lower rate going forward until it “strikes gold” again

• Application #2: We’re adjusting the EBIT margin down to

45%  key product (Xyrem) is far less profitable with lower prices (due to generics) in the Terminal Period

How to Apply These Tips to Our DCF

• Application #3: Can’t assume that big Amortization of

Intangibles expense and non-cash add-back will continue

• indefinitely. Why?
• 10-Q says the useful life is only 13.3 years, and our

projection period is 10 years…

• …so this Amortization will end soon after the final year!
• And we’re not assuming the company spends

anything to acquire or develop more intangibles

How to Apply These Tips to Our DCF

• Application #4: We’re making CapEx as a % of revenue

slightly lower to reflect lower re-investment in the business… but it still stays above D&A as a % of rev.

• Application #5: We’re also making the Change in WC as

a % of the Change in Revenue slightly lower  patent expiring threw off the numbers there

• Check: What does the Normalized Year FCF look like

now? Is the growth rate more consistent?

How to Apply These Tips to Our DCF

• Taxes: If a company has Net Operating Losses (NOLs),

tax credits, etc., they should not apply forever. They’ll expire or be used up at some point!

• Solution #1: Extend the projection period until these are

used up, at which point the cash taxes increase

• Solution #2: Just assume they don’t exist in the

Normalized Year and start the higher cash tax rate then

• Solution #3: Ignore them in FCF and only factor them

into Ent. Value  Eq. Value calculation at the end

How to Apply These Tips to Our DCF

• CapEx = Depreciation: No, no, no… not justified:
• 1. Due to inflation alone, CapEx will increase each

year… whereas Depreciation is based on older, less inflated CapEx figures

• 2. If a company’s FCF is growing in the Terminal Period,

it almost always has to increase its asset base to support that growth

• 3. Plus, there could be productivity gains, declining

technology costs over time, etc.

What NOT to Do to Normalize FCF

• Assume HIGHER Growth or Margins: This approach

very rarely makes sense – what company grows at a faster rate 10 years into the future?

• Margins: Can sometimes be justified if the company

plans to cut costs somehow… but even this is questionable

• Tax Benefits: Should not continue indefinitely – only

justification for a lower tax rate is if the company’s tax jurisdiction is different from its home country

What NOT to Do to Normalize FCF

• Recap and Summary: Normalize the Terminal Year FCF

in a DCF when the company’s FCFs in the Projection Period are not consistent with its FCFs in the Terminal Period

• Extreme Example: Bio/pharma company with a key

patent that expires in the final year  far lower FCF after

• Issues to Check: Revenue growth, margins, CapEx and

D&A, Working Capital, and tax rate/NOLs/credits

Normalized Terminal Year in a DCF

• Here: We adjusted the revenue growth and margins

down, slightly tweaked some of the others, and removed Amortization of Intangibles in the Terminal Year

• Impact: Got a ~3% FCF growth rate in the Terminal

Year instead of an unjustifiably high 15-20% growth rate

• What NOT to Do: Don’t make CapEx = D&A, don’t

assume higher growth or margins, and don’t assume an unsustainably low tax rate

Normalized Terminal Year in a DCF