The Normalized Terminal Year in a DCF

In this The Normalized Terminal Year in a DCF tutorial, you’ll learn how to normalize a company’s Free Cash Flow in the Terminal Year and Terminal Period of a Discounted Cash Flow (DCF) analysis, including the most common adjustments to make and the key mistakes to avoid.

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Table of Contents:

3:48 Why You Might Need to Normalize the Terminal Year Free Cash Flow in a DCF

7:42 How to Normalize the Terminal Year FCF for Jazz

14:07 Checking Your Work

16:35 What to AVOID When Normalizing the Terminal Year FCF

18:58 Recap and Summary

Lesson Outline:

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?”

To answer this question, remember what Terminal Value in a DCF represents: the sum of the PV of the company’s Free Cash Flows beyond the final projection year of a DCF into infinity.

Often, you calculate the Terminal Value based on the Final Year FCF and an FCF Growth Rate:

Terminal Value = Final Year FCF * (1 + FCF Growth Rate) / (Discount Rate – FCF Growth Rate)

This growth rate is often linked to GDP growth, inflation, etc.

PROBLEM: What if a company’s Free Cash Flows in the projection period are not consistent with its Free Cash Flows in its “steady state,” i.e. within the Terminal Period?

For example, what if you’re analyzing a biotech/pharmaceutical company and its Final Year FCF is the year a key drug patent expires – then its revenue and FCF will fall off a cliff in the following years!

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 Working Capital requirements similar to the historical ones?

Issue #5: Is the tax rate free of the impact of NOLs, tax credits, and other items that expire or get used up over time?

How to Normalize the Terminal Year FCF in Real Life

Application #1: We’re assuming a lower revenue growth rate of ~5% because the company’s key product patent expires 1-2 years before the final year, so it 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% because its key product (Xyrem) is far less profitable with lower prices (due to generics) in the Terminal Period.

Application #3: We can’t assume that the big Amortization of Intangibles expense and non-cash add-back will continue indefinitely because it expires a few years after the end of the final year.

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 revenue.

Application #5: We’re also making the Change in WC as a % of the Change in Revenue slightly lower, because the expiring patents threw off some of the projection-period numbers here.

Check: What does the Normalized Year FCF look like now? Is the growth rate more consistent?

Taxes, NOLs, and Tax Credits

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! So you need to account for this and make sure they do not reduce a company’s cash taxes forever.

What to AVOID When Normalizing FCF

Do not set CapEx equal to Depreciation – it’s not justified due to inflation, productivity/technology gains, and FCF growth in the Terminal Period (which tends to require an increasing asset base).

Don’t assume HIGHER Growth or Margins: This approach very rarely makes sense – what company grows at a faster rate 10 years into the future?

And don’t assume that tax benefits such as those from NOLs continue indefinitely.

RESOURCES:

http://youtube-breakingintowallstreet-com.s3.amazonaws.com/107-13-Normalized-Terminal-Year-DCF.xlsx

http://youtube-breakingintowallstreet-com.s3.amazonaws.com/107-13-Normalized-Terminal-Year-DCF-Slides.pdf

http://youtube-breakingintowallstreet-com.s3.amazonaws.com/107-13-JAZZ-Amortization-from-10-Q.pdf

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