Corporate Finance Fundamentals Guide

What is the Time Value of Money?

The Time Value of Money is a core principle of valuation that states that money as of the present
date carries more value than the same amount received in the future.

How to Calculate Time Value of Money (TVM)?

Under the time value of money (TVM) concept, a dollar received today is worth more than a dollar
received at a later date — which is one of the most fundamental concepts in corporate finance.
In short, receiving money today is preferable (i.e. more valuable) than receiving the same amount of
money on a later date.
There are two main reasons that underpin the TVM theory:
1. Opportunity Cost: If you have capital on hand currently, the funds could be used to
invest into other projects to achieve a higher return — i.e. the “opportunity cost” of the
money.
2. Inflation: There are risks to consider such as inflation or the probability that the
company in question might go bankrupt in the future — i.e. future uncertainty should be
costlier than the lower risks identified on the present date.
Since money tends to decline in value over time due to factors such as inflation, the purchasing
power of money also decreases.
With that said, cash flows received in the future (and with increased uncertainty) are worth less than
the present value (PV) of the cash flows.
If you risk one dollar in an investment, you should reasonably expect gains of more than solely your
initial one-dollar contribution as a return.
For each incremental unit of risk you take on, you should expect a proportionally higher return in
exchange.

Why is the Time Value of Money Important?

The time value of money (TVM) matter because it serves as the basis of the net present value (NPV)
calculation.
Briefly, suppose there are two investment options, as outlined below:
Option 1 → In the first option, you can receive $10,000 right now on the current date.
Option 2 → In the second option, you can receive $11,000, however, it’ll take one year
before the funds are received.
To pick the “right” option rationally, you must consider the time value of money, which is essentially
the required rate of return (i.e. cost of capital).
In this example, $11,000 is 10% greater than $10,000 — this serves as the minimum required rate of
return if you would be indifferent between these investment options.
For the second option to make sense from a monetary perspective, the returns should exceed that
of the 1st option, i.e. if you receive the $10,000 on the present date and receive a return >10%, you
should pick the first option, as it is more profitable.
Time Value of Money Formula (TVM)
The formula for the time value of money, from the perspective of the current date, is as follows:\
Present Value (PV) = FV ÷ [1 +( i ÷ n) ^(n × t)
Where:
PV = Present Value
FV = Future Value
i = Annual Rate of Return (Interest Rate)
n = Number of Compounding Periods Each Year
t = Number of Years
Alternatively, to calculate the future value given the present value, the formula used is:
Future Value (FV) = PV × [1 + (i ÷ n)] ^ (n × t)
In both formulas, “i” represents the rate of interest on comparable investments.

Present Value and Future Value Calculation Example

For instance, if the present value (PV) of an investment is $10 million, and the amount is invested at
a rate of return of 10% for one year, the future value (FV) is equal to:
FV = $10 million * [1 + (10% / 1] ^ (1 × 1) = $11 million
Moreover, using the same formula as above, we can calculate the future value (FV) assuming
quarterly compound interest — i.e. 4.0x times a year:
Thus, the calculation for our example is as follows:
FV = $10 million * [1 + (10% / 4)] ^ (4 × 1) = $11.04 million

TVM Calculation Example

Suppose you’re offered the following two options to pick from:
Option 1: Receive $225,000 in Year 4
Option 2: Receive $50,000 from Year 1 to Year 4
The determinant of which option is more profitable is the time value of money (TVM).
If we assume a 10% discount rate, which option should you proceed with?
For both option 1 and option 2, we’ll list out the cash inflow for each year.
While option 1 consists of a one-time payment of $225,000, option 2 consists of four payments of
$50,000.
The formula for discounting each cash flow is the future value (FV) divided by (1 + discount rate),
which is then raised to the power of the period number.
Once completed for each year, the sum of the discounted cash flows equals the present value of the
option, i.e. how much the future cash flows are worth on the present date.
Option 1 = $154,000
Option 2 = $158,000
In our simple example, option 2 is worth more than option 1. But of course, there are far more
considerations in reality that can complicate the decision-making process.
What is Present Value?
The Present Value (PV) is an estimation of how much a future cash flow (or stream of cash flows) is
worth right now. All future cash flows must be discounted to the present using an appropriate rate
that reflects the expected rate of return (and risk profile) because of the “time value of money.”

How to Calculate Present Value (PV)?

The present value (PV) concept is fundamental to corporate finance and valuation.
The premise of the present value theory is based on the “time value of money”, which states that a
dollar today is worth more than a dollar received in the future.
Therefore, receiving cash today is preferable (and more valuable) than receiving the same amount at
some point in the future.
There are two primary reasons that support this theory:
1. Opportunity Cost of Capital: If the cash is currently in your possession, those funds could
be invested into other projects to earn a higher return over time.
2. Inflation: Another risk to consider is the effects of inflation, which can erode the actual
return on an investment (and thereby future cash flows lose value due to uncertainty).

Present Value (PV) vs. Discount Rate

Since money received on the present date carries more value than the equivalent amount in the
future, future cash flows must be discounted to the current date when thought about in “present
terms.”
Moreover, the size of the discount applied is contingent on the opportunity cost of capital (i.e.
comparison to other investments with similar risk/return profiles).
All future receipts of cash (and payments) are adjusted by a discount rate, with the post-reduction
amount representing the present value (PV).
Given a higher discount rate, the implied present value will be lower (and vice versa).
Lower Discount Rate → Higher Valuation
Higher Discount Rate → Lower Valuation
When estimating the intrinsic value of an asset, namely via the discounted cash flow (DCF) method,
how much a company is worth is equal to the sum of the present value of all the future free cash
flows (FCFs) the company is expected to generate in the future.
More specifically, the intrinsic value of a company is a function of its ability to generate future cash
flows and the risk profile of the cash flows, i.e. the company’s value is equal to the sum of the
discounted values of its future free cash flows (FCFs).

Present Value Formula (PV)

The present value (PV) formula discounts the future value (FV) of a cash flow received in the future
to the estimated amount it would be worth today given its specific risk profile.
The formula used to calculate the present value (PV) divides the future value of a future cash flow by
one plus the discount rate raised to the number of periods, as shown below.
Present Value (PV) = FV / (1 + r) ^ n
Where:
FV = Future Value
r = Rate of Return
n = Number of Periods
Future Value (FV): The future value (FV) is the projected cash flow expected to be received
in the future, i.e. the cash flow amount we are discounting to the present date.
Discount Rate (r): The “r” is the discount rate – the expected rate of return (interest) –
which is a function of the riskiness of the cash flow (i.e. greater risk → higher discount
rate).
Number of Periods (n): The final input is the number of periods (“n”), which is the duration
between the date the cash flow occurs and the present date – and is equal to the number
of years multiplied by the compounding frequency.

Quick Present Value (PV) Calculation Example

Let’s say you loaned a friend $10,000 and are attempting to determine how much to charge in
interest.
If your friend has promised to repay the entire borrowed amount in five years, how much is the
$10,000 worth on the date of the initial borrowing?
Assuming that the discount rate is 5.0% – the expected rate of return on comparable investments –
the $10,000 in five years would be worth $7,835 today.
PV = $10,000 /(1 + 5%)^5 = $7,835

What is the Difference Between Present Value vs. Future Value?

The present value (PV) calculates how much a future cash flow is worth today, whereas the future
value is how much a current cash flow will be worth on a future date based on a growth
rate assumption.
While the present value is used to determine how much interest (i.e. the rate of return) is needed to
earn a sufficient return in the future, the future value is usually used to project the value of an
investment in the future.
Present Value (PV) → How much is the future cash flow worth today?
Future Value (PV) → How will this current cash flow be worth in the future?

1. Present Value Exercise Assumptions (PV)

Suppose we are calculating the present value (PV) of a future cash flow (FV) of $10,000.
We’ll assume a discount rate of 12.0%, a time frame of 2 years, and a compounding frequency of
one.
Future Cash Flow (FV) = $10,000
Discount Rate (r) = 12.0%
Number of Period (t) = 2 Years
Compounding Frequency (n) = 1x

2. PV Formula in Excel
Using those assumptions, we arrive at a PV of $7,972 for the $10,000 future cash flow in two years.
PV = $10,000 ÷ (1 + 12%)^(2 × 1) = $7,972
Thus, the $10,000 cash flow in two years is worth $7,972 on the present date, with the downward
adjustment attributable to the time value of money (TVM) concept.

3. Discounted Cash Flow Model Assumptions (DCF)

In the next part, we’ll discount five years of free cash flows (FCFs).
Starting off, the cash flow in Year 1 is $1,000, and the growth rate assumptions are shown below,
along with the forecasted amounts.
Year 1 = $1,000
Year 2 = 10% YoY Growth → $1,100
Year 3 = 8% YoY Growth → $1,188
Year 4 = 5% YoY Growth → $1,247
Year 5 = 3% YoY Growth → $1,285

4. DCF Analysis Using PV Function in Excel

If we assume a discount rate of 6.5%, the discounted FCFs can be calculated using the “PV” Excel
function.
Year 1 = $939
Year 2 = $970
Year 3 = $983
Year 4 = $970
Year 5 = $938
The sum of all the discounted FCFs amounts to $4,800, which is how much this five-year stream of
cash flows is worth today.
What is Future Value?
The Future Value (FV) refers to the implied value of an asset as of a specific date in the future based
upon a growth rate assumption.

How to Calculate Future Value (Step-by-Step)

The future value (FV) is a fundamental concept to corporate finance, whether it be for determining
the valuation of a potential investment or projecting cash flows to support capital budgeting
decisions.
For investors and corporations alike, the future value is calculated to estimate the value of an
investment on a later date to guide decision-making.
The calculated future value is a function of the interest rate assumption – i.e. the rate of return
earned on the original amount of capital invested, or the present value (PV).
The present value (PV) is defined as the initial investment amount, whereas the future value
represents the ending amount, with the original amount as well as any accumulated interest.
The “time value of money” states that a dollar today is worth more than a dollar tomorrow, so
future cash flows must be discounted back to the present date to be comparable to present values.
There are two types of interest:
1. Simple Interest: The amount of interest earned is calculated off the original principal (or
deposit) amount, which remains constant throughout the investment horizon.
2. Compound Interest: The incremental amount of interest earned is calculated off the
original principal amount (or deposit) and the accrued interest to date, i.e. “interest on
interest”.
Future Value Formula (FV)
The formula used to calculate the future value is shown below.
Future Value (FV) = PV × (1 + r) ^ n
Where:
PV = Present Value
r = Interest Rate (%)
n = Number of Compounding Periods
The number of compounding periods is equal to the term length in years multiplied by the
compounding frequency.
The more compounding periods there are, the greater the future value is going to be.
Annual Compounding = 1x
Semi-Annual Compounding = 2x
Quarterly Compounding = 4x
Monthly Compounding = 12x
Daily Compounding = 365x
For example, if you decided to invest $100.00 at an interest rate of 10% – assuming a compounding
frequency of 1 – the investment should be worth $110 by the end of one year.
FV = $100 × (1 + 10%) ^ 1 = $110.00
However, if the interest compounds semi-annually, the investment is worth $121 instead.
FV = $100 × (1 + 10/2%) ^ 2 = $110.25

Step 1. FV Calculation Exercise Assumptions

Suppose you deposited $400,000 into a bank account with an annual interest rate of 0.5%, which
compounds quarterly.
If we assume that the term length is 6 years – the following are the inputs to calculate the future
value of the deposit.
Present Value (PV) = $400,000
Interest Rate (r) = 0.5%
Term Length (t) = 6 Years
Compounding Frequency = Quarterly (4x)
Since the number of compounding periods is equal to the term length (6 years) multiplied by the
compounding frequency (4x), the number of compounding periods is 24.
Number of Compounding Periods (nper) = 24

Step 2. Calculate Future Value in Excel (“FV” Function)

The “FV” Excel function can be used to calculate how much the original $400,000 deposit is worth
after a six-year time frame.
“= FV (rate, nper, pmt, pv)”
On the date of the deposit, the $400,000 was an outflow (i.e. an investment) from your perspective,
so the amount should be entered with a negative sign in front.

Step 3. Future Value Calculation Analysis (Compounding Frequency)

If we enter our assumptions into the formula above, we get the following:
FV (0.5%, 24, 0, –$400,000) = $450,864
So your $400,000 deposit has grown to $450,864 after six years of remaining in the account, which
paid an interest rate of 0.5% compounded on a quarterly basis.
The more frequently that the deposit is compounded, the greater the amount of interest earned,
which we can confirm by adjusting the compounding frequency.
 Annual Compounding = $412,151
Semi-Annual Compounding = $424,671
Quarterly Compounding = $450,864
Monthly Compounding = $572,818

What is NPV?
Net Present Value (NPV) refers to the difference between the present value (PV) of a future stream
of cash inflows and outflows.
In practice, NPV is widely used to determine the perceived profitability of a potential investment or
project — which can help guide investing and operating decisions.

What is the Definition of Net Present Value (NPV)?

The present value (PV) of a stream of cash flows represents how much the future cash flows are
worth as of the current date.
Since a dollar received today is worth more than a dollar received on a later date (i.e. the “time
value of money”), the cash flows must be discounted to the present date using the appropriate rate
of return, which is known as the discount rate.
The net present value represents the discounted values of future cash inflows and outflows
related to a specific investment or project.

NPV Formula
To calculate the net present value (NPV) in Excel, the XNPV function can be used.
Unlike the NPV function, which assumes the time periods are equal, XNPV takes into account the
specific dates that correspond to each cash flow.
Therefore, XNPV is a more practical measure of NPV, considering cash flows are usually generated at
irregular intervals.
The Excel formula for XNPV is as follows:
=XNPV(Rate, Values, Dates)
Where:
Rate = The appropriate discount rate based on the riskiness and potential returns of the cash
flows
Values = The array of cash flows, with all cash outflows and inflows accounted for
Dates = The corresponding dates for the series of cash flows that were selected in the
“values” array

How to Interpret Net Present Value (NPV)?

In terms of capital budgeting, here are the general rules of thumb to follow:
If NPV > 0: Accept (Profitable)
If NPV = 0: Indifferent (Break-Even Point)
If NPV < 0: Reject (Unprofitable)
If the net present value is positive, the likelihood of accepting the project is greater. But note that
the following guidelines mentioned earlier are generalizations and are not meant to be rigid rules.
For example, a project could be unprofitable yet still be accepted by management if there are other
non-monetary considerations (e.g. intangible factors such as marketing/publicity, and relationship-
building) that help rationalize the decision.

NPV Calculator – Excel Template

1. Discount Rate, Initial Investment and Cash Flow Assumptions

Let’s suppose that we’re attempting to decide whether to accept or decline a project.
The initial investment of the project in Year 0 amounts to $100m, while the cash flows generated by
the project will begin at $20m in Year 1 and increase by $5m each year until Year 5.
The discount rate, date, and cash flow assumptions for calculating the net present value are listed
below:
Discount Rate = 10%
Year 0 (8/31/21) = -$100m
Year 1 (12/31/21) = $20m
Year 2 (12/31/22) = $25m
Year 3 (12/31/23) = $30m
Year 4 (12/31/24) = $35m
Year 5 (12/31/25) = $40m
The period from Year 0 to Year 1 is where the timing irregularity occurs (and why the XNPV is
recommended over the NPV function).

2. NPV Calculation Example in Excel (XNPV Function)

Since we have all the necessary inputs, we can enter them into the formula presented earlier.
Upon doing so, we get $17.3m as the net present value (NPV).

3. Manual Net Present Value Calculation Example (NPV)

Alternatively, we can also manually discount each of the cash flows by dividing the cash flow by (1 +
discount rate) ^ the number of periods.
Year 0: -$100m / (1+10%)^0.0 = -$100.0m
Year 1: $20m / (1+10%)^0.3 = $19.4m
Year 2: $25m / (1+10%)^1.3 = $22.0m
Year 3: $30m / (1+10%)^2.3 = $24.0m
Year 4: $35m / (1+10%)^3.3 = $25.5m
Year 5: $40m / (1+10%)^4.3 = $26.5m
In Excel, the number of periods can be calculated using the “YEARFRAC” function and selecting the
two dates (i.e. beginning and ending dates).

If we calculate the sum of all cash inflows and outflows, we get $17.3m once again for our NPV.
In closing, the project in our example exercise would likely be accepted given its positive calculated
NPV.
Accept or Reject Project?: “Accept”

What is PVGO?
PVGO, or “present value of growth opportunities”, estimates the portion of a company’s share price
attributable to expectations of future earnings growth.
How to Calculate PVGO (Step-by-Step)
PVGO is the component of a company’s share price corresponding to expectations of
future earnings growth.
PVGO, shorthand for the “present value of growth opportunities,” represents the value of a
company’s future growth.
The PVGO metric measures the potential value-creation from a company reinvesting earnings back
into itself, i.e. from accepting projects to drive future growth.
There are two components to a company’s current share price:
1. Present Value (PV) of No-Growth Earnings
2. Present Value (PV) of Earnings with Growth
The earnings with no growth can be valued as a perpetuity, where the expected earnings per share
(EPS) next year is divided by the cost of equity (Ke).
The latter part, the future earnings growth, is what PVGO attempts to measure, i.e. the value of
growth.

PVGO Formula
The formula shown below of the market share price states that a company’s valuation is equal to the
sum of the present value (PV) of its no-growth earnings and the present value of growth
opportunities.
Vo = [EPS (t =1) / Ke ] + PVGO
Where:
Vo = Market Share Price
EPS (t =1) = Next Year Earnings Per Share (EPS)
Ke = Cost of Equity
After rearranging the formula, the formula is as follows.
PVGO = Vo – [EPS (t =1) / Ke]
Therefore, PVGO is conceptually the difference between a company’s value minus the present value
(PV) of its earnings, assuming zero growth.

How to Interpret PVGO: Equation Analysis

Corporate Decision: Reinvest or Payout Dividends?
The higher the PVGO, the more earnings should be invested rather than issuing dividends
to shareholders (and vice versa).
In theory, the objective of all corporates should be to maximize shareholder wealth.
That being said, shareholder wealth is created when companies consistently reinvest earnings into
positive net present value (NPV) projects.
If there are no projects worth pursuing from a returns standpoint, these zero-growth companies
should distribute their earnings to shareholders in the form of dividends.
Negative PVGO: More specifically, a negative present value of growth opportunities implies
that by reinvesting earnings, a company is eroding value rather than creating it. Hence,
the company should distribute more of its net earnings to shareholders as dividends.
Positive PVGO: If a company’s PVGO is positive — i.e. ROE is greater than its cost of
capital — reinvesting into future growth can generate more value for shareholders
than dividend payments. An industry-leading PVGO suggests the company has far more
growth opportunities in its pipeline that could be pursued than its peers, resulting in
greater upside potential in a company’s future share price.
The PVGO can be a useful guide in the critical decision-making process of picking between
reinvesting earnings or paying out dividends.
If PVGO < 0 → Distribute Earnings as Dividends
If PVGO > 0 → Reinvest Earnings
The metric is often expressed as a percentage of the current market share price (V o).
High PVGO % of Vo → Greater Present Value (PV) Contribution from Growth Expectations
Low PVGO % of Vo → Lower Present Value (PV) Contribution from Growth Expectations
Normalized Share Price
One limitation to PVGO is the assumption that the current share price reflects the Company’s fair
value, which can be quite a risky assertion considering how volatile (and irrational) the market can
be.
Thus, it is recommended to either ensure the share price is normalized to reflect historical
performance or use the one-year average share price.

Suppose a company is currently trading at a share price of $50.00, with the market anticipating its
earnings per share (EPS) next year to be $2.00.
If we assume a required rate of return of 10%, what proportion of the company’s market price is
attributable to its future growth?
Market Share Price (Vo) = $50.00
Expected Earnings Per Share (EPS t=1) = $2.00
Cost of Equity (Ke) = 10%
After entering the provided assumption into our share price formula from earlier, we are left with
the following:
$50.00 = ($2.00 / 10%) + PVGO
By dividing the EPS expected next year by the required rate of return (i.e. the cost of equity), we
arrive at the zero-growth valuation of $20.
We can now solve for PVGO by rearranging the formula and then subtracting the zero-growth
valuation price component ($2.00 / 10% = $20.00) from the total valuation.
$50.00 = $20.00 + PVGO
PVGO = $50.00 – $20.00 = $30.00
Upon dividing the $30 PVGO by the $50 share price, we can conclude that the market assigns 60% of
the market price to future growth — which implies that significant growth expectations are priced
into our illustrative company’s current share price.
PVGO % Vo = $30.00 / $50.00 = 60%
What is APV?
The Adjusted Present Value (APV) is defined as the sum of the present value of a project assuming
solely equity financing and the PV of all financing-related benefits.

How to Calculate Adjusted Present Value (APV)?

Since the additional financing benefits are taken into account, the primary benefit of the
adjusted present value (APV) approach is that the economic benefits stemming from financing and
tax-deductible interest expense payments are broken out.
The formula used to calculate the adjusted present value (APV) consists of two components:
1. Present Value (PV) of Unlevered Firm → The present value (PV) of an unlevered firm
refers to the present value of the firm, under the pretense that the company has zero
debt within its capital structure (i.e. is 100% equity-financed). By discounting the
projected free cash flows (FCFs) to the firm at the unlevered cost of capital – i.e. the cost
of equity – the value of the unlevered firm can be estimated.
2. Present Value (PV) of Financing Net Effects → The financing effects are the net benefits
related to debt financing, most notably the interest tax shield. The interest tax shield is
an important consideration because interest expense on debt (i.e. the cost of borrowing)
is tax-deductible, which reduces the taxes due in the current period, i.e. the interest “tax
shield”.
The interest tax shield can be calculated by multiplying the interest amount by the tax rate.
Interest Tax Shield = Interest Expense x Tax Rate (%)
The APV approach allows us to see whether adding more debt results in a tangible increase (or
decrease) in value, as well as enables us to quantify the effects of debt.
Note that since the APV is based on the present-day valuation, both the unlevered firm value and
the financing effects must be discounted back to the current date.

Adjusted Present Value Formula (APV)

The formula to calculate the adjusted present value (APV) is as follows.
Adjusted Present Value (APV) = PV of Unlevered Firm + PV of Financing Effects

What is the Difference Between APV vs. WACC?

The APV method shares many similarities to a DCF analysis. However, one major difference lies in
the discount rate (i.e. the weighted average cost of capital).
Unlike the WACC, which is a blended discount rate that captures the effect of financing and taxes,
the APV attempts to unbundle the components for individual analysis to view them as independent
factors.
WACC → The WACC of a company is approximated by blending the cost of equity and after-
tax cost of debt
Adjusted Present Value (APV) → In contrast, the APV values the contribution of these effects
separately.
But despite providing a handful of benefits, APV is used far less often than WACC in practice, and it is
predominantly used in the academic setting.

1. Corporate Finance Project Assumptions

Suppose a company is considering undertaking a project that is expected to generate the following
cash flows.
Year 0, Cash Flow = -$25m
Years 1 to 5, Cash Flow = $200m
As for the tax rate, discount rate, and terminal value, we’ll assume the following in our exercise:
Cost of Equity = 12%
Cost of Debt = 10%
Tax Rate = 30%
Terminal Growth Rate = 2.5%

2. Present Value of Free Cash Flow Calculation (PV)

From our financials, we know that in Year 0, the FCF is $25m while the forecasted years are kept
constant at $200m. To discount each of the FCFs to the present day, we’ll use the following formula:
PV of FCF = Free Cash Flow / (1 + Cost of Equity) ^ Period Number
For example, the following formula is used for discounting Year 1’s FCF.
PV of Year 1 FCF: $200m / (1 + 12%) ^ 1
PV of Year 1 FCF: $179m
Once this process is repeated for each period, we can take the sum of all the PV of FCFs, which
comes out to $696m.
Then, we’ll estimate the terminal value (TV) – the lump sum value of the project at the end of the
explicit forecast period – by using the formula below:
Terminal Value (TV) = Year 5 Free Cash Flow * (1 + Terminal Growth Rate) / (Cost of Equity –
Terminal Growth Rate)
TV = $200m * (1 + 2.5%) / (12% – 2.5%) = $2,158m
But recall that the APV calculation is as of the present date, thus we must discount this TV amount to
the present.
PV of Terminal Value (TV) = Terminal Value / (1 + Cost of Equity) ^ Period Number
PV of TV = $2,158m / (1 + 2.5%) ^ 5 = $1,224m
To wrap up the 1st part of our APV calculation, the only remaining step is to add the PV of Stage 1
FCFs and PV of TV:
Sum of PV of FCFs + TV = $696m + $1,224m = $1,920m
3. Interest Tax Shield Calculation Analysis
In the next part of our APV calculation, the following interest expense values are going to be
assumed to estimate the interest tax shield, i.e. the tax savings from interest expense.
Year 0, Interest Expense = $40m
Year 1, Interest Expense = $32m
Year 2, Interest Expense = $24m
Year 3, Interest Expense = $16m
Year 4, Interest Expense = $8m
Year 5, Interest Expense = $0m
From the list above, we can see the interest expense is reducing down by $8m each year until
reaching $0m in Year 5. As a result, there will be no debt assumed heading into the terminal value
period.
To discount each of the interest tax shield amounts, we’ll do the following two steps:
1. Tax Shield: Multiply the interest expense by the tax rate assumptions to calculate the tax
shield
2. PV of Tax Shield: Calculate the present value (PV) of each interest tax shield amount by
dividing the tax shield value by (1 + cost of debt) ^ period number
The PV of the interest tax shield can be calculated by discounting the annual tax savings at the pre-
tax cost of debt, which we are assuming to be 10% in our example.
Upon doing so, we get $32m as the sum of the PV of the interest tax shield.
For more complex models, we’d recommend using the “MIN” function in Excel to make sure that the
interest tax shield value does NOT exceed the value of the taxes paid in the relevant period.

4. Adjusted Present Value Calculation Example (APV)

In the final section of our exercise, we will utilize the two inputs from the prior steps to calculate the
adjusted present value (APV) of the project.
1. The PV of the Stage 1 FCFs and Terminal Value (TV)
2. The PV of the Interest Tax Shield Values
In conclusion, we compute the adjusted present value (APV) as $1.95bn by adding the two together.
The finished output sheet has been posted below for reference.

CAPITAL BUDGETING FUNDAMENTALS

What is Payback Period?
The Payback Period measures the amount of time required to recoup the cost of an initial
investment via the cash flows generated by the investment.

How to Calculate Payback Period (Step-by-Step)

Perhaps the simplest method for evaluating the feasibility of undertaking a potential investment or
project, the payback period is a fundamental capital budgeting tool in corporate finance.
Conceptually, the metric can be viewed as the amount of time between the date of the initial
investment (i.e., project cost) and the date when the break-even point has been reached, which is
when the amount of revenue produced by the project is equal to the associated costs.
The earlier the cash flows from a potential project can offset the initial investment, the
greater the likelihood that the company or investor will proceed with pursuing the
project.
In contrast, the longer it takes for a project to “pay for itself”, the less attractive the project
becomes as it implies reduced profitability.
While there certainly are exceptions (i.e., projects that necessitate significant time before generating
sustainable profits), a large portion of companies – especially those that are publicly traded – tend to
be more short-term oriented and focus on near-term revenue and earnings per share (EPS) targets.
For a public company, the share price of the company could falter if near-term sales or profitability
goals are not met, as the market is unlikely to uphold the current valuation just because
management claims to be operating with a longer-term horizon in mind.
Each company will internally have its own set of standards for the timing criteria related to accepting
(or declining) a project, but the industry that the company operates within also plays a critical role.
In addition, the potential returns and estimated payback time of alternative projects the company
could pursue instead can also be an influential determinant in the decision (i.e. opportunity costs).

How to Interpret Payback Period in Capital Budgeting

Shorter Duration → As a general rule of thumb, the shorter the payback period, the more
attractive the investment, and the better off the company would be – which is because
the sooner the break-even point has been met, the more likely additional profits are to
follow (or at the very least, the risk of losing capital on the project is significantly
reduced).
Longer Duration → A longer payback time, on the other hand, suggests that the invested
capital is going to be tied up for a long period – thus, the project is illiquid and the
probability of there being comparatively more profitable projects with quicker recoveries
of the initial outflow is far greater.

Payback Period Formula

In its simplest form, the calculation process consists of dividing the cost of the initial investment by
the annual cash flows.
Payback Period = Initial Investment ÷ Cash Flow Per Year
For instance, let’s say you own a retail company and are considering a proposed growth strategy
that involves opening up new store locations in the hopes of benefiting from the expanded
geographic reach.
The essential question being answered from the calculation is:
“Given the cost of opening up new store locations in different states, how long would it take
for revenue from those new stores to pay back the entire amount of the investment?”
If opening the new stores amounts to an initial investment of $400,000 and the expected cash flows
from the stores would be $200,000 each year, then the period would be 2 years.
$400k ÷ $200k = 2 Years
So it would take two years before opening the new store locations has reached its break-even point
and the initial investment has been recovered.
But since the metric rarely comes out to be a precise, whole number, the more practical formula is
as follows.
Payback Period = Years Before Break-Even + (Unrecovered Amount ÷ Cash Flow in Recovery Year)
Here, the “Years Before Break-Even” refers to the number of full years until the break-even point is
met. In other words, it is the number of years the project remains unprofitable.
Next, the “Unrecovered Amount” represents the negative balance in the year preceding the year in
which the cumulative net cash flow of the company exceeds zero.
And this amount is divided by the “Cash Flow in Recovery Year”, which is the amount of cash
produced by the company in the year that the initial investment cost has been recovered and is now
turning a profit.

Step 1. Non-Discounted Payback Period Calculation Example

First, we’ll calculate the metric under the non-discounted approach using the two assumptions
below.
1. Initial Investment: $10mm
2. Cash Flows Per Year: $4mm
Our table lists each of the years in the rows and then has three columns.
The first column (Cash Flows) tracks the cash flows of each year – for instance, Year 0 reflects the
$10mm outlay whereas the others account for the $4mm inflow of cash flows.
Next, the second column (Cumulative Cash Flows) tracks the net gain/(loss) to date by adding the
current year’s cash flow amount to the net cash flow balance from the prior year.
Hence, the cumulative cash flow for Year 1 is equal to ($6mm) since it adds the $4mm in cash flows
for the current period to the negative $10mm net cash flow balance.

The third and final

column is the metric that we are working towards and the formula uses the “IF(AND)” function in
Excel that performs the following two logical tests.
1. The current year’s cumulative cash balance is less than zero
2. The next year’s cumulative cash balance is greater than zero
If the two are true, that means the break-even occurs in between the two years – and therefore, the
current year is selected.
But because there is likely a fractional period that we cannot neglect, we must divide the cumulative
cash flow balance for the current year (negative sign in front) by the cash flow amount of the next
year, which is then added to the current year from earlier.
The screenshot below shows the formula in Excel.

From the finished output of the first example, we can see the answer comes out to 2.5 years (i.e., 2
years and 6 months).
By the end of Year 2, the net cash balance is negative $2mm, and $4mm in cash flows will be
generated in Year 3, so we add the two years that passed before the project became profitable, as
well as the fractional period of 0.5 years ($2mm ÷ $4mm).

Step 2. Discounted Payback Period Calculation Analysis

Moving onto our second example, we’ll use the discounted approach this time around, i.e. accounts
for the fact that a dollar today is more valuable than a dollar received in the future.
The three model assumptions are as follows.
1. Initial Investment: $20mm
2. Cash Flows Per Year: $6mm
3. Discount Rate: 10.0%
The table is structured the same as the previous example, however, the cash flows are discounted to
account for the time value of money.
Here, each cash flow is divided by “(1 + discount rate) ^ time period”. But other than this distinction,
the calculation steps are the same as in the first example.
In closing, as shown in the completed output sheet, the break-even point occurs between Year 4 and
Year 5. So, we take four years and then add ~0.26 ($1mm ÷ $3.7mm), which we can convert into
months as roughly 3 months, or a quarter of a year (25% of 12 months).
The takeaway is that the company retrieves its initial investment in approximately four years and
three months, accounting for the time value of money.

What is the Discounted Payback Period?

The Discounted Payback Period estimates the time needed for a project to generate enough cash
flows to break even and become profitable.

How to Calculate Discounted Payback Period (Step-by-Step)

The shorter the payback period, the more likely the project will be accepted – all else
being equal.
In capital budgeting, the payback period is defined as the amount of time necessary for a company
to recoup the cost of an initial investment using the cash flows generated by an investment.
Once the payback period is met, the company has reached its break-even point – i.e. the amount
of revenue generated by a project is equal to its costs – so beyond the “break-even” threshold, the
project is no longer a “loss” to the company.
Shorter Payback Period → The earlier the cash flows from a project can offset the initial
expenditure, the more likely the company will approve the project.
Longer Payback Period → The more time needed for the project’s cash flows to surpass the
initial expenditure, the less likely the project will be approved.
However, one common criticism of the simple payback period metric is that the time value of
money is neglected.
Because of the opportunity cost of receiving cash earlier and the ability to earn a return on those
funds, a dollar today is worth more than a dollar received tomorrow.
Therefore, it would be more practical to consider the time value of money when deciding which
projects to approve (or reject) – which is where the discounted payback period variation comes in.
Calculating the payback period is a two-step process:
Step 1: Calculate the number of years before the break-even point, i.e. the number of years
that the project remains unprofitable to the company.
Step 2: Divide the unrecovered amount by the cash flow amount in the recovery year, i.e.
the cash produced in the period that the company begins to turn a profit on the project
for the first time.

Discounted Payback Period Formula

The formula for computing the discounted payback period is as follows.
Discounted Payback Period = Years Until Break-Even + (Unrecovered Amount / Cash Flow in
Recovery Year)

Simple Payback Period vs. Discounted Method

The formula for the simple payback period and discounted variation are virtually identical.
In fact, the only difference is that the cash flows are discounted in the latter, as is implied by the
name.
The implied payback period should thus be longer under the discounted method.
Why? The initial outflow of cash flows is worth more right now, given the opportunity cost of capital,
and the cash flows generated in the future are worth less the further out they extend.
The discounted payback period, in theory, is the more accurate measure, since fundamentally, a
dollar today is worth more than a dollar received in the future.
In particular, the added step of discounting a project’s cash flows is critical for projects with
prolonged payback periods (i.e., 10+ years).

Discounted Payback Period Example Calculation

Suppose a company is considering whether to approve or reject a proposed project.
If undertaken, the initial investment in the project will cost the company approximately $20 million.
After the initial purchase period (Year 0), the project generates $5 million in cash flows each year.
Based on the project’s risk profile and the returns on comparable investments, the discount rate –
i.e., the required rate of return – is assumed to be 10%.
All of the necessary inputs for our payback period calculation are shown below.
Initial Investment = –$20 million
Cash Flow Per Year = $5 million
Discount Rate (%) = 10%
In the next step, we’ll create a table with the period numbers (”Year”) listed on the y-axis, whereas
the x-axis consists of three columns.
1. Discounted Cash Flow: In Year 0, we can link to the $20 million cash outflow, and for all
the other years, we can link to the cash flow amount of $5 million – but remember, we
must discount each cash flow by dividing it by one plus the discount rate raised to the
period number. Hence, the $5 million in cash flow amounts to a present value (PV) of
$4.5 million in Year 1 but declines to a PV of $1.9 million by Year 5.
2. Cumulative Cash Flow: In the next column, we’ll calculate the cumulative cash flow to
date by adding the discounted cash flow for the given period to the prior year’s
cumulative cash flow balance.
3. Payback Period: The third column uses the “IF(AND)” Excel function to determine the
payback period.
More specifically, the logical tests performed are the two shown below:
1. Current Year Cumulative Cash Balance < 0
2. Next Year Cumulative Cash Balance > 0
If both logical tests are true, the break-even occurred somewhere between those two years.
However, we are not done here.
Since there is most likely a fractional period that we cannot neglect, the next step is to divide the
cumulative cash flow balance as of the current year with a negative placed sign in front of the next
year’s cash flow.
The two calculated values – the Year number and the fractional amount – can be added together to
arrive at the estimated payback period.
The screenshot below shows that the time required to recover the initial $20 million cash outlay is
estimated to be ~5.4 years under the discounted payback period method.

What is Profitability Index?

The Profitability Index (PI) is the ratio between the present value of cash inflows and the present
value of cash outflows.

How to Calculate Profitability Index (Step-by-Step)

The profitability index ratio measures the monetary benefits (i.e. cash inflows) received for each
dollar invested (i.e. cash outflow), with the cash flows discounted back to the present date.
More specifically, the PI ratio compares the present value (PV) of future cash flows received from a
project to the initial cash outflow (investment) to fund the project.

Profitability Index Formula

The formula for calculating the profitability index is as follows.
Profitability Index = Present Value of Future Cash Flows / Initial Investment
Another variation of the PI formula adds the initial investment to the net present value (NPV), which
is then divided by the initial investment.
Profitability Index = (Net Present Value + Initial Investment) / Initial Investment

How to Interpret Profitability Index (PI)

In corporate finance, the primary use case for the PI ratio is for ranking projects and capital
investments.
The higher the PI ratio, the more attractive the proposed project is and the more likely it will be
pursued.
For some general guidelines on interpreting the PI ratio:
PI =1: Neutral/Acceptable
PI >1: Approve Project
PI <1: Reject Project

Profitability Index vs. Net Present Value (NPV)

The profitability index (PI) and net present value (NPV) are two closely related metrics.
If PI Ratio is >1, then NPV will be positive
If PI Ratio is <1, then NPV will be negative
The major distinction between the two is that the profitability index depicts a “relative” measure of
value whereas the net present value (NPV) represents an “absolute” measure of value.
With that said, for purposes of presenting a project or capital investment’s benefits on a per-dollar
basis of the initial investment, the profitability index is more practical since it is standardized.
The PI metric can thereby be used for comparisons among different projects. By contrast,
comparisons of NPV between projects are not always functional (i.e. non-standardized metric).

Step 1. Project Assumptions

Suppose we’re evaluating a proposed five-year project with the following assumptions.
Discount Rate: 10%
Project CF Growth Rate: 25%
Initial Investment: –$10,000,000
Project Cash Flows (Year 1): $2,000,000
The cost of funding the project is $10 million, and the amount of cash flows generated in Year 1 is $2
million, which will grow by a growth rate of 25% each year.

Step 2. NPV Calculation

We can now calculate the net present value (NPV) of the project using the NPV function in Excel:
NPV: “=NPV (10% Discount Rate, Range of Net Cash Inflows/Outflows)”
NPV = $1,756,382
In the subsequent step, we can now calculate the project’s PI given the NPV from the prior step.
Step 3. Profitability Index Calculation Analysis
The PI formula will consist of two parts:
1. In the numerator, we’ll take the NPV and add back the initial investment.
2. In the denominator, we’ll link to the initial investment cell with a negative sign in front
(so both the numerator and denominator are positive figures).
Therefore, the formula divides the present value (PV) of the project’s future cash flows by the initial
investment.
Profitability Index = ($1,756,382 + $10,000,000) / ($10,000,000) = 1.2
In conclusion, the profitability index of our five-year project is 1.2, so the project seems likely to be
accepted unless there are other projects with higher NPVs and profitability indices that are also
under consideration.

What is Residual Income?

Residual Income measures the excess net operating income earned over the required rate of return
on a company’s operating assets.

How to Calculate Residual Income (Step-by-Step)

In corporate finance, the term “residual income” is defined as the operating income generated by a
project or investment in excess of the minimum required rate of return.
The metric is used by companies to help determine whether to pursue certain projects or not.
The first step in estimating the residual income is calculating the product of the minimum required
rate of return and the average operating assets.
The minimum required rate of return is conceptually the same as the cost of capital, i.e. the
expected return given the risk profile of the project or investment in question.
The minimum return can differ based on the department or division undertaking the project – or be
separately estimated based on the operating assets – but the company’s cost of capital can also be
used, as it is usually sufficient for general capital budgeting purposes.
From there, the product of the minimum required rate of return and average operating assets is
subtracted from the project’s operating income.
Residual Income Formula
The formula for calculating the residual income is as follows.
Residual Income = Operating Income – (Minimum Required Rate of Return × Average Operating
Assets)
The product of the minimum required rate of return and average operating assets represents the
minimum target return, i.e. the “desired income”.
Target (Desired) Income = Minimum Required Rate of Return × Average Operating Assets

How to Interpret Residual Income in Corporate Finance

Capital Budgeting Rules: “Accept” or “Reject” Project
For purposes of decision-making under the context of capital budgeting, the general rule is to accept
a project if the implied residual income is greater than zero.
If Residual Income > 0 → Accept Project
If Residual Income < 0 → Reject Project
The generalized rule in capital budgeting states that in order for a company to maximize its firm
value, only projects that earn more than the company’s cost of capital should be pursued.
Otherwise, the project will reduce the value of the company, rather than create value.
By estimating the residual income before taking on projects, companies can allocate their capital on
hand more efficiently to ensure that the return (or potential return) is worth the trade-off in terms
of risk.
Positive RI → Exceeds Minimum Rate of Return
Negative RI → Lower than Minimum Rate of Return
Of course, the metric will not dictate corporate decisions on its own, but projects with positive
residual income are more likely to be accepted internally because of the increased economic
incentive.

Step 1. Project Income and Operating Assets Assumptions

Suppose a company is attempting to decide whether to pursue a project or pass on the opportunity.
The project is projected to generate $125k in operating income in Year 1.
The value of the operating assets at the beginning of the period (Year 0) was $200k, while the value
was $250k at the end of the period (Year 1).
Beginning Operating Assets = $200k
Ending Operating Assets = $250k
By adding those two figures and dividing them by two, the average operating assets equal $225k.
Average Operating Assets = $225k

Step 2. Project Residual Income Calculation Analysis

If we assume the minimum required rate of return is 20%, what is the project’s residual income?
To determine the project’s residual income, we’ll start by multiplying the minimum required rate of
return (20%) by the average operating assets ($225k).
As mentioned earlier, the resulting amount – $45k in our example – represents the target (desired)
income from the project.
The more excess income there is above the target (desired) income, the more profitable the project
is.
The final step is to subtract the target (desired) income amount from the project’s operating income
($125k).
The resulting figure is $80k, which represents the project’s residual income. Because this figure is
positive, it suggests the project should likely be approved.
 Residual Income = $125k – (20% × $225k) = $80k

What is NRV?
The Net Realizable Value (NRV) represents the profit realized from selling an asset, less the
estimated sale or disposal costs.
In practice, the NRV method is most common in inventory accounting, as well as for calculating the
value of accounts receivable (A/R).

How to Calculate Net Realizable Value (NRV)

The net realizable value (NRV) is used to appraise the value of an asset,
namely inventory and accounts receivable (A/R).
Per GAAP accounting standards – specifically the principle of conservatism – the value of assets must
be recorded on a historical basis in an effort to prevent companies from inflating the carrying value
of their assets.
For instance, inventory is recognized on the balance sheet at either the historical cost or the market
value – whichever is lower, so companies cannot overstate the inventory’s value.
NRV estimates the actual amount a seller would expect to receive if the asset(s) in question were to
be sold, net of any selling or disposal costs.
Below are the steps to calculate the NRV:
Step 1 → Determine the Expected Sale Price, i.e. the Fair Market Value
Step 2 → Calculate the Total Costs Associated with the Asset Sale, i.e. Marketing,
Advertising, Delivery
Step 3 → Subtract the Sale or Disposal Costs from the Expected Sale Price

Net Realizable Value (NRV) Formula

The formula for calculating NRV is as follows:
Net Realizable Value (NRV) = Expected Sale Price – Total Sale or Disposal Costs
For example, let’s say a company’s inventory was purchased for $100 per unit two years ago, but the
market value is now $120 per unit.
If the associated costs with the sale of the inventory is $40, what is the net realizable value?
After subtracting the selling costs ($40) from the market value ($120), we can calculate the NRV as
$80.
NPV = $120 – $80 = $80
On the accounting ledger, an inventory impairment of $20 would then be recorded.

NRV Calculation Example

Suppose a manufacturing company has 10,000 units of inventory that it intends to sell.
The market value on a per-unit basis is $60.00, and the associated selling costs are $5.00 per unit,
but 5% of the inventory is defective and requires repairs, which costs $5.00 per unit.
Inventory Units = 10,000
Market Sale Price = $60.00
Cost of Selling = $5.00
Cost of Repair = $20.00
Since 5% of the inventory is defective, that means 500 units require repairs.
% Defective Inventory = 5%
Defective Units = 500
The sale price per unit for the defective units – upon incurring the repair and selling costs – is $35.00
per unit.
Sale Price Per Unit = $60.00 – $20.00 – $5.00 = $35.00
The NRV of the defective Inventory is the product of the number of defective units and the sale price
per unit after the repair and selling costs.
NRV = 500 × 35.00 = $17,500
The percentage of non-defective inventory units is 95%, so there are 9,500 non-defective units.
Non-Defective Units = 9,500
To calculate the sale price per unit for the non-defective units, only the selling costs need to be
deducted, which comes out to $55.00.
Sale Price Per Unit = $55.00
We’ll multiply the number of non-defective units by the sale price per unit after selling costs,
resulting in the NRV of non-defective inventory of $522,500
The net realizable value (NRV) of our hypothetical company’s inventory can be calculated by adding
the defective NRV and the non-defective NRV, which is $540,000.
Net Realizable Value (NRV) = $17,500 + $522,500 = $540,000

What is Net Cash Flow?

Net Cash Flow is the difference between the money coming in (“inflows”) and the money going out
of a company (“outflows”) over a specified period.
At the end of the day, all companies must eventually become cash flow positive in order to sustain
its operations into the foreseeable future.
How to Calculate Net Cash Flow?
The net cash flow metric represents a company’s total cash inflows minus its total cash outflows in a
given period.
The capacity of a company to generate sustainable, positive cash flows determines its future growth
prospects, ability to reinvest in maintaining past growth (or excess growth), expand its profit
margins, and operate as a “going concern” over the long run.
Cash Inflows → The movement of money into a company’s pockets (“Sources”)
Cash Outflows → The money no longer in the company’s possession (“Use”)
Since accrual-based accounting fails to accurately depict a company’s true cash flow position and
financial health, the cash flow statement (CFS) tracks each inflow and outflow of cash from
operating, investing, and financing activities across a specified period.
Under the indirect method, the cash flow statement (CFS) is composed of three distinct sections:
1. Cash Flow from Operating Activities (CFO) → The starting line item is net income – the
“bottom line” of the accrual-based income statement – which is subsequently adjusted
by adding back non-cash expenses, namely depreciation and amortization, as well as the
change in net working capital (NWC).
2. Cash Flow from Investing Activities (CFI) → The next section accounts for investments,
with the primarily recurring line item being capital expenditures (Capex), followed by
business acquisitions, asset sales, and divestitures.
3. Cash Flow from Financing Activities (CFF) → The final section captures the net cash
impact from raising capital via equity or debt issuances, share buybacks, repayments on
any financing obligations (i.e. mandatory debt repayment), and issuances of dividends to
shareholders.
Conceptually, the net cash flow equation consists of subtracting a company’s total cash outflows
from its total cash inflows.
The sum of the three sections of the CFS represents the net cash flow – i.e. the “Net Change in Cash”
line item – for the given period.

Net Cash Flow Formula

The formula for calculating the net cash flow is as follows.
Net Cash Flow = Cash Flow from Operations + Cash Flow from Investing + Cash Flow from
Financing
The three sections of the cash flow statement are added together, yet it is still important to confirm
that the sign convention is correct, otherwise, the ending calculation will be incorrect.
For example, depreciation and amortization must be treated as non-cash add-backs (+),
whereas capital expenditures represent the purchase of long-term fixed assets and are thus
subtracted (–).

Net Cash Flow vs. Net Income: What is the Difference?

The net cash flow metric is used to address the shortcomings of accrual-based net income.
While accrual accounting has become the standardized method of bookkeeping per GAAP reporting
standards in the U.S., it is still an imperfect system with several limitations.
In particular, the net income metric found on the income statement can be misleading for measuring
the movement of a company’s actual cash flows.
The purpose of the cash flow statement is to ensure that investors are not misled and to provide
further transparency into the financial performance of a company, especially in terms of
understanding its cash flows.
A company that is consistently profitable at the net income line could in fact still be in a poor
financial state and even go bankrupt.

Net Cash Flow Calculator

Step 1. Business Operating Assumptions

Suppose a company had the following financial data per its cash flow statement (CFS).
Cash Flow from Operations = $110 million


Net Income = $100 million
Depreciation and Amortization (D&A) = $20 million
Change in Net Working Capital (NWC) = –$10 million
Cash Flow from Investing = –$80 million


Capital Expenditures (Capex) = –$80 million
Cash Flow from Financing = $10 million


 Issuance of Long-Term Debt = $40 million
 Repayment of Long-Term Debt = –$20 million
 Issuance of Common Dividends = –$10 million

Step 2. Cash Flow from Operations Calculation

In the cash flow from operations section, the $100 million of net income flows in from the income
statement.
Since the net income metric must be adjusted for non-cash charges and changes in working capital,
we’ll add the $20 million in D&A and subtract the $10 in the change in NWC.
Cash Flow from Operations = $110 million + $20 million – $10 million = $110 million
If the year-over-year (YoY) change in NWC is positive – i.e. net working capital (NWC) increased – the
change should reflect an outflow of cash, rather than an inflow.
For instance, if a company’s accounts receivable balance increased, the impact on cash flow is
negative because the company is owed more money from customers that purchased on credit (and
thus this represents cash that has not yet been received).
Until the payment obligation is fulfilled in cash by the customer, the outstanding dollar amount
remains on the balance sheet in the accounts receivable line item.

Step 3. Cash Flow from Investing Calculation

In the cash flow from investing section, our only cash outflow is the purchase of fixed assets – i.e.
capital expenditures, or “Capex” for short – which is assumed to be an outflow of $80 million.
Cash Flow from Investing = – $80 million
Step 4. Cash Flow from Financing Calculation
The final section is the cash flow from financing, which comprises three items.
1. Issuance of Long-Term Debt: The issuance of long-term debt is a method of raising
capital, so the $40 million is an inflow to the company.
2. Repayment of Long-Term Debt: The repayment of other long-term debt securities is an
outflow of cash, thus we place a negative sign in front, i.e. the intended cash impact is to
reduce cash flow.
3. Issuance of Common Dividends: Like the repayment of long-term debt, the issuance of
common dividends – assuming these are dividends paid to shareholders in the form of
cash – are also outflows of cash.
The overall net cash impact from these financing activities is $10 million.
Cash Flow from Financing = $40 million – $20 million – $10 million = $10 million

Step 5. Net Cash Flow Calculation and Business Profit Analysis

The sum of the three cash flow statement (CFS) sections – the net cash flow for our hypothetical
company in the fiscal year ending 2021 – amounts to $40 million.
Net Cash Flow = $110 million – $80 million + $10 million = $40 million
What is Net Capital Spending?
Net Capital Spending (NCS) measures the difference between a company’s capital expenditures and
depreciation in a given period.

How to Calculate Net Capital Spending (Step-by-Step)

In corporate finance, the net capital spending (NCS) metric is measured to track the current state of
a company’s growth trajectory as well as to support capital budgeting decisions.
The net capital spending of a company represents the amount spent on purchasing fixed assets in a
particular period. The fixed asset (i.e. PP&E) categorization refers to non-current, tangible assets that
can provide economic value for more than twelve months.
For instance, manufacturers must constantly replace existing machinery and equipment to offer
their customers high-quality products and reliable, on-time delivery (e.g. for the avoidance of
unexpected downtimes from machine failures and quality control), as well as to abide by regulations
and ensure the safety of their employees.
In order to calculate net capital spending, the year-over-year change in a company’s net fixed assets
(i.e. the ending net fixed assets minus the beginning net fixed assets) is added to
the depreciation expense recorded in the current period.
Net Capital Spending Formula (NCS)
The net capital spending formula is as follows.
Net Capital Spending (NCS) = Ending Net Fixed Assets – Beginning Net Fixed Assets + Depreciation
Net Fixed Assets: “Ending Net Fixed Assets” refers to the current period balance, whereas
the “Beginning Net Fixed Assets” refers to the prior period’s ending balance. The values
of each can be found on the non-current assets section of the balance sheet.
Depreciation: “Depreciation” is the Capex as recognized in the current period, which can be
found on the cash flow statement (CFS) or in the footnotes and supplementary sections if
consolidated with amortization expense.

How to Interpret Net Capital Spending (High vs. Low Industries)

The reliance on capital spending, or “capital expenditures”, is determined by the industry in which
the company operates within (i.e. capital-intensive vs. capital-light). Thus, the net capital spending is
of more relevance to capital-intensive industries as opposed to service-oriented industries like
consulting, where most of the incurred costs in the business model are related to labor.
As mentioned earlier, the net capital spending metric can also provide insights into the stage of
growth at which the company is currently. If a company’s net capital spending is on the higher end
relative to comparable companies in the same (or an adjacent) industry, the company is implied to
be in a period of high growth.
Companies exhibiting higher growth than their industry peers tend to possess higher net capital
spending than those with lower growth.
However, a company with a disproportionate amount capital expenditures relative to its competitors
is not necessarily a positive sign. In fact, the company might be trailing behind the rest of the
industry in terms of growth and thus be attempting to catch up by spending a significant sum of
capital on purchasing fixed assets.
If capital spending – i.e. the change in the net fixed asset balance across a period – is equal to the
depreciation expense, then the net capital spending is zero. Net zero spending signals that the
company is likely mature and in the later stages of its lifecycle with limited growth opportunities,
which is conceptually identical to a company’s depreciation as a percentage of its capital
expenditures converging to a ratio of 1.0x (or 100%).

Net Capital Spending in Capital Budgeting: Project Decisions

Thus far, we’ve discussed net capital spending in terms of tracking the trend in capital expenditures
and depreciation as part of analyzing a company’s current (and future) growth profile.
It is important to note, however, that the term “net capital spending” can also refer to the sum of
the initial investment and the after-tax salvage value, which is more commonly used for capital
budgeting (i.e. decision-making around which potential projects to pursue).
Net Capital Spending (NCS) = Initial Investment + After-Tax Salvage Value
The initial investment is the cost of undertaking the project, while the after-tax salvage value is the
tax-affected fair market value of the asset, i.e. the fixed asset is assumed to be sold at a later date.
The purpose of computing the net capital spending as described above is to forecast the total cash
flows of a project (e.g. operating cash flow, net working capital, and NCS).
Once complete, the net present value (NPV) of the project’s forecasted cash flows is calculated
alongside the internal rate of return (IRR) to help decide whether to accept or reject the project.
Suppose a company started the current year (2022) with a net fixed asset balance of $10 million,
which is the beginning balance ending balance in the prior period (2021).
By the end of 2022, the company’s net fixed assets were $15 million, reflecting an increase of $5
million from the end of 2021.
Beginning Net Fixed Assets = $10 million
 Ending Net Fixed Assets = $15 million
In 2022, the depreciation expense recognized on the income statement (and added back on the cash
flow statement) was $3 million.
Depreciation Expense = $3 million
Thus, we’ll enter our assumptions into the net capital spending formula to arrive at $8 million for the
fiscal year ending 2022.
Net Capital Spending ($15 million – $10 million) + $3 million = $8 million

What is Accounting Rate of Return?

The Accounting Rate of Return (ARR) is the average net income earned on an investment (e.g. a
fixed asset purchase), expressed as a percentage of its average book value.

How to Calculate Accounting Rate of Return (Step-by-Step)

In capital budgeting, the accounting rate of return, otherwise known as the “simple rate of return”,
is the average net income received on a project as a percentage of the average initial investment.
By comparing the average accounting profits earned on a project to the average initial outlay, a
company can determine if the yield on the potential investment is profitable enough to be worth
spending capital on.
If the project generates enough profits that either meet or exceed the company’s “hurdle rate” – i.e.
the minimum required rate of return – the project is more likely to be accepted (and vice versa).
The primary drawback to the accounting rate of return is that the time value of money (TVM) is
neglected, much like with the payback period. Hence, the discounted payback period tends to be the
more useful variation.
Accounting Rate of Return Formula
The formula to calculate the accounting rate of return is as follows.
Accounting Rate of Return = Average Net Income ÷ Average Book Value
On the income statement, net income (i.e. the “bottom line”) is a company’s accrual-based
accounting profit after all operating costs (e.g. COGS, SG&A and R&D) and non-operating costs
(e.g. interest expense, taxes) are deducted.
The standard conventions as established under accrual accounting reporting standards that impact
net income, such as non-cash expenses (e.g. depreciation and amortization), are part of the
calculation.
The average book value refers to the average between the beginning and ending book value of the
investment, such as the acquired fixed asset.
Average Book Value = (Beginning Book Value + Ending Book Value) ÷ 2
Where:
Beginning Book Value: The beginning book value is straightforward, as it refers to the initial
outlay on the date of purchase.
Ending Book Value: On the other hand, the ending book value is the residual book value, i.e.
the initial investment net of the accumulated depreciation until the end of the fixed
asset’s useful life (and date of sale).

Accounting Rate of Return Calculation Example (ARR)

Suppose you’re tasked with calculating the accounting rate of return from purchasing a fixed
asset using the following assumptions.
Initial Investment = $60 million
Salvage Value (or Scrap Value) = $20 million
Useful Life (Until Sale) = 5 Years
Given those figures, we can determine the depreciation is $8 million per year.
Annual Depreciation = ($60 million – $20 million) ÷ 5 Years = $8 million
The incremental net income generated by the fixed asset – assuming the profits are adjusted for the
coinciding depreciation – is as follows.
Incremental Net Income, Year 1 = ($3 million)
Incremental Net Income, Year 2 = $2 million
Incremental Net Income, Year 3 = $7 million
Incremental Net Income, Year 4 = $12 million
Incremental Net Income, Year 5 = $17 million
Next, we’ll build a roll-forward schedule for the fixed asset, in which the beginning value is linked to
the initial investment, and the depreciation expense is $8 million each period.
Ending Fixed Asset, Year 1 = $52 million
Ending Fixed Asset, Year 2 = $44 million
Ending Fixed Asset, Year 3 = $36 million
Ending Fixed Asset, Year 4 = $28 million
Ending Fixed Asset, Year 5 = $20 million
The ending fixed asset balance matches our salvage value assumption of $20 million, which is the
amount the asset will be sold for at the end of the five-year period.
With the two schedules complete, we’ll now take the average of the fixed asset’s net income across
the five-year time span and divide it by the average book value.
The total profit from the fixed asset investment is $35 million, which we’ll divide by five years to
arrive at an average net income of $7 million.
 Average Net Income = $35 million ÷ 5 Years = $7 million
The average book value is the sum of the beginning and ending fixed asset book value (i.e. the
salvage value) divided by two.
Average Book Value = ($60 million + $20 million) ÷ 2 = $40 million
In conclusion, the accounting rate of return on the fixed asset investment is 17.5%.
Accounting Rate of Return = $7 million ÷ $40 million = 17.5%

CORPORATE DIVIDEND POLICY DECISION

What is a Dividend?
A Dividend is the distribution of a company’s after-tax profits to its shareholders, either periodically
or as a special one-time issuance.

Dividend Definition: Corporate Policy Decision

Companies often opt for dividend issuances when they have excess cash on hand with limited
opportunities for reinvesting into operations.
Since the objective of all corporations is to maximize shareholder value, management can decide in
such a case that returning funds directly to shareholders could be the best course of action.
For publicly-listed companies, dividends are often issued to shareholders at the end of each
reporting period (i.e. quarterly).
The distribution of dividends can have two classifications:
Preferred Dividends
Common Dividends
Preferred dividends are paid out to holders of preferred shares, which
take precedence over common shares – as implied by the name.
More specifically, common shareholders are contractually restricted from receiving dividend
payments if preferred shareholders receive nothing.
Yet, the reverse is acceptable, in which preferred shareholders are issued dividends and common
shareholders are issued none.

Types of Dividends: Cash vs. Stock Payment

The form of payment on the dividend issuance could be:
Cash Dividend: Cash Payments to Shareholders
Stock Dividend: Stock Issuances to Shareholders
Cash dividends are much more common.
For stock dividends, shares are given to shareholders instead, with the potential equity ownership
dilution serving as the prime drawback.
Less common dividend types include the following:
Property Dividend: Distribution of Assets or Property to Shareholders in lieu of Cash/Stock
Liquidating Dividend: Return of Capital to Shareholders Anticipating Liquidation

Dividend Formula
There are three common metrics used to measure the payout of dividends:
Dividends Per Share (DPS): The dollar amount of dividends issued per share outstanding.
Dividend Yield: The ratio between DPS and the latest closing share price of the issuer,
expressed as a percentage.
Dividend Payout Ratio: The proportion of a company’s net earnings paid out as dividends to
compensate common and preferred shareholders.
The formulas for the dividend per share (DPS), dividend yield, and dividend payout ratio are shown
below.
Dividend Per Share (DPS) = Dividends Paid / Number of Shares Outstanding
Dividend Yield (%) = Annual Dividend Per Share (DPS) / Current Share Price
Dividend Payout Ratio = Annual DPS / Earning Per Share (EPS)

Dividend Calculation Example: Ratio Analysis Exercise

For example, let’s say that a company issues a dividend of $100 million with 200 million shares
outstanding on an annualized basis.
Dividend Per Share (DPS) = $100 million / 200 million = $0.50
If we assume the company’s shares currently trade at $100 each, the annual dividend yield comes
out to 2%.
Dividend Yield = $0.50 / $100 = 0.50%
To calculate the dividend payout ratio, we can divide the annual $0.50 DPS by the EPS of the
company, which we’ll assume is $2.00.
Dividend Payout Ratio = $0.50 / $2.00 = 25%

Dividend Stocks: What Types of Companies Issue Dividends?

Low-growth companies with established market positions and sustainable “moats” tend to be the
type of companies to issue higher dividends (i.e. “cash cows”).
Market leaders exhibiting low growth are more likely to distribute more dividends, especially if
disruption risk is low.
On average, the typical dividend yield tends to range between 2% and 5% for most companies.
But certain companies have dividend yields that are much higher – and are often referred to as
“dividend stocks”.

Examples of Dividend Stocks

Some notable companies that have historically issued high dividends are the following:
Johnson & Johnson (NYSE: JNJ)
The Coca-Cola Company (NYSE: KO)
3M Company (NYSE: MMM)
Philip Morris International (NYSE: PM)
Phillips 66 (NYSE: PSX)

High vs. Low Dividend Sectors

The sector in which the company operates is another determinant of the dividend yield.
Examples of sectors with the highest dividend yields include the following:
Basic Materials
Chemicals
Oil & Gas
Financials
Utilities
Telecom
Conversely, sectors with higher growth and more vulnerability to disruption are less likely to issue
high dividends (e.g. software).
High-growth companies frequently opt to re-invest after-tax profits to reinvest into operations for
purposes of achieving greater scale and growth.

Key Dates of Dividend Issuances

Declaration, Ex-Dividend, Holder-of-Record and Payment Date
The most important dates to be aware of for tracking dividends are the following:
Declaration Date: Issuing company releases a statement declaring the intent to pay a
dividend, as well as the date on which the dividend will be paid.
Ex-Dividend Date: The cut-off date for determining which shareholders receiving a dividend
– i.e. any shares purchased after this date will not be entitled to receive a dividend.
Holder-of-Record Date: Typically one day after the ex-dividend date, the shareholder must
have purchased shares at least two days prior to this date to receive a dividend.
Payment Date: The date when the issuing company actually distributes the dividend to
shareholders.

How Dividends Impact the 3-Statements

Income Statement: Dividend issuances do not appear directly on the income statement and
have no impact on net income – but rather, there is a section below net income that
states the dividend per share (DPS) for both common and preferred shareholders.
 Cash Flow Statement: The cash outflow of the dividend appears in the cash from
financing activities section, which reduces the ending cash balance for the given period.
Balance Sheet: On the assets side, cash will decline by the dividend amount, whereas on
the liabilities and equity side, the retained earnings will decline by the same amount (i.e.
retained earnings = prior retained earnings + net income – dividends).

Corporate Dividend and Stock Price Impact

Dividends can impact the valuation of a company (and share price), but whether the impact is
positive or negative depends on how the market perceives the move.
Since dividends are often issued by companies when the opportunities to re-invest into operations
or spend cash (e.g. acquisitions) are limited, the market can interpret dividends as a sign that the
company’s growth potential has stalled.
The impact on the share price should be relatively neutral theoretically, as the slowing growth and
announcement were likely anticipated by investors (i.e. not a surprise).
The exception is if the company’s valuation was pricing in high future growth, which the market may
correct (i.e. cause the share price to decline) if dividends are announced.

Dividends vs. Stock Buybacks: Pros and Cons Analysis

Shareholders can be compensated through two means:
1. Dividends
2. Share Repurchases (i.e. Price Appreciation)
In recent times, share buybacks have become the preferred option for many public companies.
The benefit of share buybacks is that it reduces ownership dilution, making each individual piece of
the company (i.e. share) become more valuable.
From the “artificially” higher earnings per share (EPS), the share price of the company can also see a
positive impact, especially if the company fundamentals point towards upside potential.
Another benefit that share repurchases have over dividends is the increased flexibility in being able
to time the buyback as deemed necessary based on recent performance.
Unless clearly stated to be a special “one-time” issuance, dividend programs are rarely adjusted
downward once announced.
If a long-term dividend is cut, the reduced dividend amount sends out a negative signal to the
market that future profitability could decline.
The final downside to dividend issuances is that dividend payments are taxed twice (i.e. “double
taxation”):
1. Corporate Level
2. Shareholder Level
Unlike interest expense, dividends are not tax-deductible and do not reduce the taxable income
(i.e. pre-tax income) of the issuing company.

What is Dividend Payout Ratio?

The Dividend Payout Ratio is the proportion of a company’s net income that is paid out as dividends
as a form of compensation for common and preferred shareholders.
Typically expressed as a percentage, the dividend payout ratio depicts how much of a company’s
earnings are paid out to shareholders as opposed to being retained and re-invested into operations
– which has significant implications on the type of investors that are attracted to the stock.
How to Calculate Dividend Payout Ratio?
Often referred to as the “payout ratio”, the dividend payout ratio is a metric used to measure the
total amount of dividends paid to shareholders in relation to a company’s net earnings.
Simply put, the dividend payout ratio is the percentage of a company’s earnings that are issued to
compensate shareholders in the form of dividends.
Generally speaking, earnings that are not paid out to common and/or preferred shareholders are
kept by the company and are used for other spending requirements, which can include:
Repayment of Debt and Servicing of Interest Expense
Re-Investing in Core Operations (e.g. Hire More Employees)
Upgrading Internal Workflow and Software Systems (i.e. CRM, ERP)
Acquiring Companies (M&A)
As the inverse of the retention ratio (and the sum of the two ratios should always equal 100%), the
payout ratio represents how much capital is returned to shareholders.
Since the management team made the discretionary decision to issue dividends to preferred and/or
common shareholders, it can be inferred that the company has reached a steady state in
which profitability and cash flows are not a concern.
But from a more cynical perspective, the decision to issue dividends could also suggest that the
number of projects that could be undertaken to increase growth is limited, which is why
management decided it’d be best to simply compensate investors directly via dividends.

Dividend Payout Ratio Formula

To calculate the dividend payout ratio, the formula divides the dividend amount distributed in the
period by the net income in the same period.
Dividend Payout Ratio = Dividends ÷ Net Income
For example, if a company issued $20 million in dividends in the current period with $100 million in
net income, the payout ratio would be 20%.
Payout Ratio = $20m ÷ $100m = 20%
To interpret the ratio we just calculated, the company made the decision to payout 20% of its net
earnings to its shareholders via dividends.
On the opposite end, the company’s retention ratio is 80%.
Retention Ratio = 1 – 20% = 80%
Putting this all together, the company issues 20% of its net earnings to shareholders and retains the
remaining 80% of its net income for re-investing needs.
Along the same lines, the formula could’ve also used dividends per share in the numerator
and earnings per share in the denominator.
Payout Ratio = Dividends Per Share (DPS) ÷ Earnings Per Share (EPS)
If the same company issued annual dividends of $1.00 per share (DPS) with $5.00 in diluted EPS, the
payout ratio also comes out to 20%
Payout Ratio = $1.00 DPS ÷ $5.00 EPS = 20%
In yet another alternative method, we can calculate the payout ratio as one minus the retention
ratio.
In our example, the payout ratio as calculated under this 3rd approach is once again 20%.
Payout Ratio = 1 – 80% = 20%

How Do Dividend Issuances Impact the Financial Statements?

A common accounting interview question is: “How are the three financial statements impacted if a
company initiates a dividend?”
Income Statement (I/S): If a company has initiated a cash-funded dividend, there’ll be no
immediate impact on the income statement. However, a section below the net income
line item will state the dividend per share (“DPS”) attributable to common and preferred
shareholders.
Cash Flow Statement (CFS): As for the statement of cash flows, the cash from
financing section decreases by the dividend payout amount, which lowers the ending cash
balance.
Balance Sheet (B/S): On the assets side of the balance sheet, the cash account declines by
the dividend amount issued, and the offsetting entry will be a decrease in retained
earnings since dividends come directly out of a company’s retained earnings – which is
how the balance sheet remains in balance.
Note that in the simple interview question above, we’re assuming that the funding for the dividend
payout came from the cash reserves belonging to the company, rather than raising new debt
financing to issue the dividend(s).

What are the Drawbacks to High Dividend Payout Ratios?

Just as a generalization, the payout ratio tends to be higher for mature, low-growth companies with
large cash balances that have accumulated after years of consistent performance.
Given the historical track record and steady market positioning – i.e. predictable profit margins,
downside protection, and defensible market share in a mature industry – such companies can afford
to issue dividends if management decides doing so would be most beneficial for their shareholder
base.
But one concern regarding the introduction of corporate dividend issuance programs is that once
implemented, dividends are rarely reduced (or discontinued).
Once announced, the type of investors purchasing these shares will shift towards risk-averse, long-
term investors, as the risk profile of the company becomes more closely aligned with such investors’
investment criteria.
If a dividend program is halted (or even reduced), the market tends to be prone to overreact, as
institutional and retail investors – who have access to less information than internal corporate
decision-makers – will assume the worst.
Hence, public companies are typically very reluctant to adjust their dividend policy, which is one
reason behind the increased prevalence of share buybacks.
In addition, dividends are not tax-deductible and corporate earnings receive “double-taxation”:
1. The first instance of taxation occurs when the company must pay taxes on its taxable
income (EBT).
2. The second instance of taxation takes place when shareholders receive the dividends and
are required to pay personal income taxes on their capital gains.

AT&T Dividend Payout Example (2021)

Historically, companies in the telecommunication sector have been viewed as a “safe haven” for
investors pursuing a reliable, dividend-based stream of income.
But as shown by AT&T Inc. (NYSE: T) in May 2021, approximately $16 billion in
market capitalization was lost within a span of a week after AT&T signaled a potential dividend cut as
part of an M&A deal with Discovery – which goes to show the extent that going against the main
shareholder base’s expectations can be a very costly mistake (i.e. misalignment in corporate
decisions and shareholder expectations).

AT&T 
Market Value (Source: Bloomberg)

What is a Good Dividend Payout Ratio?

Low Payout Ratio: Company is likely exhibiting high growth and reinvesting into its business,
either as a defensive measure or to capture more market share from larger incumbents –
in effect, the company is issuing fewer of its net earnings in the form of dividends, but
increasing the likelihood of increasing its share price through other means (and causing
capital gains for investors).
High Payout Ratio: Common for companies in the later stages of their life cycle – by issuing
more dividends to shareholders instead of reinvesting into the growth of the company,
the probability of capital gains for investors is reduced. However, this aligns with what
many risk-averse investors seek (i.e. dividend income investors).
Companies with high growth and no dividend program tend to attract growth investors that actually
prefer the company to continue re-investing at the expense of not receiving a steady source of
income via dividends.
Instead, such investors seek to profit from share price appreciation, which is largely a function
of revenue growth and margin expansion, among many important factors.
In the case of low-growth, dividend companies, investors typically seek some sort of assurance that
there’ll be a steady stream of income rather than share price appreciation.
The takeaway is that the motivations behind an investor base of a company are largely based on risk
tolerance and the preferred method of profit.
Target Ratio
An important aspect to be aware of is that comparisons of the payout ratio should be done among
companies in the same (or similar) industry and at relatively identical stages in their life cycle.
There is no target payout ratio that all companies in all industries and of varying sizes aim for
because the metric varies depending on the industry and the maturity of the company in question.
In short, there is far too much variability in the payout ratio based on the industry-specific
considerations and lifecycle factors for there to be a so-called “ideal” DPR.
1. Dividend Payout Ratio Calculation Example
For our modeling exercise, we’ll begin by listing out the initial model assumptions:
Year 0 Financials
Net Income = $200m
Dividends Distributed = $50m
The retained earnings equation consists of net income minus the dividends distributed, thereby the
retained earnings for Year 0 is $150m.
Retained Earnings (Year 0) = $200m Net Income – $50m Dividends Distributed = $150m
Then, considering the payout ratio is equal to the dividends distributed divided by the net income,
we get 25% as the payout ratio.
Payout Ratio (Year 0) = $50m Dividends Distributed ÷ 200m Net Income = 25%

For the entire forecast – from Year 1 to Year 4 – the payout ratio assumption of 25% will be
extended across each year.
As a side calculation, we’ll also calculate the retention ratio, which is the retained earnings balance
divided by net income.
Retention Ratio (Year 0) = $150m Retained Earnings ÷ $200m Net Income = 75%
To summarize, the 25% payout ratio indicates that 25% of the company’s net income is issued to
equity shareholders, whereas 75% of the net earnings are kept each period (and rolled over and
accumulated into the next period).

2. Forecast Retained Earnings Using the Payout Ratio

In the second part of our modeling exercise, we’ll project the company’s retained earnings using the
25% payout ratio assumption.
Forecast Assumptions
Dividend Payout Ratio: 25% Each Year
Net Income: $10m Decline Each Year
If applicable, throughout earnings calls and within financial reports, public companies often suggest
or explicitly disclose their plans for upcoming dividend issuances.
The dividend issuance can come in several variations, but two common examples are:
1. Dividend Issuance Program (i.e. Long-Term, Recurring Commitment)
2. One-Time, “Special” Dividend
For purposes of projections, it is recommended to use the managed guided payout ratio, as it’d be
rare for a management team to announce their earnings retention plan to shareholders (i.e. if no
mention of dividends, it can be assumed the earnings will be retained).

3. Dividend Payout Ratio and Retention Ratio Analysis Example

The process of forecasting retained earnings for the next four years will require us to multiply the
payout ratio assumption by the net income amount in the coinciding period.
Besides the dividend payout assumption, another assumption is that net income will experience
negative growth and fall by $10m each year – starting at $200m in Year 0 to $170m in Year 4.
As a quick side remark, the inverse of the payout ratio is the retention ratio, which is why at the
bottom we inserted a “Check” function to confirm that the two equal add up to 100% each year.
From Year 0 to Year 4, the retained earnings balance declines from $150m to $128m, which is
attributable to the 25% payout ratio, which is on the higher end, especially considering that there is
no growth in net income to offset the dividend issuances.
By itself, the payout ratio cannot definitively evaluate the financial health of a company, but it can
give investors a general sense of what the company’s management team currently prioritizes and
views as its prospects for future growth.

What is Dividend Coverage Ratio?

The Dividend Coverage Ratio (DCR) measures the number of times that a company can pay
shareholders its announced dividend using its net income.

How to Calculate Dividend Coverage Ratio (Step-by-Step)

The dividend coverage ratio, or “dividend cover” for short, states how many times a company’s
dividends can be paid using its net income.
The question answered by calculating the dividend cover metric is:
“Is the company capable of continuing to pay out its dividend to shareholders into the
foreseeable future?”
The dividend coverage ratio enables shareholders to estimate the risk of a company being unable to
issue its stated dividend.
Two common metrics tracked by shareholders are 1) the dividend payout ratio and 2) the dividend
yield.
1. Dividend Payout Ratio: Measures the proportion of a company’s net income paid out as
dividends
 2. Dividend Yield: Measures the dividend per share (DPS) relative to its latest closing share
price
Dividend Payout Ratio = Dividend Per Share (DPS) ÷ Earnings Per Share (EPS)
 
Dividend Yield = Dividend Per Share (DPS) ÷ Share Price
However, the dividend cover metric is usually used to determine the risk of the investor no longer
receiving a dividend, which is conceptually similar to the interest coverage ratio for debt holders.
But unlike interest expense, a company is not obligated to pay out a dividend to shareholders, i.e. it
cannot default on a discretionary payment to shareholders.

Dividend Coverage Ratio Formula

To calculate the dividend coverage ratio from the perspective of a common shareholder, the first
step is to subtract the preferred dividend amount from net income.
Dividends to all equity holders, both common and preferred, are paid out of retained earnings, but
common shareholders are placed below preferred shareholders in the capital structure.
Thus, common shareholders cannot be issued their dividend unless preferred shareholders are first
compensated in full.
After net income is adjusted for preferred dividends, the next step is to divide by the dividend
amount attributable to common shareholders.
Dividend Coverage Ratio = (Net Income – Preferred Dividend) ÷ Common Dividend
Conversely, the dividend cover can be calculated using the earnings per share (EPS) and dividend per
share (DPS), but the numerator must be adjusted for the payout to preferred stockholders.
Another variation is to replace net income with cash flow from operations (CFO), which many view
as a more conservative measure as it is less susceptible to earnings management.

How to Interpret the Dividend Cover (DCR)

Since the dividend coverage ratio calculates the number of times that a company’s net earnings can
meet its dividend amount, a higher ratio is “better.”
DCR <1.0x → Net income is insufficient to pay the dividend
DCR >1.0x → Net income is adequate to pay the dividend
DCR >2.0x → Net income can pay the dividend more than twice
Generally, a DCR above 2.0x is perceived as the minimum “floor” before shareholders should be
concerned regarding the sustainability of a company’s future dividends.

Dividend Coverage Ratio Calculation Example

Suppose a company reported $25 million in net income with a longstanding annual dividend of $6
million announced to common shareholders.
“If the dividend paid to preferred stockholders was $1 million, what is the dividend cover?”
After subtracting the preferred dividend from net income, we’re left with $24 million of net income
that could hypothetically be distributed to common shareholders.
With that said, the next step is to divide the leftover net income by the annual dividend to common
shareholders to arrive at 4.0x as the dividend coverage ratio.
Dividend Coverage Ratio = $24 million ÷ $6 million  = 4.0x
Given the 4.0x dividend coverage ratio, the company’s net income is sufficient to pay its annual
dividend four times, so the common shareholders are unlikely to be concerned about an upcoming
reduction in their dividend payments.
What are Dividends Payable?
Dividends Payable is classified as a current liability on the balance sheet, since the expense
represents declared payments to shareholders that are generally fulfilled within one year.

What is the Definition of Dividends Payable?

Once a proposed cash dividend is approved and declared by the board of directors, a corporation
can distribute dividends to its shareholders.
The announced dividend, despite the cash still being in the possession of the company at the time
of the announcement, creates a current liability line item on the balance sheet called “Dividends
Payable”.
The treatment as a current liability is because these items represent a board-approved future
outflow of cash, i.e. a future payment to shareholders. The carrying value of the account is set equal
to the total dividend amount declared to shareholders.
However, note that a corporation is under no obligation to proceed with the dividend distribution if
it decides otherwise is in the best interests of the shareholders, i.e. dividend payments are
discretionary decisions, not a binding legal obligation like interest expense on debt.

What Type of Account is Dividends Payable (Debit or Credit)?

Cash dividends are paid out of a company’s retained earnings, the accumulated profits that are kept
rather than distributed to shareholders.
The correct journal entry post-declaration would thus be a debit to the retained earnings account
and a credit of an equal amount to the dividends payable account.
The important distinction here is that the actual cash outflow does not occur until the actual
payment date.
On the initial date when a dividend to shareholders is formally declared, the company’s retained
earnings account is debited for the dividend amount while the dividends payable account is credited
by the same amount.
Retained Earnings → Debited [Dr.]
Dividends Payable → Credited [Cr.]
Therefore, the dividends payable account – a current liability line item on the balance sheet – is
recorded as a credit on the date of approval by the board of directors.
Later, on the date when the previously declared dividend is actually distributed in cash to
shareholders, the payables account would be debited whereas the cash account is credited.
Dividends Payable → Debited [Dr.]
Cash → Credited [Cr.]

What are Journal Entry Examples of Dividends Payable?

Suppose a corporation currently has 100,000 common shares outstanding with a par value of $10.
If the corporation’s board of directors declared a cash dividend of $0.50 per common share on the
$10 par value, the dividend amounts to $50,000.
Dividend = $0.50 × 100,000 = $50,000
The journal entry on the date of declaration is the following:

General Ledger Debit [Dr.] Credit [Cr.]

Retained Earnings $50,000

          Dividends $50,000
Payable

As shown in the general ledger above, the retained earnings account is debited by $50,000 while the
payables account is credited $50,000.
Once the previously declared cash dividends are distributed, the following entries are made on the
date of payment.

General Ledger Debit [Dr.] Credit [Cr.]

Dividends Payable $50,000

          Cash $50,000

Since the cash dividends were distributed, the corporation must debit the dividends payable account
by $50,000, with the corresponding entry consisting of the $50,000 credit to the cash account.
What is Dividend Per Share?
Dividend Per Share (DPS) represents the total dividend amount issued by a company on a per-share
basis, most often using annualized figures.
How to Calculate Dividend Per Share (Step-by-Step)
Dividends are defined as the distribution of a company’s after-tax earnings (i.e. net income) to
common and preferred shareholders as a form of shareholder compensation.
A common metric used to assess a company’s dividend policy on a per-share basis is the dividends
per share (DPS), which standardizes the metric to allow for comparisons in dividend policies among
different companies.
Unlike the gross dividend amount, the DPS of a company can also be compared to that of historical
periods to observe year-over-year (YoY) trends.

Dividend Per Share Formula (DPS)

The dividends per share is equal to the dividend issuance amount divided by the total number
of shares outstanding.
Dividends Per Share (DPS) = Annualized Dividend Amount ÷ Number of Shares Outstanding
The dividend issuance amount is typically expressed on an annual basis, meaning that a quarterly
dividend amount is multiplied by four (i.e. four quarters in one fiscal year) – assuming that the
quarterly dividend amount is to remain unchanged.
Annualized Dividend = Quarterly Dividend Amount x 4
The total number of shares outstanding should include the impact of dilutive securities, as well as be
calculated based on the annual weighted average share count between the beginning and end of
period shares outstanding.
Weighted Average of Shares Outstanding = (Beginning and End of Period Shares
Outstanding) ÷ 2

What is a Good Dividend Per Share?

If a company’s dividend per share (DPS) increases, the market reaction is usually positive.
Upon announcing a dividend, especially if a long-term dividend program rather than a one-time
issuance, the share price of the underlying issuer tends to rise.
Why? The decision to issue dividends stems from management’s confidence in the company’s
future profitability and maintenance of its current market positioning.
By contrast, the cutting of the dividend per share (DPS) sends a negative signal to the market,
indicative of uncertainty in the company’s future profits and stability.
However, the context surrounding the issuance of a high dividend per share (DPS) must be
considered.
For instance, the management team might have mistakenly announced an unsustainable dividend
program, which it refuses to reduce (or end) to avoid sending a negative signal to the market.
In contrast, the decision by a corporation to issue dividends could cause the share price to decline in
certain instances. For example, if a company with an inflated share price from its positive growth
prospects were to suddenly issue dividends rather than reinvest capital (or participate in a stock
buyback), the existing investor base could start to sell-off their positions.

Dividend Per Share Calculation Example (DPS)

Suppose a company issued a quarterly dividend of $50 million, with no announcements regarding
cutting the dividend in the near term.
The annualized dividend amount is calculated to be $200 million.
Annual Dividend Amount = $50 million x 4 = $200 million
Next, if the company is projected to have 90 million shares at the beginning of the period and 110
million shares outstanding at the end of the period, the weighted average share count is 100 million.
Weighted Average Shares Outstanding  = (90 million + 110 million) ÷ 2 = 100 million
Given those two inputs, if we divide the annualized dividend by the weighted average share count,
we calculate $2.00 as the DPS.
Dividends Per Share (DPS) = $200 million ÷ 100 million = $2.00

What is the Retention Ratio?

The Retention Ratio is the portion of net earnings that are retained by a company rather than being
paid out as dividends to shareholders.

How to Calculate Retention Ratio (Step-by-Step)

The importance of the retention ratio is related to the fact that companies re-investing their net
income into their operations implies that there are growth opportunities worth pursuing in their
current pipelines.
For companies profitable at the net income line (i.e. “the bottom line”), there are two options
available to the management team in terms of how to use the proceeds:
1. Re-Invest into Operations: Maintain possession of those earnings and, on a later date,
use them to fund ongoing operations as well as discretionary growth plans
2. Compensate Equity Shareholders: Issue payments to preferred and/or common
shareholders in the form of dividends
If the former is chosen, the percentage of profits that the company opts to hold onto as opposed to
paying out as dividends increases – which is quantified by the retention ratio.
Since the earnings retention of the company is expressed in the form of a percentage, this enables
comparisons among peer companies in the same industry.
The inverse of the retention ratio is called the “dividend payout ratio”, which measures the
proportion of net income paid out as dividends to shareholders.
Retained Earnings on Balance Sheet
When the earnings of companies are credited to retained earnings instead of being issued out as
dividends, the preserved amount flows into the “Retained Earnings” line item on the balance sheet.
To forecast retained earnings, the process consists of taking the prior period balance of retained
earnings, adding the net income from the current period, and then subtracting any dividends issued
to shareholders.

Factors Affecting the Retention Ratio

Considering the retention ratio – also known as the “plowback ratio” – indicates the amount of
retained profits, the fact that a company would decide to keep its profits tends to be a positive sign
that management is confident regarding its future business growth opportunities.
However, this interpretation is based on the assumption that management is rational and makes
corporate decisions with the “best interests” of its shareholders in mind.
As a general rule, the retention ratio is typically lower for mature, established companies that have
accumulated large cash reserves.
Often, such companies are referred to as “cash cows”, as they are characterized by large market
share in a mature, single-digit growth industry.
Consequently, these types of companies have minimal reinvestment needs and essentially have
developed into a steady turnkey business following years of strong growth to become a market
leader.

Boston Consulting Group Growth-Share Matrix (Source: 

BCG)
Here, the decision-making process is based on whether or not the projects in the current pipeline
could be undertaken in the present date – if not, it is often because the risks associated with the
projects are not justified by the potential returns.
On the other hand, a high-growth company riding a positive trajectory in terms of market expansion
and new customer acquisitions would be comparatively far more likely to retain earnings, as there
are more likely to be worthwhile projects worth undertaking.
To expand further, growing companies require additional cash to fund upcoming investments
in assets (i.e. capital expenditures) and other strategic operational investments into:
Sales & Marketing Spend (S&M)
Advertising Campaigns
Customer Service and Support
Business Development Representatives

Nuances to Earnings Retention

There are exceptions to the rules, generalizing that low growth companies have low retention ratios
(and vice versa).
For instance, a mature company might have a high retention ratio due to a business model oriented
around acquiring competitors or adjacent companies in the market (i.e. growth through
acquisitions/M&A).
Additionally, if a company operates in a capital-intensive industry (e.g. automobiles, oil & gas) that
requires large funds to maintain their current level of output, this industry dynamic also would call
for higher retention rates.
And along the same lines, companies with cyclical operating performance must preserve more cash
on hand to be able to withstand an economic downturn.
The final consideration is that the act of a company retaining more of its earnings should not always
be interpreted as a positive indicator, as confirmation is required to ensure the capital is being spent
effectively and efficiently via metrics such as the:
Return on Invested Capital (ROIC)
Return on Assets (ROA)
Return on Equity (ROE)
Therefore, the retention ratio should be used in conjunction with other metrics to assess the actual
financial health of a company.

Retention Ratio Formula

To calculate the retention ratio, the formula subtracts the common and preferred dividends
distributed from the net income of the current period and then divides the difference by the current
period’s net income value.
Once dividends for the period have been paid out, the remaining profits are considered retained
earnings.
With that said, the numerator, in which dividends are deducted from net income, is simply the
retained earnings account.
Retention Ratio Formula
Retention Ratio = (Net Income – Dividends) / Net Income
For instance, let’s say a company has reported a net income of $100,000 in 2021 and paid $40,000 of
annual dividends. In our scenario, the retention ratio is 60%, which was calculated using the
following formula:
Retention Ratio = ($100k Net Income – $40k Dividends Paid) ÷ $100k Net Income
Retention Ratio = 60%
An alternative method to calculate the retention ratio is by subtracting the payout ratio from one.
Retention Ratio Formula
Retention Ratio = 1 – Payout Ratio
Continuing off on the prior example, we arrive at a retention ratio of 60% once again.
Payout Ratio = $40k Dividends Paid ÷ $100k Net Income = 40%
Retention Ratio = 1 – 40% Payout Ratio
Retention Ratio = 60%
Conceptually, the formula should make sense given how the retention ratio is the opposite of the
payout ratio, which is the percentage of net earnings paid out to shareholders as dividends.

Retention Ratio Example Calculation

For our simple modeling exercise, we’ll use the following assumptions for the historical financials:
Year 0 Financials
Net Income = $100m
Dividends Distributed = $10m
Considering the retained earnings equation is net income minus the dividends distributed, the
retained earnings for Year 0 come out to $90m.
 Retained Earnings (Year 0) = $100m Net Income – $10m Dividends Distributed = $90m
Furthermore, the payout ratio is calculated by dividing the dividends distributed by the net income.
Payout Ratio (Year 0) = $10m Dividends Distributed ÷ 100m Net Income = 10%
As for the retention ratio, the equation is retained earnings divided by net income, as discussed
earlier.
Retention Ratio (Year 0) = $90m Retained Earnings ÷ $100m Net Income = 90%
The 90% retention ratio signifies that net of any dividends paid out to equity shareholders, 90% of
the company’s net earnings are kept and accumulated on its balance sheet to be spent on a later
date.

Retention Ratio Projection

In the next section, we’ll practice forecasting retained earnings using the payout ratio, which is
directly linked to the retention ratio.
Public companies tend to publicly disclose their plans for dividends issuance programs – whether it
be a long-term plan or one-time special dividend. However, rather than also explicitly announcing
their retention plans, retention metrics have to be calculated using the relationship between
dividends and retained earnings.
To project the retained earnings balance in Year 1 and Year 2, we’ll be using two assumptions:
Payout Ratio Assumptions
Year 1: 25%
Year 2: 40%
Given the increasing payout of dividends, we’d expect retained earnings to decline even with the
$10m year-over-year (YoY) increase in net income.
Retained Earnings (Year 1): $83m
Retained Earnings (Year 2): $72m
Confirming our statement from earlier, the inverse of the payout ratio is the retention ratio, so we
can see that the sum of the two ratios equals 100% in all three years in the completed model output.
What is Buyback Yield?
The Buyback Yield is the ratio between the value of a company’s net stock repurchases and its
market capitalization as of the beginning of a period, expressed as a percentage.

What is the Definition of Buyback Yield?

The buyback yield reflects the percentage of a company’s market capitalization (or “market cap”)
returned to common shareholders in the form of stock buybacks.
Stock buybacks, often referred to as “share repurchases”, is a method for corporations to return
value to its shareholders, i.e. equity investors. The rationale for stock buybacks, similar to the
issuance of dividends, is to return value to investors.
In recent times, however, publicly-traded companies are increasingly more likely to utilize stock
repurchases in lieu of dividends for various reasons.
Market Signal (Undervalued Stock Price) → The decision by a corporation to repurchase
shares can frequently send out a positive signal regarding management’s belief that its
shares are currently undervalued by the market. The buyback of shares – assuming the
current market price is in fact underpriced – should theoretically contribute towards more
long-term returns for shareholders.
Positive Growth Trajectory → Stock buybacks can reaffirm the corporation has sufficient
cash set aside to fund its near-term growth initiatives, and management’s priority remains
 long-term shareholder value creation. Hence, the “excess cash” belonging to the company
is returned to shareholders via stock repurchases, rather than allowing the cash to sit idle
on their balance sheet (and generate low yields in investment accounts).
One-Time Event → Unlike a dividend issuance program, the occurrence of stock repurchases
can be a one-time event, signaling management’s optimism around the company’s growth
prospects and liquidity. In contrast, a dividend program – once formally announced to the
public – is frequently interpreted as a sign that opportunities to reinvest capital into
growth are starting to wane.
Increase in Stock Price → By reducing the total number of shares in circulation in the open
markets, a company can effectively cause its valuation to rise. For instance, investors often
rely on the price to earnings ratio (P/E) to estimate the appropriate market value of a
company’s shares. Since the reported earnings per share (EPS) metric – the denominator
of the P/E ratio – increases post-buyback, the P/E ratio declines, which can potentially
cause the company’s shares to rise to value to continue trading at the same P/E ratio.
Offset Stock Dilution → The share count of a company can rise from new stock issuances and
dilutive securities such as warrants, options, and stock based compensation (SBC). The
rise in shares outstanding can cause a company’s earnings per share (EPS) to decline, so
share repurchases can offset the dilution in equity ownership to prevent downward
movement in the stock price.

The Power of Share Repurchases (Source: OSAM)

What is a Good Buyback Ratio?

Generally speaking, corporations with aggressive stock buyback programs to maintain a high
buyback ratio is not a sustainable, long-term strategy to drive shareholder returns.
But rather, a high buyout ratio is the function of a corporation with a strong fundamental profile in
terms of profitability and growth trajectory, i.e. the consequence, not the cause.
For example, a notable public company with one of the most significant share repurchases is Apple
(AAPL). From 2012 to the end of fiscal year 2022, Apple spent in excess of $572 billion on stock
buybacks.
However, the notion that stock buybacks can create long-term shareholder value is a controversial
topic, as many critics perceive share repurchases as near-term oriented tactics to cause an artificial
rise in its market value per share.
The market value of a company frequently rises following the buyback, yet the fundamental drivers
of valuation – e.g. revenue growth, profit margins, and free cash flow generation (FCF) – remain the
same, which is the premise of the argument that stock buybacks do not create real shareholder
value.
How to Calculate Buyback Yield?
The buyback yield metric is calculated as the total value of share buybacks in a given period divided
by the company’s market capitalization at the beginning of the period, with the most common
periodicity used in the ratio being the next twelve months.
The step-by-step process to calculate the buyback yield is as follows.
1. Shares Repurchases → Determine the total number of share repurchases conducted by a
company over a given period.
2. Stock Repurchase Price → Identify the prices at which each share repurchase occurred.
3. Gross Stock Buyback Value → Multiply the number of shares repurchased for each
tranche by the coinciding repurchase price to determine the total value of a company’s
stock buybacks.
4. Net Stock Buyback Value → Subtract the gross stock buyback value by the value of the
new stock issuances in the matching period.
5. Market Capitalization → Determine the company’s market cap at the beginning of the
period, which equals the product of the company’s beginning total share count on a
diluted basis and the initial market share price.
6. Buyback Yield → Divide the total value of the share buybacks by the market
capitalization at the beginning of the period.
7. Conversion to Percentage → Multiply the resulting figure by 100 to convert the buyback
yield into a percentage.

Buyback Yield Formula

The formula to calculate the buyback yield on a gross basis is as follows.
Gross Buyback Yield (%) = Total Share Repurchases ÷ Beginning Market Capitalization
But since corporations frequently issue new shares over the course of a given period (e.g. stock
based compensation), the following buyback yield formula – expressed on a net basis – should be
used instead.
Net Buyback Yield (%) = (Total Share Repurchases – Total Share Issuances) ÷ Beginning Market
Capitalization
Total Share Buybacks ($) → The total share buybacks is the total value of a company’s
spending attributable to repurchasing shares.
Total Share Issuances ($) → The total share issuances is the total value of the new issuances
of stock by a company over a specified period.
Market Capitalization ($) → The market cap of a company can be determined by multiplying
the market value per share at the start of the period by the total number of shares
outstanding.
The short-form formula to calculate the net buyback yield is as follows.
Net Buyback Yield (%) = Total Value of Share Repurchases, net ÷ Beginning Market Capitalization
The resulting yield is expressed as a percentage, indicating the proportion of a company’s market
cap as of the beginning of the year was returned to shareholders via share buybacks.
Simplification of Formula
The total value of share buybacks is determined as the product of the number of shares purchased
and the price at which the repurchase occurred.
Therefore, it is necessary to compute the value returned using the granular data found in the public
filings of the company that pertain to each share repurchase transaction.

Buyback Yield Calculation Example

Suppose a publicly-traded corporation had a market capitalization of $10 billion as of the beginning
of fiscal year 2022.
Market Share Price, BoP = $20.00
Number of Diluted Shares Outstanding, BoP = 500 million
Market Capitalization ($) = $20.00 × 500 million = $10 billion
From the start of 2022 to the end of the fiscal year, the total monetary value of the shares
repurchased to date totaled $520 million, whereas the total value of the new stock issuances
amounted to $20 million.
Market Capitalization, Beginning of FY-2022 ($) = $10 billion
Total Shares Repurchased ($) = $520 million
Total Share Issuances ($) = $20 million
Therefore, the net stock issuance for 2022 was $500 million, which we’ll divide by the market
capitalization at the beginning of the fiscal year to arrive at a buyback yield of 5.0%.
Stock Repurchases, net ($) = $520 million – $20 million = $500 million
Buyback Yield (%) = $500 million ÷ $10 billion = 5.0%
In conclusion, the 5.0% buyback yield of our hypothetical corporation implies that 5.0% of the
company’s market cap at the start of 2022 was returned to shareholders in the form of stock
buybacks over the course of the next twelve months.
What is the Plowback Ratio?
The Plowback Ratio is the percentage of a company’s earnings retained and reinvested into
operations as opposed to being paid out as dividends to shareholders.

How to Calculate the Plowback Ratio (Step-by-Step)

The plowback ratio, also known as the “retention ratio,” is the fraction of a company’s net
earnings that are retained to be reinvested into its operations.
Management’s decision to hold onto earnings could suggest that there are currently profitable
opportunities worth pursuing.
The inverse of the plowback ratio — the “dividend payout ratio” — is the proportion of net
income paid out in the form of dividends to compensate shareholders.
Considering that higher retention indicates more growth potential, a higher dividend payout
ratio should result in lower growth expectations, i.e. the two are inversely related.
If a company opted to pay out a large percentage of its earnings as dividends, no (or minimal)
growth should be expected out of the company.
The rationale behind a long-term dividend program is typically that growth opportunities are limited
and the company’s pipeline of potential projects has been exhausted; thus, the best course of action
to maximize shareholder wealth is to pay them directly via dividends.

Plowback Ratio and Implied Growth Formula

In theory, greater retention of earnings and rates of reinvestment into profitable projects should
coincide with higher near-term growth rates (and vice versa).
A higher plowback ratio implies a higher growth rate, all else being equal.
As a result, a company’s growth rate (g) can be approximated by multiplying its return on equity
(ROE) by its plowback ratio.
Growth Formula
g = ROE × b
Where:
g = Growth Rate (%)
ROE = Return on Equity
b = Plowback Ratio
The plowback ratio, however, cannot be used as a standalone metric, as just because earnings are
retained does not mean it is being spent efficiently. The ratio should therefore be tracked alongside
the following return ratios:
Return on Invested Capital (ROIC)
Return on Assets (ROA)
Return on Equity (ROE)

Plowback Ratio and Company Lifecycle

If a company is profitable at the net income line — i.e. “the bottom line” — there are two main
options for management to spend those earnings:
1. Re-Invest: The net earnings can be kept and then be used to fund ongoing operations
(i.e. working capital needs), or discretionary growth plans (i.e. capital expenditures).
2. Dividends: The net earnings can be used to compensate shareholders; i.e., direct
payments can be made to either preferred and/or common shareholders.
The retention ratio is generally lower for mature companies with established market shares (and
large cash reserves).
But for companies in high-growth sectors at risk of disruption and/or a large number of competitors,
constant reinvestments are typically necessary, which leads to lower retention.
Capital-Intensive / Cyclical Industries
Note that not all market-leading, established companies have low retention ratios.
For example, companies operating in capital-intensive industries such as automobiles, energy (oil &
gas), and industrials must constantly spend significant amounts of money just to maintain their
current output.
Capital-intensive industries are also often cyclical in performance, which further creates the need for
retaining more cash on hand (i.e. withstand a slowdown in demand or global recession).
Plowback Ratio Formula
One method to calculate the plowback ratio is to subtract common and preferred dividends from net
income, and then divide the difference by net income.
After dividends for the period have been paid out to shareholders, the residual profits are
called retained earnings, i.e. net income minus dividend distributions.
Formula
Plowback Ratio = Retained Earnings ÷ Net Income

Plowback Ratio Calculation Example

Suppose a company has reported a net income of $50 million and paid $10 million in dividends for
the year.
Plowback Ratio = ($50 million – $10 million) ÷ $50 million = 80%
In our illustrative scenario, the plowback ratio is 80%, i.e. the company paid out 20% as dividends,
and the remaining 80% was kept to be reinvested at a later date.
An alternative method to calculate the ratio is to subtract the dividend payout ratio from one.
Formula
Plowback Ratio = 1 – Payout Ratio
Recall that the plowback ratio is the inverse of the payout ratio, so the formula should be intuitive
since the sum of the two ratios must equal one.
Using the same assumptions as in the prior example, we can calculate the plowback ratio by
subtracting 1 minus the 20% payout ratio.
Payout Ratio = $10 million ÷ $50 million = 20%
We can then subtract the 20% payout ratio from 1 to calculate a plowback ratio of 80%, which aligns
with the previous calculation.
Plowback Ratio = 1 – 20% = 80%
Plowback Ratio — Per Share Calculation
The plowback ratio can also be calculated using per-share figures, with the two inputs consisting of:
1. Earnings Per Share (EPS)
2. Dividend Per Share (DPS)
Let’s assume that a company has reported an earnings per share (EPS) of $4.00 and paid an annual
dividend per share (DPS) of $1.00.
The company’s dividend payout ratio is equal to the earnings per share (EPS) divided by the dividend
per share (DPS).
Payout Ratio = $1.00 ÷ $4.00 = 25%
Considering that 25% of the company’s net earnings were paid out as dividends, the plowback ratio
can be calculated by subtracting 25% from 1.
Plowback Ratio = 1 – 25% = .75, or 75%
In conclusion, 75% of the company’s net earnings were kept for future reinvestments while 25% was
paid out to shareholders as dividends.

CORPORATE ACTIONS
What is a Stock Buyback?
A Stock Buyback occurs when a company decides to repurchase its own previously issued shares
either directly in the open markets or via a tender offer.
Stock Buyback Definition in Corporate Finance
A stock buyback, or “stock repurchase,” describes the event wherein shares previously issued to the
public and were trading in the open markets are bought back by the original issuer.
After a company repurchases a portion of its shares, the total number of shares outstanding (and
available for trading) in the market is subsequently reduced.
Buybacks can demonstrate that the company has sufficient cash set aside for near-term spending
and point to management’s optimism about upcoming growth, resulting in a positive share price
impact.
Since the proportion of shares owned by existing investors increases post-repurchase, management
is essentially betting on itself by completing a buyback.
In other words, the company might believe its current share price (and market capitalization) is
undervalued by the market, making buybacks a profitable move.

How a Stock Buyback Works (Step-by-Step)

The share price impact, in theory, should be neutral, as the share count reduction is offset by the
decline in cash (and equity value).
Sustainable, long-term value creation stems from growth and operational improvements – as
opposed to just returning cash to shareholders.
Yet share buybacks can still affect a company’s valuation, either positively or negatively, contingent
on how the market as a whole perceives the decision.
Positive Stock Price Impact – If the market incorrectly under-priced the cash a company
owns in the valuation, the buyback can result in a higher share price.
Negative Stock Price Impact – If the market views the buyback as a last resort signaling that
the company’s pipeline of investments and opportunities is running out, the net impact is
likely negative.
The repurchase can benefit a company’s shareholders due to increasing earnings per share (EPS) –
both on a basic EPS and diluted EPS basis.
Basic EPS = (Net Income – Preferred Dividends) ÷ Weighted Average Common Shares Outstanding
 
Diluted EPS = (Net Income – Preferred Dividends) ÷ Weighted Average of Diluted Common Shares
Outstanding
The core issue here, however, is that no real value has been created – i.e. the fundamentals of the
company remain unchanged post-buyback.
Nevertheless, the implied share price projected by the price-to-earnings ratio (P/E) can increase
post-buyback.
P/E Ratio = Share Price ÷ Earnings Per Share (EPS)

Implied Share Price Calculation Example (Post Stock Repurchase)

Let’s say, for example, that a company has generated $2 million in net income and has 1 million
shares outstanding prior to completing a stock buyback.
With that said, the diluted EPS pre-buyback is equal to $2.00.
Diluted EPS = $2m ÷ 1m = $2.00
Moreover, we will assume the company’s share price was $20.00 on the date of the repurchase, so
the P/E ratio is 10x.
P/E Ratio = $20.00 ÷ $2.00 = 10.0x
If the company repurchases 200k shares, the post-buyback number of diluted shares outstanding is
800k.
Given the $2 million in net income, the post-buyback diluted EPS equals $2.50.
Diluted EPS = $2m ÷ 800k = $2.50
To maintain the 10x P/E ratio, the implied share price would be $25.00, which we calculated by
multiplying the new diluted EPS figure by the P/E ratio.
Implied Share Price = $2.50 × 10.0x = $25.00
% Change = ($25.00 ÷ $20.00) – 1 = 25%
In our example scenario, there is in fact a positive share price impact, with the underlying cause of
artificial inflation in EPS.
The accounting treatment on the balance sheet is shown below.
Cash is credited by $4 million ($20.00 Share Price x 200k Shares Repurchased).
Treasury Stock is debited $4 million.
While the total shareholders’ equity on the balance sheet declines, there are fewer claims on the
remaining equity.

Share Buybacks vs. Dividend Issuances: Corporate Decision

Share purchases are one method for companies to compensate shareholders, with the other option
consisting of dividend issuances.
The difference between share buybacks and dividend issuances is that rather than equity
shareholders receiving cash directly, repurchases consolidate equity ownership per share (i.e. reduce
dilution), which can indirectly create value.
One reason companies prefer share buybacks is to avoid the “double taxation” associated with
dividends, in which the dividend payments are taxed twice:
 1. Corporate Level (i.e. dividends are NOT tax-deductible)
2. Shareholder Level
Plus, many companies pay employees using stock-based compensation to conserve cash, so the net
dilutive impact of those securities can be partially (or entirely) counteracted by buybacks.
Once implemented, dividends are rarely cut unless deemed necessary. This is because the market
tends to assume the worst and expects future earnings to decrease if a long-term dividend program
is abruptly cut, causing a sharp decline in share price.
Conversely, share repurchases are often one-time events.

Apple Stock Repurchase Example and Trends (2022)

In the past decade, there has been a substantial shift towards share buybacks instead of dividends,
as certain companies attempt to take advantage of their undervalued stock issuances while others
strive to increase their stock price artificially.
The announcement of a long-term dividend program tends to be interpreted as a statement that the
company is now mature with fewer investments/projects to put their earnings to use.
Particularly among high-growth companies in the tech sector, most thereby opt for buybacks in lieu
of dividends as buybacks send a more optimistic signal to the market regarding future growth
prospects.
For example, Apple (NASDAQ: AAPL) has led all companies in the S&P 500 in the amount spent on
share buybacks. In 2021, Apple spent a total of $85.5 billion on share repurchases and $14.5 billion
on dividends – as its market capitalization briefly touched $3 trillion in 2022.

What is a Stock Split?

A Stock Split occurs when a publicly-traded company’s board of directors decides to separate each
outstanding share into multiple shares.
How Do Stock Splits Work?
The rationale behind stock splits is that individual shares are currently priced so high that potential
shareholders are deterred from investing.
Stock splits are most often declared by companies with share prices determined as being too high,
i.e. the shares are no longer accessible to individual investors.
Stock splits cause a company’s share price to become more affordable to retail investors, thereby
broadening the investor base that could own equity.
More specifically, an abnormally high share price can prevent retail investors from diversifying their
portfolios.
By allocating a greater percentage of their capital towards shares in one company, an individual
investor takes on more risk, which is why the average everyday investor is unlikely to purchase even
one high-priced share.
For instance, the share price of Alphabet (NASDAQ: GOOGL) as of the latest closing date (3/2/2022)
was roughly $2,695 per share.
If an individual investor has $10k in capital to invest and purchased a single Class A share of
Alphabet, the portfolio is already 26.8% concentrated in one share, meaning that the portfolio’s
performance is largely dictated by Alphabet’s performance.

How Do Stock Splits Impact Share Price?

After a stock split, the number of shares in circulation increases, and the share price of each
individual share declines.
However, the market value of the company’s equity and the value attributable to each existing
shareholder remains unchanged.
The effects of a stock split are summarized below:
Number of Shares Increases
Reduction in Market Value Per Share
More Accessible Stock to Broader Range of Investors
Increased Liquidity
Stock splits theoretically have a neutral impact on a company’s overall valuation, despite the decline
in share price, i.e. the market capitalization (or equity value) remains unchanged post-split.
But there are certain side considerations such as the increased liquidity within the markets that
could benefit existing shareholders.
Once a stock split has occurred, the range of investors that can potentially purchase stocks in the
company and become shareholders expands, resulting in greater liquidity (i.e. easier for existing
shareholders to sell their stakes in the open markets).
Unlike issuances of new shares, stock splits are not dilutive to existing ownership interests.
A stock split can be visualized as cutting a slice of pie into more pieces.
The total size of the pie does NOT change (i.e. equity value remains unchanged)
The slice belonging to each person does NOT change (i.e. fixed equity ownership %).
However, the one detail that does, in fact, change is that more pieces can be distributed to people
who may not have a slice.
Companies that have historically performed stock splits have been shown to outperform the market,
but stock splits result from growth and positive investor sentiment rather than the stock split itself
being the cause.
Learn More → Hedge Fund Primer

Stock Split Ratio and Split-Adjusted Price Formula

Stock Split Ratio Post-Split Shares Owned Split Adjusted Share Price

2-for-1 = Pre-Split Shares Owned × 2 = Pre-Split Share Price ÷ 2

3-for-1 = Pre-Split Shares Owned × 3 = Pre-Split Share Price ÷ 3

4-for-1 = Pre-Split Shares Owned × 4 = Pre-Split Share Price ÷ 4

5-for-1 = Pre-Split Shares Owned × 5 = Pre-Split Share Price ÷ 5

Let’s assume that you currently own 100 shares in a company with a share price of $100.
If the company declares a two-for-one stock split, you would now own 200 shares at $50 per share
post-split.
Shares Owned Post-Split = 100 Shares × 2 = 200 Shares
Share Price Post-Split = $100 Share Price ÷ 2 = $50.00
Dividends and Stock Splits
If the company undergoing a stock split has a dividend, the dividends per share (DPS) issued to
shareholders will be adjusted in proportion to the split.

Stock Split Calculation Example

Suppose a company’s shares are currently trading at $150 per share, and you’re an existing
shareholder with 100 shares.
If we multiply the share price by the shares owned, we arrive at $15,000 as the total value of your
shares.
Total Value of Shares = $150.00 Share Price × 100 Shares Owned = $15,000
Let’s say the company’s board decides to approve a 3-for-1 split. You now hold 300 shares, each
priced at $50 each post-split.
Total Shares Owned = 100 × 3 = 300
Share Price = $150.00 ÷ 3 = $50.00
After the split, your holdings are still worth $15,000, as shown by the calculation below.
Total Value of Shares = $50.00 Share Price × 300 Shares Owned = $15,000
Given the reduced share price, you are more likely to sell your shares more easily because there are
more potential buyers in the market.
Google Stock Split Example (2022)
Alphabet Inc. (NASDAQ: GOOG), the parent company of Google, stated in early February 2022 that a
20-for-1 stock split would be enacted on all three classes of their shares.
Alphabet Q4-21 Earnings Call
“The reason for the split is it makes our shares more accessible. We thought it made sense to do.”
– Ruth Porat, Alphabet CFO
As of July 1, 2022, each Alphabet shareholder will be given 19 more shares for each share already
owned, which will be transferred on July 15 — shortly afterward, its shares begin trading at the split-
adjusted price on the 18th.

Alphabet Q-4 2021 Results — Stock Split Commentary (Source: 

Q4-21 Press Release)
Alphabet has a three-class share structure:
Class A: Common Shares with Voting Rights (GOOGL)
Class B: Shares Reserved for Google Insiders (e.g. Founders, Early Investors)
Class C: Common Shares without Voting Rights (GOOG)
Hypothetically, if the split for GOOGL were to occur in March, as of its latest closing price of $2,695,
each share post-split would be priced at approximately $135 apiece.
Since Alphabet’s announcement, many investors have urged other companies with high share prices
to do the same, and many are expected to follow their lead, such as Amazon and Tesla.
Alphabet’s stock split should not have a material impact on the share of its valuation — yet,
considering how long-awaited the stock split was and how its shares were trading near $3,000 per
share — the influx of new investors and more volume could still affect its market value.
What is a Reverse Stock Split?
A Reverse Stock Split is performed by companies attempting to increase their share price by
reducing the number of shares in circulation.

How Does a Reverse Stock Split Work (Step-by-Step)

In a reverse stock split, a company exchanges a set number of shares it previously issued for a fewer
number of shares, but the value attributable to each investor’s overall holdings is kept the same.
After the reverse stock split, the share price rises from the reduction in share count – yet the
market value of equity and ownership value should remain the same.
The reverse split essentially converts each existing share into a fractional ownership of a share, i.e.
the opposite of a stock split, which occurs when a company divides each of its shares into more
pieces.
Upon conducting the split, the price of the post-split adjusted shares should rise since the number of
shares declines.
Stock Split → More Shares Outstanding and Lower Share Price
Reverse Stock Split → Fewer Shares Outstanding and Greater Share Price

How Do Reverse Stock Splits Impact Share Price?

The concern with reverse stock splits, however, is that they tend to be perceived negatively by the
market.
The announcement of a reverse stock split often sends out a negative signal to the market, so
companies are typically hesitant to perform reverse stock splits unless necessary.
In theory, the impact of reverse splits on a company’s valuation should be neutral, as the total equity
value and relative ownership remain fixed despite the change in share price.
But in reality, investors can view reverse splits as a “sell” signal, causing the share price to decline
even further.
Since management is aware of the negative consequences of a reverse split, the market is even
more likely to interpret such actions as an admission that the company’s outlook appears grim.

Reverse Split Rationale: NYSE Market Exchange Delisting

The reason for engaging in a reverse split is normally related to the share price being too low.
Public companies listed on the New York Stock Exchange (NYSE) run the risk of being delisted if their
share price declines below $1.00 for more than 30 straight days.
In an effort to avoid delisting (and the embarrassment of such an occurrence), management can
propose a formal request to the board of directors to declare the reverse split to emerge above the
$1.00 threshold.
Reverse Stock Split Formula Chart
The following chart outlines the most common reverse split ratios, along with the formulas to
compute the post-split shares owned by the investor and the split-adjusted share price.

Reverse Stock Split Reverse Split Adjusted Share

Post-Split Shares Owned
Ratio Price

1-for-2 0.500 × Shares Share Price × 2

Owned

1-for-3 0.333 × Shares Share Price × 3

Owned

1-for-4 0.250 × Shares Share Price × 4

Owned

1-for-5 0.200 × Shares Share Price × 5

Owned

1-for-6 0.167 × Shares Share Price × 6

Owned

1-for-7 0.143 × Shares Share Price × 7

Owned

1-for-8 0.125 × Shares Share Price × 8

Owned

1-for-9 0.111 × Shares Share Price × 9

Owned

1-for-10 0.100 × Shares Share Price × 10

Owned

Step 1. Reverse Stock Split Ratio Scenario Assumptions (1-for-10)

The number of shares owned after the reverse split can be calculated by the stated ratio of the stock
split multiplied by the number of existing shares owned.
For instance, a 1-for-10 reverse split ratio equals 10%, which can be thought of as exchanging ten
$1.00 bills for a single $10.00 bill.
1 ÷ 10 = 0.10 (or 10%)

Step 2. Calculate Number of Post-Reverse Shares Owned

Suppose that you are a shareholder with 200 shares before the reverse split – under a 1-for-10
reverse split, you would own 20 shares afterward.
Shares Owned Post-Reverse Split = 10% × 200 = 20

Step 3. Post-Reverse Split Share Price Impact Analysis

Next, let’s assume that the company’s pre-split share price was $0.90.
The post-reverse split share price is calculated by multiplying by the number of shares consolidated
into one share, which is ten in our illustrative scenario.
Share Price Post-Reverse Split = $0.90 × 10 = $9.00
Initially, the market value of your equity is worth $180.00 (200 Shares × $0.90), and after the reverse
split, they are still worth $180.00 (20 Shares × $9.00).
But to reiterate from earlier, the market reaction to the split determines whether there truly is no
value lost over the long run.

General Electric (GE) Reverse Stock Split Example in 2021

In actuality, reverse splits are quite uncommon, especially by blue-chip companies, but one recent
exception is General Electric (GE).
General Electric, the one-time leading industrial conglomerate, declared a 1-for-8 reverse stock split
back in July 2021.
The decision came after GE’s market capitalization reached around $600 billion in 2000, making it
one of the most valuable publicly traded companies in the U.S.
But after the 2008 financial crisis, GE Capital took significant losses and encountered a series of
failed acquisitions around non-renewable energy (e.g. Alstom).
GE’s poor acquisition strategy garnered a reputation for “buying high and selling low,” as well as
often doubling down on unproductive strategies.
Since then, GE’s market cap has declined more than 80% after a decade comprised of
operational restructuring (e.g. cost-cutting, lay-offs), divestitures to meet debt
obligations, asset write-downs, legal settlements with the SEC, and the removal from the Dow
Jones Industrial Average.
 GE 
Market Capitalization from 2000 to 2021 (Source: Refinitiv)
General Electric (GE) proposed an 8-for-1 reverse stock split to raise its share price which was barely
staying above double digits so that its share price would be more in line with comparable peers such
as Honeywell, which was trading above $200 per share.
The board approved the corporate decision of directors, and GE’s share price post-split increased 8x
while the number of shares outstanding was reduced by 8.
GE’s reverse split-adjusted share price traded at approximately $104 with optimism surrounding CEO
Larry Culp’s initiatives to turn around GE back by selling off non-core assets and streamlining
operations.
Number of Shares Outstanding: ~ 8.8 billion → 1.1 billion
Share Price: ~ $14 → $112
However, GE’s turnaround encountered numerous obstacles, and currently, its shares trade at a sub-
$90 per share.
GE eventually announced in late 2021 that it plans to split up into three separate publicly traded
companies.
The reverse stock split of GE, which many consider a failure, fell short in addressing the actual
underlying issues within the company that caused its downfall – i.e. the outcome of the reverse split
is contingent on the management team implementing operating initiatives for real long-term value
creation.

What is Dividend Discount Model (DDM)?

The Dividend Discount Model (DDM) states that the intrinsic value of a company is a function of the
sum of all the expected dividends, with each payment discounted to the present date.
Considered to be an intrinsic valuation method, the unique assumption specific to the DDM
approach is the treatment of dividends as the cash flows of a company.
How the Dividend Discount Model Works?
Under the dividend discount model (DDM), the value per share of a company is equal to the sum of
the present value of all expected dividends to be issued to shareholders.
Although a subjective determination, valid claims could be made that the free cash flow calculation
is prone to manipulation through misleading adjustments.
Under the strictest criterion, the only real “cash flows” received by shareholders are dividend
payments – hence, using dividend payments and the growth of said payments are the primary
factors in the DDM approach.

Two-Stage and Multi-Stage DDM Variations

There are several variations of the dividend discount model (DDM) with the maturity and historical
payout of dividends determining which appropriate variation should be used.
As a general rule, the more mature the company and the more predictable the dividend growth
rate (i.e. an unchanged policy with a stable track record), the fewer stages the model will be
comprised of.
But if dividend issuances have been fluctuating, the model must be broken into separate parts to
account for the unstable growth.

Multi-Stage DDM vs. Gordon Growth Model

Multi-stage dividend discount models tend to be more complicated than the simpler Gordon Growth
Model, because, at the bare minimum, the model is broken into 2 separate parts:
1. Initial Growth Stage: Higher, Unsustainable Dividend Growth Rates
2. Constant Growth Stage: Lower, Sustainable Dividend Growth Rates
In effect, the estimated share price accounts for how companies adjust their dividend payout policy
as they mature and reach the later stages of the forecast.
For instance, unlike the Gordon Growth Model – which assumes a fixed perpetual growth rate – the
two-stage DDM variation assumes the company’s dividend growth rate will remain constant for
some time.
At some point, the growth rate is then decreased as the growth assumption used in the first stage is
unsustainable in the long term.

Types of Dividend Discount Model (DDM)

1. Zero Growth: The simplest variation of the dividend discount model assumes the growth
rate of the dividend remains constant into perpetuity, and the share price is equal to the
annualized dividend divided by the discount rate.
2. Gordon Growth DDM: Frequently called the constant growth DDM, as implied by the
name, the Gordon Growth variation attaches a perpetual dividend growth rate with no
change throughout the entirety of the forecast.
3. Two-Stage DDM: Considered a “multi-stage” DDM, the two-stage DDM determines the
value of a company’s share price with the model split between an initial forecast period
of increased dividend growth and then a period of stable dividend growth.
4. Three-Stage DDM: An extension of the two-stage DDM, the three-stage variation
consists of three stages, with the dividend growth rate declining over time.

DDM vs. DCF: Intrinsic Value Methodologies

The dividend discount model (DDM) states that a company is worth the sum of the present value
(PV) of all its future dividends, whereas the discounted cash flow model (DCF) states that a company
is worth the sum of its discounted future free cash flows (FCFs).
While the DDM methodology is relied upon less by equity analysts and many nowadays view it as an
outdated approach, there are several similarities between the DDM and DCF valuation
methodologies.

Discounted Cash Flow (DCF) Dividend Discount Model (DDM)

The DDM forecasts a company’s The DCF, on the other hand, projects a
future dividend payments company’s future free cash flows
based on specific dividend per (FCFs) based on discretionary
share (DPS) and growth rate operating assumptions such as
assumptions, which are profitability margins, revenue
discounted using the cost of growth rate, free cash flow
equity. conversion ratio, and more.

For calculating the terminal value, And for the terminal value calculation,
an equity value-based multiple the exit multiple used can be either
(e.g. P/E) must be used if the an equity value-based multiple or
exit multiple approach is used. enterprise value-based multiple –
depending on whether the DCF is
 on a levered or unlevered basis.

Upon completion, the DDM directly calculates the equity value (and implied share price) similar to
levered DCFs, whereas unlevered DCFs calculate the enterprise value directly – and would require
further adjustments to get to equity value.

Cost of Equity in Dividend Discount Model (DDM)

The projected cash flows in a DDM – the dividends anticipated to be issued – must be discounted
back to the date of the valuation to account for the “time value of money”.
The discount rate used must represent the required rate of return (i.e. the minimum hurdle rate) for
the group of capital provider(s) who receive or have a claim to the cash flows being discounted.
With that said, the appropriate discount rate to use in the DDM is the cost of equity because
dividends come out of a company’s retained earnings balance and only benefit the company’s
equityholders.
On the income statement, if you imagine going down from “top-line” revenue to the “bottom-
line” net income, payments to lenders in the form of interest expense affect the ending balance.
Net income is thus considered a post-debt, levered metric.

Dividend Discount Model (DDM) Criticism

Compared to its more widely used counterpart, the discounted cash flow model, the dividend
discount model is used far less often in practice.
To some degree, all forward-looking valuations are flawed – with the DDM being no exception.
In particular, some of the drawbacks to the DDM method are:
Sensitivity to Assumptions (e.g. Dividend Payout Amount, Dividend Payout Growth Rate,
Cost of Equity)
Reduced Accuracy for High-Growth Companies (i.e. Negative Denominator if Unprofitable,
Growth Rate > Cost of Equity)
Declining Volume of Corporate Dividends – Opting for Share Repurchases Instead
Neglects Share Buybacks (i.e. Repurchases are Major Considerations for All Stakeholders and
Outside Spectators in the Market)
The DDM is more suitable for large, mature companies with a consistent track record of paying out
dividends. Even then, it can be very challenging to forecast out the growth rate of dividends paid.
In a perfect world where all corporate decisions were made by the book, dividend payout amounts
and growth rates would be a direct reflection of the true financial health and expected performance
of a company.
But the reality of the situation is that even poorly run companies could continue to issue large
dividends, causing potential distortions in valuations.
The decision to issue large dividends could be attributable to:
1. Upper-Level Mismanagement: Management could be missing opportunities for re-
investing into their core operations and are instead focusing on creating value for
shareholders by issuing dividends.
2. Share Price Reduction Concern: Once implemented, companies rarely cut or end a
previously announced dividend issuance program, as it serves as a negative signal to the
market, which most investors interpret in the worst possible way.

Commercial Bank DDM Valuation

Commercial banks are well-known for issuing relatively large dividend payouts consistently. The
dividend discount model (DDM) is thereby frequently used in such instances.
The multi-stage DDM is most common for bank valuation models, which split up the forecast into
three distinct stages:
1. Development Growth Stage: The forecasted dividend issuances are explicitly made and
then discounted to the present using the cost of equity.
2. Maturity Growth Stage: The projected dividends are based on the assumption the
company’s return on equity and cost of equity will converge (i.e. mature companies
cannot sustain a return on equity much greater than their cost of equity into perpetuity).
3. Terminal Growth Stage (Perpetual): The final phase represents the present value of all
future dividends once the company has reached maturity with a 1) perpetual dividend
growth rate or 2) terminal equity value-based multiple being used.

Step 1. Two-Stage Dividend Discount Model Assumptions

For our DDM modeling example exercise, the following assumptions will be used:
Dividends Per Share (DPS) – Current Period: $2.00
Cost of Equity (Ke): 6.0%
Dividend Growth Rate (g) – Stage 1: 5.0%
Dividend Growth Rate (g) – Stage 2: 3.0%
To summarize, the company issued $2.00 in dividends per share (DPS) as of Year 0, which will grow
at a rate of 5% across the next five years (Stage 1) before slowing down to 3.0% in the perpetuity
phase (Stage 2).
Regarding the company’s risk/return profile, our company’s cost of equity is 6.0% – the minimum
return required by equity holders.

Step 2. Two-Stage Dividend Discount Model Example

Once we have entered the model assumptions, we’ll create a table with the explicit present value
(PV) of each dividend in Stage 1.
The formula for discounting each dividend payment consists of dividing the DPS by (1 + Cost of
Equity) ^ Period Number.

After repeating the calculation for Year 1 to Year 5, we can add up each value to get $9.72 as the PV
of the Stage 1 dividends.
Next, we’ll move to Stage 2 dividends, which we’ll start by calculating the Year 6 dividend and
entering the value into the constant growth perpetuity formula.
Upon multiplying the DPS of $2.55 in Year 5 by (1 + 3%), we get $2.63 as the DPS in Year 6. Then, we
can divide the $2.63 DPS by (6.0% – 3.0%) to arrive at $87.64 for the terminal value in Stage 2.
But since the valuation is based on the present date, we must discount the terminal value by dividing
$87.64 by (1 + 6%)^5.

Step 3. Two-Stage DDM Implied Share Price

In the final step, the PV of the Stage 1 phase is added to the PV of the Stage 2 terminal value.
Value Per Share ($) = $9.72 + $65.49 = $75.21
The implied share price based on our two-stage dividend discount model is $75.21, as shown by the
screenshot of the completed output below.
What is the Gordon Growth Model?
The Gordon Growth Model calculates a company’s intrinsic value under the assumption that its
shares are worth the sum of all its future dividends discounted back to their present value (PV).
Considered the simplest variation of the dividend discount model (DDM), the single-stage Gordon
Growth Model assumes a company’s dividends continue to grow indefinitely at a constant rate.

How to Calculate Gordon Growth Model (GGM)?

The Gordon Growth Model (GGM), named after economist Myron J. Gordon, calculates the fair
value of a stock by examining the relationship between three variables.
1. Dividends Per Share (DPS): DPS is the value of each declared dividend issued to
shareholders for each common share outstanding and represents how much money
shareholders should expect to receive on a per-share basis.
2. Dividend Growth Rate (g): The dividend growth rate is the projected rate of annual
growth, which in the case of a single-stage GGM, a constant growth rate is assumed.
3. Required Rate of Return (r): The required rate of return is the “hurdle rate” needed by
equity shareholders to invest in the company’s shares with consideration towards other
opportunities with similar risks in the stock market.
Given the fixed dividend issuance growth rate assumption, the Gordon Growth Model is suited for
companies with steady dividend growth and no plans for adjustments.
Thus, the GGM is used most frequently for mature companies in established markets with minimal
risks that would create the need to cut (or end) their dividend payout program.
Interpreting the Gordon Growth Model (GGM)
The Gordon Growth Model approximates the intrinsic value of a company’s shares using the
dividend per share (DPS), the growth rate of dividends, and the required rate of return.
 If the share price calculated from the GGM is greater than the current market share price,
the stock is undervalued and could be a potentially profitable investment.
If the calculated share price is less than the current market price, the shares are considered
overvalued.

Gordon Growth Model Formula

The Gordon Growth Model (GGM) values a company’s share price by assuming constant growth in
dividend payments.
The formula requires three variables, as mentioned earlier, which are the dividends per share (DPS),
the dividend growth rate (g), and the required rate of return (r).
Gordan Growth Model Formula
Gordon Growth Model (GGM) = Next Period Dividends Per Share (DPS) / (Required Rate of
Return – Dividend Growth Rate)
Since the GGM pertains to equity holders, the appropriate required rate of return (i.e. the discount
rate) is the cost of equity.
If the expected DPS is not explicitly stated, the numerator can be calculated by multiplying the DPS
in the current period by (1 + Dividend Growth Rate %).
For example, if a company’s shares are trading at $100 per share and a minimum required rate of
return of 10% (r) with plans to issue a $4.00 dividend per share (DPS) next year, which is expected to
increase by 5% annually (g).
Value Per Share = $4.00 DPS / (10% Required Rate of Return – 5% Annual Growth Rate)
Value Per Share = $80.00
In our example, the share price of the company is overpriced by 25% ($100 vs $85).

DCF Terminal Value Calculation – Growth in Perpetuity Approach

Often referred to as the “Growth in Perpetuity Approach” in DCF analyses, another use-case of the
Gordon Growth Model is to calculate the terminal value of a company at the end of the stage-one
cash flow projection period.
To calculate the terminal value, a perpetual growth rate assumption is attached for the forecasted
cash flows beyond the initial forecast period.

What are the Pros and Cons of Gordon Growth Model (GGM)?
The Gordon Growth Model (GGM) offers a convenient, easy-to-understand method for calculating
the approximate value of a company’s share price.
As we saw earlier, the single-stage model requires only a handful of assumptions, but this aspect
tends to restrict the accuracy of the model when it comes to high-growth companies with changing
capital structures, dividend payout policies, etc.
Instead, the GGM is most applicable for mature companies with a consistent track record
of profitability and issuance of dividends.
The main drawback to the GGM is the assumption that dividends will continue to grow at the same
rate indefinitely.
In reality, companies and their business model undergo significant adjustments as time passes and
as new risks emerge in the market.
Because of the assumption that dividends grow at a fixed rate perpetually, the model is most
meaningful for mature, established companies with consistent growth in dividends.
Another concern for reliance on the GGM is that underperforming companies can issue large
dividends to themselves (e.g. a reluctance to cut dividends) despite the deterioration in their
financials.
Hence, a disconnect between the fundamentals of the company and the dividend policy can occur,
which the GGM would not capture.

Gordon Growth Model Example Calculation

In our example scenario, the following assumptions will be used:
Model Assumptions
Dividends Per Share (DPS) – Current Period: $5.00
Required Rate of Return (Ke): 8.0%
Expected Dividend Growth Rate (g): 3.0%
Based on those assumptions, the company has issued a dividend per share (DPS) of $5.00 in the
latest period (Year 0), which is expected to grow at a constant 3.0% each year into perpetuity.
In addition, the required rate of return (i.e. the cost of equity) for this company is 8.0%.
Note that similar to a discounted cash flow model, if the expected perpetuity growth rate were to be
greater than the required rate of return, adjustments to the assumptions would be required.
Otherwise, the calculated share prices from the model would be meaningless, and other valuation
methods would be more appropriate.
Value Per Share Calculation in Year 0
Dividends Per Share (DPS): $5.00
Required Rate of Return (Ke): 8.0%
Expected Dividend Growth Rate (g): 3.0%
Value Per Share ($) = $5.00 DPS ÷ (8.0% – 3.0%) = $100

Gordon Growth Model Projection Period

Next, we’ll need to extend the assumptions across the forecast period from Year 1 to Year 5.
By multiplying the dividends per share (DPS) of $5.00 in Year 0 by (1 + 3.0%), we get $5.15 as the DPS
in Year 1 – and this same process will be repeated for each forecast period.
As for the required rate of return and expected dividend growth rate, we can simply link to our
model assumptions section and hard-code the amounts since both are assumed to remain constant.

Gordon Growth Model Share Price Calculation

In the final section, we’ll calculate the Gordon Growth Model derived value per share in each period.
The formula consists of taking the DPS in the period by (Required Rate of Return – Expected
Dividend Growth Rate).
For example, the value per share in Year is calculated using the following equation:
Value Per Share ($) = $5.15 DPS ÷ (8.0% Ke – 3.0% g) = $103.00
From the completed model output, we can see how from Year 0 to Year 5, the estimated share price
grows from $100.00 to $115.93, which is driven by the incremental increase in the dividends per
share (DPS) of $0.80 in the same time span.

What is the Implied Dividend Growth Rate?

The Implied Dividend Growth Rate can be derived from rearranging the dividend discount model
formula.

Implied Dividend Growth Rate Formula

The dividend discount model (DDM) states that the intrinsic value (and share price) of a company is
determined by the sum of all of its future dividend issuances, discounted to the present date.
While the dividend discount model is typically used for estimating the fair value of a dividend-issuing
company, the formula can be rearranged to back solve for the implied dividend growth rate, instead.
The simplest variation of the dividend discount model is the Gordon Growth Model, which assumes
that dividends are anticipated to grow indefinitely at a constant rate.
The Gordon Growth Model approximates the share price of a company by taking the next period’s
dividend per share (DPS) and dividing it by the required rate of return minus the dividend growth
rate.
Gordon Growth Model (GGM) Formula
Gordon Growth Model (GGM) = Next Period Dividends Per Share (DPS) ÷ (Cost of Equity –
Dividend Growth Rate)
Since all variations of the dividend discount model treat dividend issuances as the cash flows of the
company, the appropriate discount rate — i.e. the required rate of return — is the cost of equity
(ke), which represents solely equity shareholders.
Normally, the formula above would be used to predict a company’s share price and to decide
whether its shares are undervalued (or overvalued).
But we’ll do the reverse here in order to calculate the dividend growth rate, where we divide DPS by
the current share price and subtract that amount from the cost of equity.
Implied Dividend Growth Rate Formula
Implied Dividend Growth Rate = Cost of Equity – (Dividends Per Share ÷ Current Share Price)

What is a Good Implied Dividend Growth Rate?

The dividend growth rate assumption is a key input in determining the fair value of a company’s
shares in a dividend discount model.
But in order for the model to function properly, the growth rate must be less than the required rate
of return, i.e. the discount rate assumption.
If the growth rate assumption exceeds the discount rate, the output from the model will be
negative, which would result in a nonsensical conclusion.
The same reasoning applies to our modified model, where we’ll calculate the implied dividend
growth rate, as opposed to the stock price.
With regard to interpreting the implied growth rate’s impact on the estimated intrinsic value of the
company, the following rules are generally true:
Higher Implied Growth Rate + Lower Discount Rate → Higher Valuation
Lower Implied Growth Rate + Higher Discount Rate → Lower Valuation

Implied Dividend Growth Rate Calculation Example

Suppose a company is trading at a share price of $40.00 as of the current date.
The expected dividend per share (DPS) next year is $2.00 and the cost of equity, i.e. the required
rate of return for shareholders, is 10.0%.
Current Share Price = $40.00
Expected Dividend Per Share (DPS) = $2.00
Cost of Equity (ke) = 10.0%
Given those set of assumptions, we’ll calculate our implied growth rate by taking dividing our DPS
($2.00) by the current share price ($40.00) and then subtracting it from the cost of equity (10.0%).
Implied Dividend Growth Rate = 10.0% – ($2.00 ÷ $40.00) = 5.0%
We arrive at an implied growth rate of 5.0%, which we would then compare to the growth rate
embedded in the current market share price to determine if the company’s shares are undervalued,
overvalued, or priced near their fair value.
DCF Modeling Fundamentals Guide
What is Intrinsic Value?
Intrinsic Value is the estimated worth of an asset following the objective analysis of its fundamentals
and internal data – without reliance on external factors such as prevailing market pricing.

How to Calculate Intrinsic Value (Step-by-Step)

The premise of intrinsic value states that how much an asset is worth can be derived from assessing
the asset internally.
For instance, a company’s share price can be approximated by assessing the underlying
fundamentals:
Revenue: Historical Trends, Key Drivers of Revenue, Future Growth Outlook
Margin Profile: Historical Profit Margins (e.g. Gross Margin, Operating Margin, EBITDA
Margin, Net Profit Margin), Opportunities for Cost-Cutting, Industry Averages, Future
Spending Needs
Competitive Advantage: “Economic Moat”, Competitive Landscape, Market Size and Market
Share
In the context of corporate valuation, the intrinsic value of a company is estimated from its future
cash flows, growth potential, and risk. Thus, the foundation of a DCF valuation model is the 3-
statement financial model.
Intrinsic Value Formula
The formula for calculating the intrinsic value states the asset’s estimated worth is a function of its
future cash flows, which must be discounted to the present date.
The expected cash flows of the asset are each discounted, and the sum of those cash flows
represents the asset’s intrinsic value.
Intrinsic Value = Σ CF / (1 + r) ^ t
Where:
CF = Future Cash Flows
r = Discount Rate (WACC, Cost of Equity)
t = Time Period

Intrinsic Value Method – Discounted Cash Flow (DCF) Model

The discounted cash flow model (DCF) approach calculates the present value (PV) of the company’s
expected cash flows (i.e. discounted to the present date), which is the estimated value of the
company.
Here, all the future cash flows (CF) of the company are discounted using an appropriate discount
rate (r) that factors in risk – and then adds all the discounted cash flows together.
Therefore, the intrinsic valuation is a function of the future free cash flows – either FCFF or FCFE –
expected to be generated by the company’s operations.
Each DCF model relies significantly on discretionary assumptions.
While all assumptions are subjective, if the model assumptions are completely baseless, the
estimated value of the company will be far off from its intrinsic (“true”) value.
> Current Share Price → Undervalued – Potential Buy
= Current Share Price → “Correct” Market Pricing
< Current Share Price → Overvalued – Potential Short-Sell

Intrinsic Value Method – Dividend Discount Model (DDM)

Another intrinsic valuation method is the dividend discount model (DDM), although the DDM is not
used as frequently as the DCF.
The dividend discount model (DDM) values a company based on the present value (PV) of its future
dividends, with assumptions regarding the dividend amount and growth rate.
The intuition behind the DDM is similar to the DCF, however, the major difference is that dividends
are used as the cash flows.
Under the DDM, the dividends issued by a company are assumed to be representative of the
company’s financial health and future outlook.
The intrinsic value – considering how the obtained valuation is largely independent of market pricing
– can uncover undervalued investment opportunities for investors to profit from the mispricing.

What is a DCF Model?

The Discounted Cash Flow Model, or “DCF Model”, is a type of financial model that values a
company by forecasting its cash flows and discounting them to arrive at a current, present value.
DCFs are widely used in both academia and in practice.
Valuing companies using a DCF model is considered a core skill for investment bankers, private
equity, equity research and “buy side” investors.
This DCF analysis suggests that Apple might be overvalued (or that our assumptions are wrong!)
A DCF model estimates a company’s intrinsic value (the value based on a company’s ability to
generate cash flows) and is often presented in comparison to the company’s market value.
For example, Apple has a market capitalization of approximately $909 billion. Is that market price
justified based on the company’s fundamentals and expected future performance (i.e. its intrinsic
value)? That is exactly what a DCF seeks to answer.
In contrast with market-based valuation like a comparable company analysis, the idea behind the
DCF model is that the value of a company is not a function of arbitrary supply and demand for that
company’s stock. Instead, the value of a company is a function of a company’s ability to generate
cash flow in the future for its shareholders.

DCF Model Basics: Present Value Formula

The DCF approach requires that we forecast a company’s future cash flows and discount them to the
present in order to arrive at a present value for the company. That present value is the amount
investors should be willing to pay (the company’s value). We can express this formulaically as the
follwoing (we denote the discount rate as r):

So, let’s say you decide you’re willing to pay $800 for the below. We can solve this as:

If I make the same proposition but instead of only promising $1,000 next year, say I promise $1,000
for the next 5 years.The math gets only slightly more complicated:

In Excel, you can calculate this using the PV function (see below). However, if cash flows are different
each year, you will have to discount each cash flow separately:
How to Build a DCF Model: 6-Step Framework
The premise of the DCF model is that the value of a business is purely a function of its future cash
flows. Thus, the first challenge in building a DCF model is to define and calculate the cash flows that
a business generates. There are two common approaches to calculating the cash flows that a
business generates.
1. Unlevered DCF approach
Forecast and discount the operating cash flows. Then, when you have a present value,
just add any non-operating assets such as cash and subtract any financing-related
liabilities such as debt.
2. Levered DCF approach
Forecast and discount the cash flows that remain available to equity shareholders
after cash flows to all non-equity claims (i.e. debt) have been removed.
Both should theoretically lead to the same value at the end (though in practice it’s actually pretty
hard to get them to be exactly equal). The unlevered DCF approach is the most common and is thus
the focus of this guide. This approach involves 6 steps:

Step 1. Forecasting unlevered free cash flows

Step 1 is to forecast the cash flows a company generates from its core operations after
accounting for all operating expenses and investments.
These cash flows are called “unlevered free cash flows.”

Step 2. Calculating the terminal value

You can’t keep forecasting cash flows forever. At some point, you must make some high-level
assumptions about cash flows beyond the final explicit forecast year by estimating a lump-
sum value of the business past the explicit forecast period.
That lump sum is called the “terminal value.”

Step 3. Discounting the cash flows to the present at the weighted average cost of capital
The discount rate that reflects the riskiness of the unlevered free cash flows is called
the weighted average cost of capital.
 Because unlevered free cash flows represent all operating cash flows, these cash flows
“belong” to both the company’s lenders and owners.
As such, the risks of both providers of capital (i.e. debt vs. equity) need to be accounted for
using appropriate capital structure weights (hence the term “weighted average” cost of
capital).
Once discounted, the present value of all unlevered free cash flows is called the enterprise
value.

Step 4. Add the value of non-operating assets to the present value of unlevered free cash flows
If a company has any non-operating assets such as cash or has some investments just sitting
on the balance sheet, we must add them to the present value of unlevered free cash
flows.
For example, if we calculate that the present value of Apple’s unlevered free cash flows is
$700 billion, but then we discover that Apple also has $200 billion in cash just sitting
around, we should add this cash.

Step 5. Subtract debt and other non-equity claims

The ultimate goal of the DCF is to get at what belongs to the equity owners (equity value).
Therefore if a company has any lenders (or any other non-equity claims against the
business), we need
to subtract this from the present value.
What’s left over belongs to the equity owners.
In our example, if Apple had $50 billion in debt obligations at the valuation date, the equity
value
would be calculated as: $700 billion (enterprise value) + $200 billion (non-operating assets) –
$50 (debt) = $850 billion
Often, the non-operating assets and debt claims are added together as one term called net
debt (debt
and other non-equity claims – non-operating assets).
You’ll often see the equation: enterprise value – net debt = equity value. The equity value
that the DCF calculates is comparable to the market capitalization (the market’s
perception of the equity value).

Step 6. Divide the equity value by the shares outstanding

The equity value tells us what the total value to owners is. But what is the value of each
share? In order to calculate this, we divide the equity value by the company’s diluted
shares outstanding.

Calculating Unlevered Free Cash Flows (FCF)

Here is the formula for unlevered free cash flow:
FCF = EBIT x (1- tax rate) + D&A + NWC – Capital expenditures
EBIT = Earnings before interest and taxes. This represents a company’s GAAP-based operating
profit.
Tax rate = The tax rate the company is expected to face. When forecasting taxes, we usually
use a company’s historical effective tax rate.
D&A = Depreciation and amortization.
NWC = Annual changes in net working capital. Increases in NWC are cash outflows while
decreases are cash inflows.
 Capital expenditures represent cash investments the company must make in order to sustain
the forecasted growth of the business. If you don’t factor in the cost of required
reinvestment into the business, you will overstate the value of the company by giving it
credit for EBIT growth without accounting for the investments required to achieve it.

FCFs are ideally driven from a 3-statement model

Forecasting all these line items should ideally come from a 3-statement model because all of the
components of unlevered free cash flows are interrelated: Changes in EBIT assumptions impact
capex, NWC, and D&A. Without a 3-statement model that dynamically links all these components
together, it is difficult to ensure that the changes in assumptions of one component correctly impact
the other components.
Because this takes more work and more time, finance professionals often do preliminary analyses
using a quick, back-of-the-envelope DCF model and only build a full DCF model driven by a 3-
statement model when the stakes are high, such as when an investment banking deal goes “live” or
when a private equity firm is in the later stages of the investment process.

The 2-stage DCF model

The 3-statement models that support a DCF are usually annual models that forecast about 5-10
years into the future. However, when valuing businesses, we usually assume they are a going
concern.  In other words, the assumption is that they will continue to operate forever.
That means that the 3-statement model only takes us so far. We also have to forecast the present
value of all future unlevered free cash flows after the explicit forecast period. This is called the 2-
stage DCF model. The first stage is to forecast the unlevered free cash flows explicitly (and ideally
from a 3-statement model). The second stage is the total of all cash flows after stage 1. This
typically entails making some assumptions about the company reaching mature growth. The present
value of the stage 2 cash flows is called the terminal value.
Calculating the terminal value
In a DCF, the terminal value (TV) represents the value the company will generate from all the
expected free cash flows after the explicit forecast period. Imagine that we calculate the following
unlevered free cash flows for Apple:
Apple is expected to generate cash flows beyond 2022, but we cannot project FCFs forever (with any
degree of accuracy). So how do we estimate the value of Apple beyond 2022? There are two
common approaches:
1. Growth in Perpetuity
2. Exit EBITDA Multiple Method

The growth in perpetuity approach

The growth in perpetuity approach assumes Apple’s UFCFs will grow at some constant growth rate
assumption from 2022 to … forever. The formula for calculating the present value of a cash flow
growing at a constant growth rate in perpetuity is called the “Growth in perpetuity formula”:

If we assume that after 2022, Apple’s UFCFs will grow at a constant 4% rate into perpetuity and will
face a weighted average cost of capital of 10% in perpetuity, the terminal value (which is the present
value of all Apple’s future cash flows beyond 2022) is calculated as:
At this point, notice that we have finally calculated enterprise value as simply the sum of the stage 1
present value of UFCFs + the present value of the stage 2 terminal value.

Exit EBITDA Multiple Method

The growth in perpetuity approach forces us to guess the long-term growth rate of a company. The
result of the analysis is very sensitive to this assumption. A way around having to guess a company’s
long term growth rate is to guess the EBITDA multiple the company will be valued at the last year of
the stage 1 forecast.
A common way to do this is to look at the current EV/EBITDA multiple the company is trading at (or
the average EV/EBITDA multiple of the company’s peer group) and assume the company will be
valued at that same multiple in the future. For example, if Apple is currently valued at 9.0x its last
twelve months (LTM) EBITDA, we can assume that in 2022 it will be valued at 9.0x its 2022 EBITDA.
Growth in perpetuity vs. exit EBITDA multiple method
Investment bankers and private equity professionals tend to be more comfortable with the EBITDA
multiple approach because it infuses market reality into the DCF. A private equity professional
building a DCF will likely try to figure out what he/she can sell the company for 5 years down the
road, so this arguably provides a valuation via an EBITDA multiple.
However, this approach suffers from a significant conceptual problem: It incorporates current
market valuations within the DCF, which arguably defeats the whole purpose of the DCF. Making
matters worse is the fact that the terminal value often represents a significant pecentage of the
value contribution in a DCF, so the assumptions that go into calculating the terminal value are all the
more important.
Getting to enterprise value: Discounting the cash flows by the WACC
Up to now, we’ve been assuming a 10% discount rate for Apple, but how is that actually quantified?
Quantifying the discount rate, which in this case is the weighted average cost of capital (WACC), is a
critical field of study in corporate finance. You can spend an entire college semester learning about
it. We’ve written a complete guide to WACC here, but below are the basic elements for how it is
typically calculated:
The WACC formula

Where:
Debt = market value of debt
Equity = market value of equity
rdebt = cost of debt
 requity = cost of equity
Getting to equity value: Adding the value of non-operating assets 
Many companies have assets not directly tied to operations. Assets such as cash obviously increase
the value of the company (i.e. a company whose operations are worth $1 billion but also has $100
million in cash is worth $1.1 billion). But up to now, the value is not accounted for in the unlevered
free cash flow calculation. Therefore, these assets need to be added to the value. The most common
non-operating assets include:
Cash
Marketable securities
Equity investments
Below is Apple’s 2016 year-end balance sheet. The non-operating assets are its cash and equivalents,
short-term marketable securities and long-term marketable securities. As you can see, they
represent a significant portion of the company’s balance sheet.

Unlike operating assets such as PP&E, inventory and intangible assets, the carrying value of non-
operating assets on the balance sheet is usually fairly close to their actual value. That’s because they
are mostly comprised of cash and liquid investments that companies generally can mark up to fair
value. That’s not always the case (equity investments are a notable exception), but it’s typically safe
to simply use the latest balance sheet values of non-operating assets as the actual market values.
Getting to equity value: Subtracting debt and other non-equity claims
At this point, we need to identify and subtract all non-equity claims on the business in order to arrive
at how much of the company value actually belongs to equity owners. The most common non-equity
claims you’ll encounter are:
All debt (short term, long term, bonds, loans, etc..)
Capital Leases
Preferred stock
Non-controlling (minority) interests
Below are Apple’s 2016 year-end balance sheet liabilities. You can see it includes commercial paper,
current portion of long term debt and long term debt. These are the three items that would make up
Apple’s non-equity claims.
As with the non-operating assets, finance professionals usually just use the latest balance sheet
values of these items as a proxy for their actual values. This is usually a safe approach when the
market values are fairly close to the balance sheet values. The market value of debt doesn’t usually
deviate too much from the book value unless market interest rates have changed dramatically since
the issue or if the company’s credit profile has changed dramatically (i.e. a company in financial
distress will have its debt trading at pennies on the dollar).
One place where the book value-as-proxy-for-market-value can be dangerous is with “non-
controlling interests.” Non-controlling interests are usually understated on the balance sheet. If
they are significant, it is preferable to apply an industry multiple to better reflect their true value.
The bad news is that we rarely have enough insight into the nature of the non-controlling interests’
operations to figure out the right multiple to use. The good news is that non-controlling interests are
rarely large enough to make a significant difference in valuation (most companies don’t have any).
Net debt formula
When building a DCF model, finance professionals often net non-operating assets against non-equity
claims and call it net debt, which is subtracted from enterprise value to arrive at equity value:
Enterprise value – net debt = Equity value
The formula for net debt is simply the value of all nonequity claims less the value of all non-
operating assets:
Gross Debt (short term, long term, bonds, loans, etc..)
+ Capital Leases
+ Preferred stock
+ Non-controlling (minority) interests
– Cash
– Marketable securities
– Equity investments
Net debt
Using Apple’s 2016 10K, we can see that it has a substantial negative net debt balance. For
companies that carry significant debt, a positive net debt balance is more common, while a negative
net debt balance is common for companies that keep a lot of cash.
From equity value to equity value per share
Once a company’s equity value has been calculated, the next step is to determine the value of each
individual share. In order to figure this out, we have to determine the number of shares that are
currently outstanding. We have written a thorough guide to calculating a company’s current
shares but will summarize the key steps here:
1. Take the current actual share count from the front cover of the company’s latest annual (10K) or
interim (10Q) filing.  For Apple, it is:
 
2. Next, add the effect of dilutive shares. These are shares that aren’t quite common stock yet, but
that can become common stock and thus be potentially dilutive to the common shareholders (i.e.
stock options, warrants, restricted stock and convertible debt and convertible preferred stock).
Assuming that we calculated 50 million dilutive securities for Apple, we can now put all the pieces
together and complete the analysis:

Key DCF Assumptions

We have now completed the 6 steps to building a DCF model and have calculated the equity value of
Apple.
What were the key assumptions that led us to the value we arrived at?
The three key assumptions in a DCF model are:
1. The operating assumptions (revenue growth and operating margins)
2. The WACC
3. Terminal value assumptions: Long-term growth rate and the exit multiple
Each of these assumptions is critical to getting an accurate model. In fact, the DCF model’s sensitivity
to these assumptions, and the lack of confidence finance professionals have in these assumptions,
(especially the WACC and terminal value) are frequently cited as the main weaknesses of the DCF
model.
Nonetheless, the DCF model is one of the most common models used by investment bankers and
other finance professionals, and the DCF output is almost always presented using a range of terminal
value and WACC assumptions, as well as in context to other valuation methodologies. A common
way this is presented is using a football field valuation matrix.
We wrote this guide for those thinking about a career in finance and those in the early stages of
preparing for job interviews. This guide is quite detailed, but it stops short of all corner cases and
nuances of a fully-fledged DCF model.
What is Market Value?
The Market Value of a company’s common equity is a function of the most recent price paid by
investors in the open markets to purchase a share and the total number of diluted shares
outstanding.

How to Calculate Market Value (Step-by-Step)

The market value, or “market capitalization”, is the fair value of a public company’s common equity,
which can be expressed as a standalone metric or on a per-share basis.
The market value of an underlying asset—the shares issued by a publicly-traded company that
represent partial ownership in the issuer’s common equity—depicts not only the general perception
by the financial markets on how much each share is worth, but the actual prices paid.
That said, the share price of a company is ultimately set by the market participants that engage in
transactions in the open markets.
Thus, the market value per share fluctuates based on the current conditions and certain forward-
looking factors, such as investor sentiment regarding the company’s outlook, the developing
industry or secular trends of relevance, and the market’s perception of company fundamentals
(e.g. profit margins, growth prospects, risk profile).
In addition, external factors like current market conditions and the economic outlook (e.g. fear of
recession, Fed interest rate policy predictions) can also cause a company’s share price to fluctuate,
which are out of the direct control of the company.
Current share prices can be readily observed in real-time via market data resources and news outlets
such as Bloomberg, the Wall Street Journal (WSJ) and CNBC.

Market Value Formula

The formula to calculate the market value of equity is as follows.
Market Value = Market Value Per Share × Total Diluted Shares Outstanding
When calculating the market cap, the common share count should be determined on a fully diluted
basis, which refers to the inclusion of the effects of potentially dilutive securities like options,
warrants, and convertible debt instruments.
The market value per share can be derived by rearranging the formula.
Market Value Per Share = Market Capitalization ÷ Total Diluted Shares Outstanding

How to Interpret Market Value Per Share

One common use case of manually calculating the market value per share would be if the market
capitalization were also calculated manually in a discounted cash flow model (DCF), as opposed to
pulling the figure directly from a third-party resource.
The calculated market value per share can be compared to the actual share price to determine
whether the company’s shares are currently undervalued, overvalued, or priced fairly by the market.
Implied Share Price > Market Share Price → Undervalued
Implied Share Price < Market Share Price → Overvalued
Implied Share Price = Market Share Price → Fairly Valued

Book Value of Equity (BVE) vs. Market Value of Equity

The book value of equity (BVE) is the historical value of a company’s common equity recorded for
purposes of bookkeeping, whereas the market value is more indicative of the current value of the
company’s common equity based on recent transactions.
Book Value of Equity (BVE) → Unlike the market value, the book value of equity is an
accrual accounting metric (and thus reflects the historical value instead of the fair value).
Conceptually, the book value of equity can be thought of as the residual value if a
company’s assets were to be hypothetically liquidated to pay off its liabilities before the
remaining proceeds are distributed to common shareholders.
Market Value → The market value represents the fair value of a company’s common equity,
which is based on the actual prices paid by buyers and sellers in the open markets. The
market value is forward-looking and thus constantly fluctuates each trading day due to
changes in investor sentiment and news surrounding the company, among various other
factors. In practically all cases, the market value will exceed the book value of equity by a
substantial margin, barring unusual circumstances.

Book Value Per Share (BVPS) vs. Market Value Per Share
The book value of equity and market value are frequently expressed on a per-share basis.
Book Value Per Share (BVPS) → The book value per share is the book value of equity
(i.e. shareholders equity) denoted on a per-share basis.
Market Value Per Share → The market value per share is the price that reflects the fair value
of each common share, which is determined by the most recent transactions that actually
occurred in the open markets.

Step 1. Market Value Per Share Calculation Example

Suppose a public company’s shares are trading at $18.00 as of the latest closing date.
In order to estimate the intrinsic value of the company, you’ve built a DCF model in which the
implied market value came out to be $20 billion.
DCF-Derived Market Value = $20 billion
Using the treasury stock method (TSM), the company’s common share count is one billion on a fully
diluted basis.
Total Diluted Common Shares Outstanding = 1 billion
By dividing the $20 billion in equity value by the 1 billion in total diluted shares, the implied share
price is $20.00 per share.
Market Value Per Share, Estimated = $2 billion ÷ 100 million = $20.00
The actual market value per share is implied to be trading at a 10% discount relative to the DCF-
derived share price. The difference in the current share price and the manually calculated market
value per share is attributable to the discretionary assumptions used in the DCF model.

Step 2. Market Value Calculation Example

In the next step, we’ll quickly reverse the calculation by multiplying the estimated market value per
share by the total diluted share count.
Market Value = $20.00 × 1 billion = $20 billion
The market value we arrive at is $20 billion, which was our initial assumption.

What is Fair Market Value?

The Fair Market Value (FMV) refers to the current price that an interested buyer in the open market
is willing to pay to purchase a certain asset.
Fair Market Value (FMV): Accounting Definition
The fair market value (FMV) is defined as the price set by the open market at which an asset could
be sold (or purchased).
The fair value of an asset is the price it’ll sell for in an open, competitive market whereby the seller
and buyers all have adequate information with no external factors like time impacting their decision-
making.

How to Calculate Fair Market Value (Step-by-Step)

Two underlying assumptions for the fair value estimation are that the buyer and seller are both:
Assumption #1 → Willfully Entering the Transaction
Assumption #2 → Informed of Material Facts Regarding the Asset(s)
To provide specific examples, a seller in a distressed scenario divesting assets can often accept lower
prices for the sake of convenience and time (i.e. a “fire sale”).
Despite the fact that the seller could likely receive a higher bid if given more time, quick sales of
assets and receiving cash (i.e. urgent liquidity) could be prioritized above selling at the fair value of
the asset.
For the second assumption, all material information of relevance should be shared on both sides. In
other words, there should be no hidden information that could lead to a party underpaying or
overpaying for the asset (e.g. defects).
On the date of transaction close, there should be a mutual agreement between the buyer and seller,
who are both acting in their self-interests.

Fair Market Value vs. Intrinsic Value

Intrinsic Value: Unlike the intrinsic value of an asset, which is estimated after evaluating its
fundamental profile (e.g. cash flow generation, profitability), the fair value is a readily
available price set by the market.
Fair Market Value (FMV): The benefit of the fair market value is the fact that a real buyer
and seller were willing to exchange at the given price, which makes the valuation “fair”
 and market-based. At the end of the day, the market sets the price, regardless of the
amount of diligence and fundamental research supporting a different valuation.

Fair Market Value Examples (FMV): Real Estate Home Prices

As a simple example, if you’re selling a used car, the highest bid received from a buyer is the fair
market value (FMV), as long as the two aforementioned criteria are sufficiently met.
Likewise, if you’re selling a house, your objective is to find a buyer willing to meet (or exceed) the
asking price.
If the home is priced too high, it’ll sit on the market for a longer duration, but the probability of
finding the highest-paying buyer increases (and vice versa).
Thus, estimating the fair market value of the home ahead of time can help in pricing the property
correctly, so that the following two factors are balanced:
Goal Purchase Offer Received
Time Needed Until Closure
Note: Another related example is real estate taxes, as the amount of real estate taxes due is based
on the fair value of the property.

FMV Examples: Stock Prices, M&A and Insurance Sector

Stock Prices: Another example would be the share prices of publicly-traded companies,
whereby the latest trading price (i.e. the most recent transaction) represents the fair
value of the company’s stock. Since market pricing data is prone to containing anomalies
(i.e. mistakes/errors, overbidding from irrational behavior), the average trading price for
the day can be taken to arrive at a “normalized” share price.
Mergers and Acquisitions (M&A): One of the more common use cases of the fair market
value concept is in mergers and acquisitions (M&A), in which the purchased assets are
often written up to their fair value as part of post-transaction purchase accounting. In
effect, the value recorded on the books of the acquirer more accurately reflects the
actual value of the asset, as opposed to the book value.
Insurance Industry: Insurance companies frequently request the fair market value of the
assets under coverage, as this impacts how much filed claims are worth. For the fair
market value to be unbiased, an appraisal conducted by a third party is often done to
value an asset without any conflict of interest.

What is Terminal Value?

The Terminal Value represents the estimated value of a company beyond the final year of the
explicit forecast period, i.e. the Stage 1 cash flows.
Usually, the terminal value contributes around three-quarters of the total implied valuation derived
from a discounted cash flow (DCF) model – thus, calculating the value of a company’s free cash flows
(FCFs) past the initial forecast stage with reasonable assumptions is an critical part of a DCF analysis
that determines the model’s reliability.
How to Calculate Terminal Value?
The premise of the DCF approach states that an asset (the company) is worth the sum of all of its
future free cash flows (FCFs) – which are discounted to the present day to account for the “time
value of money” (i.e., $1 received today is worth more than $1 received on a later date).
Since it is not feasible to project a company’s FCF indefinitely, the standard DCF model is made up of
two “parts”:
1. Explicit FCF forecast (~5-10 years)
2. Terminal Value (TV)
The accuracy of cash flow forecasts tends to become less reliable the further into the future one
goes.
But eventually, simplified high-level assumptions become necessary to capture the lump sum value
at the end of the forecast period.
In practice, there are two widely used calculation methods:
1. Growth in Perpetuity Approach
2. Exit Multiple Approach

Terminal Value Formula: Growth in Perpetuity Approach

The growth in perpetuity approach attaches a constant growth rate onto the forecasted cash flows
of a company after the explicit forecast period.
Here, the terminal value is calculated by treating a company’s terminal year FCF as a growing
perpetuity at a fixed rate.
One of the first steps to building a DCF is projecting the company’s future FCFs until its financial
performance has reached a normalized “steady state”, which subsequently serves as the basis of the
terminal value under the growth in perpetuity approach.
The long-term growth rate should theoretically be the growth rate that the company can sustain into
perpetuity.
Often, GDP growth or the risk-free rate can serve as proxies for the growth rate.
Given how the TV accounts for a substantial portion of a company’s valuation, the terminal year
must not be distorted by cyclicality or seasonality patterns.
The long-term growth rate assumption should generally range between 2% to 4% to reflect a
realistic, sustainable rate.
Otherwise, the implicit assumption of an excessively high growth rate (i.e., >5%) is that the company
is on track to someday outpace the growth of the global economy – which is clearly an unrealistic
scenario.
Closely tied to the revenue growth, the reinvestment needs of the company must have also
normalized near this time, which can be signified by:
Depreciation becoming close to equaling Capex (i.e. 100% ratio)
Capex as a percentage of revenue ranges near the lower end of what is typical in the
company’s industry (i.e., the majority of Capex is now maintenance-related)
One frequent mistake is cutting off the explicit forecast period too soon when the company’s cash
flows have yet to reach maturity.
Perpetuity Terminology Review
A perpetuity is defined as security (e.g., bond) with no fixed maturity date, and the formula for
calculating the present value (PV) of a perpetuity is equal to the cash flow value divided by the
discount rate (i.e., expected rate of return based on the risks associated with receiving the cash
flows).
For instance, if the cash flow at the end of the initial forecast period is $100 and the discount rate is
10.0%, the TV comes out to $1,000 ($100 ÷ 10.0%).
But as mentioned earlier, the perpetuity growth method assumes that a company’s cash flows grow
at a constant rate perpetually.
Because of this distinction, the perpetuity formula must account for the fact that there is going to be
growth in the cash flows, as well. Hence, the denominator deducts the growth rate from the
discount rate.
Returning to the example from earlier, if the cash flow at the end of the initial projection period is
$100 and the discount rate is 10.0% but this time around, there is a perpetuity growth rate of 3%,
the TV comes out as ~$1,471.
TV = ([$100 x (1 + 3.0%)] ÷ [10.0% – 3.0%])
The formula under the perpetuity approach involves taking the final year FCF and growing it by the
long-term growth rate assumption and then dividing that amount by the discount rate minus the
perpetuity growth rate.
Terminal Value = [Final Year FCF * (1 + Perpetuity Growth Rate)] ÷ (Discount Rate – Perpetuity
Growth Rate)
Here, the terminal value is reliant on two major assumptions:
1. Discount Rate (r)
2. Perpetuity Growth Rate (g)
If the cash flows being projected are unlevered free cash flows, then the proper discount rate to use
would be the weighted average cost of capital (WACC) and the ending output is going to be
the enterprise value.
But if the cash flows are levered FCFs, the discount rate should be the cost of equity and the equity
value is the resulting output.

Terminal Value Formula: Exit Multiple Approach

The exit multiple approach applies a valuation multiple to a metric of the company to estimate its
terminal value.
In theory, the exit multiple serves as a useful point of reference for the future valuation of the target
company in its mature state.
The formula for the TV using the exit multiple approach multiplies the value of a certain financial
metric (e.g., EBITDA) in the final year of the explicit forecast period by an exit multiple assumption.
The exit multiple assumption is typically derived from a peer comparables set, including through an
average of current public trading multiples and multiples as derived from precedent transactions of
comparable targets.
Terminal Value = Final Year EBITDA x Exit Multiple
The exit multiple method also comes with its share of criticism as its inclusion brings an element
of relative valuation into the intrinsic valuation.
The DCF model utilizes a fundamentals-oriented perspective and one of the touted benefits is its
independence from prevailing market valuations, which can be prone to mispricing at times due to
irrational investor sentiment (e.g., short-term overreactions).
But compared to the perpetuity growth approach, the exit multiple approach tends to be viewed
more favorably because the assumptions used to calculate the TV can be better explained (and are
thus more defensible).
The growth rate in the perpetuity approach can be seen as a less rigorous, “quick and dirty”
approximation – even if the values under both methods differ marginally.
In either approach, TV represents the present value of the company’s cash flows in the final year of
the explicit forecast period before entering the perpetuity stage (i.e. if Year 10 cash flows are used
for the calculations, the resulting TV derived from the methods above represent the present value of
the TV in Year 10).
Since the DCF is based on what a company is worth as of today, it is necessary to discount the future
TV back to the present date (i.e. in the aforementioned example, the Year 10 TV needs to be
discounted back to the equivalent Year 0 TV).
Present Value of TV = Unadjusted TV ÷ (1 + Discount Rate) ^ Years

DCF Terminal Value Implied Growth Rate Formula

The perpetuity growth approach is recommended to be used in conjunction with the exit multiple
approach to cross-check the implied exit multiple – and vice versa, as each serves as a “sanity check”
on the other.
Unless there are atypical circumstances such as time constraints or the absence of data surrounding
the valuation, the calculation under both methods is normally listed out side-by-side.
For example, if the implied perpetuity growth rate based on the exit multiple approach seems
excessively low or high, it may be an indication that the assumptions might require adjusting.
Implied Exit Multiple = Unadjusted TV ÷ Final Year EBITDA
If the exit multiple approach was used to calculate the TV, it is important to cross-check the amount
by backing into an implied growth rate to confirm that it’s reasonable.
In effect, the TV under either approach should be reasonably close – albeit, the exit multiple
approach is viewed more favorably in practice due to the relative ease of justifying the assumptions
used, especially since the DCF method is intended to be an intrinsic, cash-flow oriented valuation.
Implied Growth Rate = (Discount Rate * TV – Final Year FCF) ÷ (TV + Final Year FCF)

1. DCF Model Stage 1 Cash Flow Forecast Assumptions

Let’s get started with the projected figures for our hypothetical company’s EBITDA and free cash
flow. In the last twelve months (LTM), EBITDA was $50mm and unlevered free cash flow was
$30mm.
From Year 1 to Year 5 – the forecasted range of stage 1 cash flows – EBITDA grows by $2mm each
year and the 60% FCF to EBITDA ratio ($30mm in FCF ÷ $50mm in EBITDA) is assumed to remain
fixed – this assumption is extrapolated for each forecasted period.
For example, the FCF in “Year 5” is $36mm, which is computed by multiplying the $60mm in EBITDA
by the 60.0% FCF conversion assumption.
In the next step, we’ll be summing up the PV of the projected cash flows over the next five years –
i.e., how much all of the forecasted cash flows are worth today.
Since the discount rate assumption is hardcoded as 10.0%, we can divide each free cash flow
amount by (1 + the discount rate), raised to the power of the period number.
For purposes of simplicity, the mid-year convention is not used, so the cash flows are being
discounted as if they are being received at the end of each period.
Note the appropriate cash flows to select in the range should only consist of future cash flows and
exclude any historical cash flows (e.g., Year 0).
Once we discount each FCF and sum up the values, we get $127mm as the PV of the stage 1 FCFs –
and this amount remains constant under either approach.

2. Growth in Perpetuity Terminal Value Calculation

Now that we’ve finished projecting the stage 1 FCFs, we can move onto calculating the terminal
value under the growth in perpetuity approach.
To be conservative, we’ll be using 2.5% as the long-term growth rate assumption.
Next, the Year 5 FCF of $36mm is going to be multiplied by the 2.5% growth rate to arrive at $37mm
for the FCF value in the next year, which will then be inserted into the formula for the calculation.
Upon dividing the $37mm by the denominator consisting of the discount rate of 10% minus the
2.5%, we get $492mm as the TV in Year 5.
But another important step is that the TV we calculated is as of Year 5, while the DCF valuation is
based on the value in relation to today.
We can then discount the value back to the present date to get $305mm as the PV of the TV.
If we sum up the two values – the $127mm PV of stage 1 FCFs and $305mm PV of the TV – we get
$432mm as the implied enterprise value.

3. Exit Multiple Terminal Value Calculation

Moving onto the other calculation method, we’ll now walk through the exit multiple approach.
The $127mm in PV of stage 1 FCFs was previously calculated and can just be linked to the matching
cell on the left. Then, we’ll grab the terminal year EBITDA, which is $60mm in Year 5.
The exit multiple assumption we’ll use here is going to be 8.0x. By multiplying the $60mm in
terminal year EBITDA by the comps-derived exit multiple assumption of 8.0x, we get $480mm as the
TV in Year 5.
But once again, the PV of this amount must be calculated by dividing $480mm by (1 + 10% discount
rate) raised to the power of 5, which comes out to $298mm.
The $425mm TEV was calculated by taking the sum of the $127mm PV of stage 1 FCFs and the
$298mm in the PV of the TV.

4. Implied Growth Rate and DCF Valuation Analysis

In our final section, we’ll perform sanity checks on our calculations to determine whether our
assumptions were reasonable or not.
Starting with the growth in perpetuity approach, we can back out the implied exit multiple by
dividing the TV in Year 5 ($492mm) by the final year EBITDA ($60mm), which comes out to an
implied exit multiple of 8.2x.
In the subsequent step, we can now figure out the implied growth rate under the exit multiple
approach.
Considering the implied multiple from our perpetuity approach calculation based on a 2.5% long-
term growth rate was 8.2x, the exit multiple assumption should be around that range.
The exit multiple used was 8.0x, which comes out to a growth rate of 2.3% – a reasonable constant
growth rate that confirms that our terminal value assumptions pass the sanity check.
What are the Pros and Cons of the DCF Analysis?
The DCF analysis estimates a company’s intrinsic value using explicit assumptions for the company’s
future free cash flows (FCFs), discount rate, and terminal value.
If the assumptions are sound, the DCF is the most theoretically sound corporate valuation approach,
yet the reliance on assumptions is also the DCF’s main shortcoming as projecting future financial
performance is not an easy task.

Discounted Cash Flow (DCF) Overview

The discounted cash flow (DCF) analysis values a company under the premise that its value is equal
to the sum of its future cash flows, discounted at an appropriate rate.
The discount rate used should reflect the risks associated with the company’s cash flows – or said
differently, represent the required rate of return based on investments with comparable risk.
DCFs are used to judge the fundamental value of a company, which differs from market-based
valuations that rely on investor sentiment, wherein a company is valued based on how the market
values comparable companies.
Learn More → Investment Banking Primer

DCF Pros
Intrinsic Valuation
The DCF method is a fundamentals-oriented approach, so the implied valuation is a function of the
company’s projected free cash flows (FCFs) and the cost of capital (i.e. discount rate) assumption.
In fact, the reliance of the DCF on discretionary assumptions regarding future financial performance
is the reason that the DCF is viewed as a more academically rigorous approach to measuring value.
The specific underlying drivers of the valuation are explicitly modeled – i.e. the assumptions related
to revenue growth, profitability margins, free cash flows – causing the DCF-derived valuation to be
more defensible as specific assumptions can be discussed in detail.

Market-Independence
Furthermore, the DCF analysis is independent of the market, so the current trading price should be
neglected and not impact the ending valuation.
The market can be and often is wrong on the pricing of a company – and the DCF is unaffected by
temporary market distortions and the mispricing of securities.
Another benefit to the DCF approach is that the valuation is self-sufficient and not dependent on the
existence of similar companies/transactions.
For instance, if there are no “pure-play” comparables or a limited number of peers, the DCF can still
be used as it does NOT require the existence of any comparable companies.

DCF Cons
Sensitivity to Assumptions
The reliance on assumptions is the main drawback of the DCF approach, in which minor adjustments
to key assumptions could have material impacts on the DCF valuation.
Since each assumption can have a sizeable impact on the firm’s valuation, the accuracy of the
valuation is a function of the financial projections (i.e. “garbage in, garbage out”).
In particular, projecting a company’s financials accurately becomes even more challenging for early-
stage companies.

Terminal Value Contribution

The present value (PV) of the terminal value can account for upwards of three-quarters of the
valuation – which is a major source of criticism, given the relatively simplistic calculation of the
terminal value.
For example, in the perpetuity growth approach to estimating the terminal value, the GDP growth
rate or risk-free rate (i.e. 1% to 3%) is typically used as a proxy for the company’s long-term growth
rate.
The perpetuity growth rate should reflect the “steady-state” period when growth has gradually
slowed down to a normalized, sustainable rate – but the growth rate cannot accurately be
calculated.
At a certain point, simple assumptions are required beyond the Stage 1 forecast period.

Fixed Capital Structure

The final disadvantage of the DCF approach is that the company’s capital structure is assumed to
remain constant.
Companies tend to gradually take on more debt financing as they mature, but factoring this into a
DCF can be impractical, especially since increased debt reliance is not a certainty, either.
While an adjusted capital structure can be assumed in a DCF model – with the D/E ratios of
comparable mature companies used as a point of reference – the distinction between “sub-optimal”
and “optimal” capital structures is subjective.

DCF Sensitivity Analysis

The DCF output should be viewed as an “estimation” of a company’s value rather than a “precise
calculation” of how much a company is worth.
These approximations of company valuations should be viewed as a range of values instead of a
single value, which is why sensitivity analysis is a critical step in any DCF analysis.
In a sensitivity analysis, the most influential variables are selected and then sensitized to assess their
impact on the implied share price (and total valuation).
The most important variables to sensitize are the following:
Cost of Capital – i.e. Weighted Average Cost of Capital (WACC)
Terminal Value Growth Rate Assumption / Exit Multiple
Revenue Growth Rate and Operating Assumptions (e.g. Operating Margin, EBITDA Margin)
While operating assumptions like revenue growth are often sensitized in DCF models, the discount
rate is typically more important (and impactful on the overall valuation).

DCF Pros and Cons Conclusion

The different valuation methods, including both intrinsic and relative valuation approaches, should
be used in conjunction to arrive at a range of valuation estimates.
By using more than one valuation method, the resulting estimated value is more reliable, as each
approach serves as a sanity check on the other method.
If the output from each valuation method deviates irrationally far from each other, it is
recommended to revisit the assumptions and adjust if deemed necessary.
For the most part, especially for companies with wide followings by equity analysts and investors,
the implied DCF valuation should be within the same ballpark as the current trading price.
Otherwise, there is most likely a significant error in the model causing the anomalies.
Therefore, relative valuation methods can provide a market-based sanity check to the intrinsic
valuation obtained from a DCF analysis (and vice versa).

What is NOPAT?
Net Operating Profit After Tax (NOPAT) represents a company’s theoretical after-tax operating
income if it had no debt in its capital structure.
By removing the impact of financing differences in capital structures, comparisons between industry
peers become more “apples to apples” – especially since discretionary decisions regarding leverage
can significantly skew data sets.

How to Calculate NOPAT (Step-by-Step)

NOPAT is an abbreviation that stands for Net Operating Profit After Tax – and is a measure of profit
that assumes that the company did NOT receive tax benefits from holding debt.
Among industry practitioners, as well as in academia, the metric is frequently used interchangeably
with terms such as:
“Tax-Effected” EBIT
Earnings Before Interest After Taxes (EBIAT)
So how exactly is the tax rate “adjusted”?
Simply put, the metric represents a company’s operating profit after removing financing items
like interest expense, which directly impacts the taxes paid via the “interest tax shield”.

NOPAT Formula
NOPAT represents the operating income available to all providers of capital (e.g. debt lenders, equity
shareholders).
In particular, calculating the metric is a critical step in calculating a company’s available future free
cash flows (FCFs), which serve as the foundation of the discounted cash flow analysis (DCF) method.
The calculation comprises multiplying EBIT by (1 – t), in which “t” refers to the target’s marginal tax
rate.
Net Operating Profit After Tax (NOPAT) = EBIT * (1 – Tax Rate)
EBIT is your gross profit minus the total operating expenses for the period – and the OpEx line item
can include items such as depreciation, employee salaries, overhead, and rent.
While for purposes of modeling, the marginal tax rate can be used, the effective tax rate – the actual
tax rate paid based on historical data – can also serve as a useful point of reference.
Another formula begins with net income and has a couple of additional steps to calculate the metric.
NOPAT = (Net Income + Non-Operating Losses – Non-Operating Gains + Interest
Expense + Taxes) * (1 – Tax Rate)
From net income (“bottom line”), we add back non-operating losses and deduct any non-operating
gains, and then add back the impact of interest expense and taxes. In effect, we have gone from net
income up to the operating income line item.
Just like the 1st formula, the next step is to multiply by (1 – Tax Rate).
Net income is a metric that accounts for the effects of non-core income / (losses), interest expense,
and taxes, which is why we’re removing the impact of those line items from our calculation.
In theory, the metric should represent the core operating income (EBIT) of a company – taxed after
removing the impact of non-operating gains / (losses), debt financing (e.g. “tax shield”), and taxes
paid.
Thus, the net operating profit after tax is a company’s potential cash earnings if its capitalization
were unleveraged — that is, if it had no debt, i.e. tax savings from existing debt are NOT included.

Step 1. Operating Assumptions

Suppose that we have the following two companies – Company A and Company B – which share the
following financial data:
Revenue: $300m
Cost of Goods Sold (COGS): $50m
Selling, General & Administrative (SG&A): $40m
Until we reach the operating income line, the two companies have identical financials and profit
margins.
Gross Profit: $250m
Operating Profit: $210m
Step 2. Capital Structure Analysis (Debt-to-Equity Mix)
The financials of our hypothetical companies begin to diverge because of a non-operating expense,
interest expense.
Further, the interest expense incurred is a function of each company’s capital structure (i.e. the
debt-to-equity mix).
While Company A is an all-equity financed company with zero interest expense, Company B has
incurred $100m of interest expense, which reduces its taxable income since interest is tax-
deductible.
At the pre-tax income line (EBT), we see the following divergence:
Company A EBT: $210m
Company B EBT: $110m
The source of the $100m difference is the interest expense mentioned earlier – furthermore, the
taxes of the two companies vary significantly because of the tax savings associated with interest (i.e.
the “interest tax shield”).
At a 35% tax rate, the companies pay the following taxes:
Company A Taxes Paid: $74m
Company B Taxes Paid: $39m
Here, Company B has benefited from $35m in tax savings ($74m – $39m).

Step 3. NOPAT Calculation Analysis

Conceptually, we know our end goal is to net out the impact of estimated taxes from operating
income (EBIT).
In the first approach, the calculation is straightforward, as we just multiply EBIT by (1 – Tax Rate).
If we input the relevant data points into our formula, we get the following equation:
$210m * (1 – 35%) = $137m
Note that despite the fact that Company B benefited from the interest tax shield, the value for both
companies is equivalent.

Step 4. Alternative NOPAT Calculation (Starting from Net Income)

In the second approach, we’ll be starting from net income.
We need to work our way from net income to EBIT, before repeating the same process as the first
approach.
Company A EBIT = $137m Net Income + $0m Interest Expense + $74m Taxes = $210m
Company B EBIT = $72m Net Income + $100m Interest Expense + $39m Taxes = $210m
So for both companies, EBIT comes out to $210m, and the subsequent step is the following:
$210m EBIT * (1 – 35% Tax Rate) = $137m
To reiterate from earlier, the impact of debt financing is ignored – more specifically, the interest tax
shield is removed.
In closing, we can confirm that under both methods, the NOPAT comes out to $137m – which shows
the capital-structure neutrality of the metric.
What is Unlevered Free Cash Flow?
Unlevered Free Cash Flow is the cash generated by a company before accounting for interest and
taxes, i.e. it represents cash available to all capital providers.
Unlevered free cash flow measures the cash generated from a company’s core operations, i.e. the
recurring business activities that are expected to continue into the foreseeable future.
How to Calculate Unlevered Free Cash Flow (Step-by-Step)
Unlevered free cash flow, or “UFCF”, represents the cash flow left over for all capital providers, such
as debt, equity, and preferred stock investors.
Companies capable of generating more unlevered FCFs possess more discretionary cash which can
be allocated to reinvestments into operations or to fund future growth strategies (e.g. capital
expenditures), as well as to have sufficient cash on hand to meet interest payments on time and
repay the debt principal on the date of maturity.
The UFCF metric is often used interchangeably with the term “free cash flow to firm”, reflecting how
these cash flows belong to all stakeholders in the company rather than to only one specific group of
capital providers.
Conceptually, unlevered free cash flow is the cash available to all of a company’s stakeholders – e.g.
debt lenders, preferred stockholders, and common shareholders – which was generated from its
core recurring operations and after accounting for all necessary operating expenses and the
purchase of fixed assets (i.e. capital expenditures).
By intentionally neglecting the capital structure of the company – i.e. the company’s total debt load
– more practical comparisons of industry peers of different sizes and capitalizations are feasible.
There are numerous ways to calculate unlevered free cash flow, but the most common approach is
comprised of the following four steps:
Step 1 → Calculate Net Operating Profit After Tax (NOPAT)
Step 2 → Adjust for Non-Cash Items, e.g. Depreciation and Amortization (D&A)
Step 3 → Subtract Capital Expenditures (Capex)
Step 4 → Subtract Increase in the Change in Net Working Capital (NWC)
The resulting figure is the company’s unlevered FCF for the given period.

Unlevered Free Cash Flow Formula

The formula for calculating unlevered free cash flow (UFCF) is as follows.
Unlevered Free Cash Flow = NOPAT + Depreciation and Amortization – Increase in Net Working
Capital (NWC) – Capital Expenditures
NOPAT, or “EBIAT”, is a company’s hypothetical after-tax operating income (EBIT) if its capital
structure carried no debt at all.
NOPAT = EBIT × (1 – Tax Rate)
The removal of the effects of financing decisions and the capital structures results in more useful
comparisons among industry peers (i.e. “apples to apples”), as the discretionary decisions
surrounding capital structure decisions and reliance on leverage could otherwise significantly skew
comp sets.
Depreciation and amortization (D&A) each represent non-cash add backs on the cash flow
statement, i.e. no real cash outflow occurred. While depreciation reduces the carrying value of fixed
assets (PP&E) across its useful life assumption, amortization reduces the value of intangible assets.
Calculating the change in net working capital (NWC) is an area where mistakes often occur.
Increase in Δ in NWC → Less UFCF
Decrease in Δ in NWC → More UFCF
If the change in NWC increases, UFCF declines because it represents an “outflow” of cash.
For instance, if a company’s accounts receivable balance were to increase year-over-year (YoY), the
company is owed more cash payments from customers that paid using credit. But if the change in
NWC decreases, UFCF increases because it represents an “inflow” of cash.
Returning to our example involving accounts receivables, a decline in A/R indicates that the
company has collected the owed cash payment from its customers that paid on credit.*
The final step is to subtract capital expenditures (capex), which represents the purchase of fixed
assets with useful lives in excess of twelve months, i.e. long-term investments such as factories,
machinery, buildings, and equipment.
The reason capex is deducted in the formula is that it is a core part of the company’s business model
and should be considered a recurring expense because it is required for the continued generation of
FCFs.

Forecasting Unlevered FCFs in a DCF Model

Unlevered free cash flow corresponds to enterprise value, i.e. the value of a company’s core
operations to all capital providers.
In practice, a company’s unlevered free cash flow is most often projected as part of creating a DCF
valuation model.
The basis of the DCF model states that the valuation of a company is worth the sum of its future
cash flows discounted to the present date.
Unlevered FCFs: In an unlevered DCF analysis – which is more commonly used – the free
cash flows (FCFs) projected are unlevered in order to arrive at the enterprise value (TEV).
WACC: In an unlevered DCF analysis, a company’s UFCFs are discounted to the present date
using the weighted average cost of capital (WACC), which also represents all stakeholders
in a company.
Stakeholders: When forecasting a company’s unlevered FCFs, the items reflected must be
applicable to all stakeholders and be a recurring component of a company’s core
operations.
Learn More → Enterprise Value Quick Primer

Unlevered Free Cash Flow vs. Levered Free Cash Flow

The difference between unlevered FCF and levered FCF comes down to the capital providers
represented.
Unlevered Free Cash Flow: Unlevered FCF is attributable to all stakeholders in a company,
whereas levered FCF is only representative of common shareholders. In order words,
the levered free cash flow represents the residual cash remaining once all payments
related to debt, such as interest, have been deducted. Unlike levered free cash flow
or free cash flow to equity (FCFE), the UFCF metric is unlevered, which means that the
company’s debt burden is not taken into account.
Levered Free Cash Flow: Contrary to an unlevered DCF, the output of a levered DCF is the
company’s equity value as opposed to the enterprise value. Moreover, the
appropriate discount rate in a levered DCF is the cost of equity (ke) instead of WACC,
i.e. cost of equity and levered free cash flow are each specific to common shareholders.

Unlevered Free Cash Flow Calculation Example (UFCF)

Suppose a company generated a total of $250 million in EBIT throughout fiscal year 2021.
If we assume a tax rate of 26%, the tax expense is $65 million, which we’ll deduct from EBIT to
calculate $185 million for NOPAT.
NOPAT = $250 million × (1 – 26%) = $185 million
Starting from NOPAT, the following three adjustments must then be made:
1. D&A = $20 million
 2. Capex = –$40 million
3. Increase in NWC = –$5 million
Upon entering those inputs into our UFCF formula, we arrive at $160 million as our hypothetical
company’s unlevered free cash flow for the year.
Unlevered Free Cash Flow = $185 million + $20 million – $40 million – $5 million = $160
million

What are the Common DCF Mistakes?

The DCF model relies significantly on forward-looking projections and discretionary assumptions,
making it prone to bias and mistakes.
In the following post, we’ve compiled a list of the most common errors seen in DCF models, which
should be a helpful guide for those learning about financial and valuation modeling.

Overview of Common Mistakes in DCF Models

How to “Sanity Check” a DCF Model
The DCF model states that the value of a company is equal to the sum of all of a company’s
projected free cash flows (FCFs), which are discounted to the present date using an appropriate
discount rate.
However, the discretionary assumptions used to project a company’s future performance are its
main drawback, as these decisions are subjective and prone to the biases of the individual
performing the analysis.
For that reason, the valuations derived from a DCF can vary greatly from each other.
The checklist below summarizes a few common errors often found in DCF models:
Inclusion of Free Cash Flows (FCF) Before Year 1
Too Short Initial Stage 1 Forecast Horizon
Depreciation ≠ Capital Expenditures in Final Year of Forecast Period
Mismatch in Free Cash Flows (FCFs) and Discount Rate
Unrealistic Reinvestment Assumptions
Forgetting to Discount Terminal Value (TV)
Mismatch in Exit Multiple and Valuation Multiple
Terminal Value > 75% of Implied Valuation
Disregard of Relative Valuation — No “Sanity Check”

Inclusion of Free Cash Flows (FCF) Before Year 1

The first mistake seen in DCF models is accidentally including the latest historical period as part of
the Stage 1 cash flows.
The initial forecast period should consist of only projected free cash flows (FCFs) and never any
historical cash flows.
The DCF is based on projected cash flows, not historical cash flows. While most understand this
concept, many DCF models are linked from a separate tab, where the historical periods will also be
carried over and may be erroneously linked into the DCF calculation.
As a result, make sure to discount and add only the company’s future cash flows.

Too Short Initial Forecast Horizon (Stage 1)

The next error is related to having an initial forecast period that is too short, i.e. Stage 1.
For a mature company, a standard five-year forecast horizon is sufficient, i.e. the company is
established with predictable cash flows and profit margins.
The time necessary for a mature company to reach a long-term sustainable state is brief — in fact, it
could be even shorter than five years, if appropriate.
On the other hand, certain DCF models performed on high-growth companies need to extend the
initial forecast period to a ten or even fifteen-year horizon.
Ask yourself, “Can this company continue to grow at this growth rate perpetually?”
If not, the forecast should be extended until the company matures further.
However, note that the longer the initial forecast period, the less credible the implied valuation is —
which is also why the DCF is most reliable for mature companies with established market positions.

Depreciation % of Capital Expenditures Converge into Final Forecast Period

Closely related to the prior mistake, a company’s depreciation as a percentage of its capital
expenditures (Capex) should converge near a ratio of 1.0x, or 100%, by the end of the initial forecast
period.
As a company matures, the opportunities for capital expenditures decline, resulting in less capex
overall. More specifically, the majority of the company’s capex will be maintenance capex, as
opposed to growth capex.
Given the reduced capex, having depreciation outpacing capex perpetually would be unrealistic as
depreciation cannot reduce the value of a fixed asset (PP&E) below zero.

Mismatch in Free Cash Flows (FCFs) and Discount Rate

The most common DCF model is the unlevered DCF, where the free cash flow to firm (FCFF) is
projected.
Since FCFF represents the cash flows that belong to all stakeholders, such as debt lenders and equity
holders, the weighted average cost of capital (WACC) is the appropriate discount rate to use.
In contrast, the levered DCF — which is used far less common in practice — projects the free cash
flow to equity (FCFE) of a company, which belongs solely to common shareholders. In this case, the
correct discount rate to use is the cost of equity.

Unrealistic Reinvestment Assumptions

Generating future growth requires spending, so it cannot just be reduced without reason.
Of course, reinvestments such as capex and the change in net working capital (NWC) will gradually
decrease as a company matures and revenue growth slows down.
Yet, the reinvestment rate must still be reasonable and in line with that of the company’s industry
peers.
For example, a company can be assumed to grow at 2.5% perpetually, but rational assumptions must
be made where the continued revenue growth is supported, as opposed to simply cutting
reinvestments to zero.

Forgetting to Discount Terminal Value (TV)

After calculating the terminal value (TV), a crucial next step is to discount the terminal value to the
present date.
An easy mistake to make is to neglect this step and add the undiscounted terminal value to the
discounted sum of the free cash flows (FCFs).
The terminal value is calculated using either:
Perpetuity Growth Method (or)
Exit Multiple Methods
But regardless of which approach is used, the terminal value calculated represents the present value
(PV) of the company’s cash flows in the final year of the explicit forecast period prior to entering the
long-term perpetuity stage, not the value as of the present date.
Since the DCF estimates what a company is worth as of today, it is necessary to discount the
terminal value (i.e. the future value) to the present date, i.e. Year 0.
The following formula is used to discount the terminal value.
Present Value of Terminal Value Formula
Present Value of Terminal Value = Unadjusted TV / (1 + Discount Rate) ^ Years

Unrealistic Terminal Growth Rate Assumption

The terminal growth rate assumption refers to the growth rate at which a company is expected to
grow at into perpetuity.
One common error seen — particularly for high-growth companies — is an unrealistic terminal
growth rate, such as 5%.
If a company is growing quickly far above its peers, extend the explicit forecast period until its
growth rate normalizes.
A reasonable terminal growth rate assumption should generally be in line with the GDP growth rate,
i.e. between 2% to 4%.
For a long-term growth rate in the upper part of that range (i.e. 4%), there should also be a valid
reason supporting that assumption — e.g. a market leader such as Amazon (AMZN).
Otherwise, the terminal growth rate of most companies should be around 2% to 3%.

Mismatch in Exit Multiple and Valuation Multiple

In the exit multiple approach of calculating the terminal value, the exit multiple chosen should
correspond to the cash flows projected.
For an unlevered DCF, the multiples used are typically EV/EBITDA or EV/EBIT.
Why? Enterprise value represents all stakeholders, just like unlevered free cash flows.
But in the case of a levered DCF, where levered free cash flows are projected, an equity value-based
multiple must be used such as the price-to-earnings ratio (P/E).

Terminal Value > 75% of Implied Valuation

One of the most common criticisms of the DCF model is the contribution of the terminal value to the
total implied valuation.
While a terminal value that is 60% to 75% of the total DCF value is ordinary, a terminal value that
exceeds 85% of the total DCF value is a red flag that suggests that the initial forecast period should
be extended and/or other assumptions likely require adjusting.
The perpetuity growth approach can also be used to cross-check the exit multiple approach’s
terminal value (and vice versa).
The solution to this issue is to first prolong the explicit forecast period, as it might not be long
enough for the company to have reached a normalized, stable growth state in the final year.
If that does not fix the problem, the terminal value assumptions such as the long-term growth rate
could be too aggressive and not reflect stable growth.

Disregard of Relative Valuation — No “Sanity Check”

The DCF suffers from many drawbacks, with the most notable one being the overall sensitivity of the
model to the assumptions used.
Hence, it is important to perform scenario analysis and sensitivity analysis to any complete DCF
valuation model.
The independence of the DCF from the market is considered one of its benefits, but entirely
neglecting the market price can often be a mistake.
Intentionally not performing any comps analysis as a “sanity check” under the reasoning that the
market is the wrong approach.
The DCF and comps analysis should be used together, which is why institutional investors and
investment banks never rely solely on one valuation method — albeit, there are times when certain
approaches are weighted more heavily than others, such as if there are no comps.
Therefore, the intrinsic value and market value approaches should be used in conjunction to
determine a valuation range, rather than attempting to pinpoint a single, precise valuation.
Learn More → Common Errors in DCF Models (Michael J. Mauboussin)

What are Non-Recurring Items?

Non-Recurring Items are gains and losses recognized on the income statement that must be
adjusted, as they are neither part of ongoing core operations nor an accurate reflection of future
performance.

Non-Recurring Items: Financial Statement Adjustments

The act of “scrubbing” refers to adjusting financial data for non-recurring items to ensure the
company’s cash flows and metrics are normalized to depict its actual ongoing operating
performance.
Recurring Items → Income and Expenses Likely to Continue
 Non-Recurring Items → One-Time Income and Expenses Unlikely to Continue
Public companies must file their financial statements — i.e. the income statement, cash flow
statement, and balance sheet — following rules established under Generally Accepted Accounting
Principles (GAAP).
But while GAAP attempts to standardize financial reporting in a fair, consistent way with as
much transparency as possible, there are still imperfections in certain areas where discretion is
necessary.
Understanding the historical performance of a business is critical for forecasting its future
performance, since past performance impacts forward-looking assumptions.

Non-Recurring Items: Common Examples

Common examples of non-recurring items are defined in the chart below.

Example Definition

Restructuring Companies undergoing restructuring (i.e. reorganization)

Expenses incur substantial fees to RX advisory groups, as well as
turnaround consultants or court fees.

Litigation Fees The legal fees of a company that is the defendant in a lawsuit
— or the gain from successfully winning a lawsuit.

Impairments Assets such as inventory and PP&E can be deemed impaired,

(Write-Downs / which results in either a write-down or write-off being
Write-Offs) recorded.

Gains / (Losses) on Companies often sell non-core assets or divest

Sale of Assets underperforming business divisions.

Employee Underperforming (or distressed) companies can reduce costs

Severance Packages with widespread lay-offs.

Income / (Expenses) The income or expenses from a discontinued division can be

from Discontinued reported in the financial statements.
Operations

Mergers & Companies engaging in M&A hire investment banks for their
Acquisitions (M&A) advisory services.
Fees

Accounting Policy Changes in accounting policies must be adjusted for (e.g.

Changes FIFO vs LIFO, depreciation method) to prevent any
misjudgments caused by comparing unadjusted year-over-
year (YoY) financial data.
Identifying Non-Recurring Items in Financial Reports
When searching for non-recurring items, most of your time should be spent combing through
the 10-K and 10-Q reports.
The starting point should be the income statement, where significant non-recurring items are often
plainly recorded.
But certain line items are often embedded within other line items, so a more in-depth review is
necessary into sections such as:
Management, Discussion, and Analysis (MD&A)
Footnotes to Financial Statements
The following terms can be searched for within the filings to be directed toward the right sections.
“non-recurring”
“infrequent”
“unusual”
“extraordinary”
If there is enough time, earnings calls could also be consulted, but in most cases, the financial
statements supplemented with the earnings press release and shareholder presentation are
sufficient.
In particular, discussions or content related to non-GAAP financial figures, most notably “adjusted
EBITDA” and non-GAAP earnings per share (EPS), can be helpful.
Forward-looking guidance by management on a pro forma basis can sanity check your adjustments,
but be mindful of how management is incentivized to present their financials in the best possible
light.

Industry-Specific Adjustments
Industry knowledge is a necessary prerequisite to adjust for non-recurring expenses.
Litigation fees in the pharmaceutical industry are very common, for example, as patient disputes and
patent lawsuits are a frequent occurrence (i.e. research and development (R&D) spending comes
with substantial risks).
Equity analysts must question if such expenses are a normal occurrence within the pharmaceutical
industry and consider the likelihood of these sorts of expenses reappearing in the future.
But many adjustments are subjective – so the more important rule is to maintain consistency and
make note of discretionary decisions.
That being said, equity research reports can provide insightful commentary on non-recurring items
from analysts that cover the specific sector.

Types of Non-Recurring Items in GAAP Accounting

Under U.S. GAAP, there are three distinct categories of non-recurring items:
1. Discontinued Operations: The income and expenses from business divisions no longer
operating or that underwent a divestiture must be removed.
2. Extraordinary Items: These items are determined as both unusual in nature and
infrequent in occurrence (e.g. catastrophic site damage caused by a hurricane).
3. Unusual or Infrequent Items: These items are either unusual in nature or their
occurrence is infrequent but NOT both (e.g. the gains or losses of acquiring equipment
by a manufacturing company recognized on a company’s financial statements).
A noteworthy difference between GAAP and IFRS reporting is that IFRS does not approve of the
classification of extraordinary items.
Changes in accounting policies must also be disclosed in public company filings with management
commentary on the nature of the change, reasons for the change, and differences from prior periods
to guide historical adjustments.
Common examples of accounting disclosures are:
First-in-First-Out (FIFO) or Last-in-First-Out (LIFO)
Depreciation Method (e.g. Useful Life Assumption of Fixed Asset, Salvage Value)
Correction of Mistakes in Past Filings

Scrubbing Financials in Comps Analysis

Comps analysis must be performed as close to “apples to apples” as possible, so all non-
recurring items must be excluded.
When performing comparable company analysis or precedent transactions analysis, scrubbing the
financials of the peer group is an essential step.
If not, the financials are skewed from the inclusion of non-recurring items and can lead to misguided
conclusions.
Unadjusted last twelve months (LTM) multiples suffer the distortive impacts caused by non-recurring
items, which misrepresents the recurring core operating performance of the company.
Thus, the LTM financials must be scrubbed for non-recurring items to arrive at a “clean” multiple.
As for forward multiples, i.e. next twelve months (NTM) multiples, the projected financials used to
calculate the multiples should already be adjusted.

Taxes Adjustments of Non-Recurring Items

Non-recurring items can be presented as either pre-tax or after-tax.
If pre-tax, the elimination of taxable non-recurring items must be accompanied by a tax
adjustment, since we cannot remove an item while ignoring the tax impact.
If post-tax, the non-recurring item is simply ignored, meaning that there is no need to adjust
taxes.
For example, if adjusting for restructuring charges of $10 million in the operating expenses section,
the charge is added back to calculate adjusted EBIT (and adj. EBITDA).
Since the restructuring charge is pre-tax, the incremental tax expense on the $10 million add-back
must be subtracted for post-tax metrics, namely net income and earnings per share (EPS).
If we assume a 20% marginal tax rate, the tax expense adjustment is the add-back multiplied by
the tax rate, which comes out to $2 million.
Incremental Tax Expense = $10 Million Add-Back x 20% Marginal Tax Rate = $2 million
As a result, we must deduct the incremental tax expense from the company’s unadjusted GAAP
reported net income.

What is the Mid-Year Convention?

The Mid-Year Convention treats forecasted free cash flows (FCFs) as if they were generated at the
midpoint of the period.
Since the cash inflows and outflows occur continuously year-round, it could be inaccurate to assume
that the cash proceeds are all received at the end of each year. As a compromise, mid-year
discounting is oftentimes integrated into DCF models to assume that FCFs are received in the middle
of the annual period.
How to Calculate the Mid-Year Convention (Step-by-Step)
In the context of DCF modeling, if the mid-year convention adjustment is not used, the implicit
assumption is that the projected cash flows of the company are received at year-end (i.e. December
31, in the context of a calendar year).
The mid-year convention assumes the FCF generation of a company occurs evenly,
therefore resulting in a steadier inflow of cash throughout the fiscal year.
Mid-year discounting accounts for the fact that the free cash flows of a company are received
throughout the year as opposed to only at year-end.
The mid-year convention can therefore be a necessary adjustment since, at times, the year-end
assumption can be misleading in the portrayal of when cash flows are actually received.
In reality, the cash flows of a company are generated steadily throughout the year; however, the
exact timing within a fiscal year tends to vary by the company in question (and industry).
Below is an illustrative diagram that depicts the mid-year convention in use – notice how 0.5 is
subtracted from each time period:

Valuation Implications of Mid-Year Convention Adjustment

If the unadjusted, year-end assumption is used, the period number for the 1st year of the projection
is straightforward (i.e., one).
But under the mid-year convention, the discount period of 1 is adjusted to 0.5 since the assumption
is that half of a year has passed before the cash is considered to be in the hands of the company.
The adjusted discount factor formula is as follows:
Discount Factor (Mid-Year Convention) = 1 / [(1 + Discount Rate) ^ (Period Number – 0.5)]
For mid-year discounting, the discount periods used are:
1st Year → 0.5
2nd Year → 1.5
3rd Year → 2.5
4th Year → 3.5
5th Year → 4.5
Since the discount periods are of lower value, this means the cash flows are received earlier,
which leads to higher present values (and implied valuations).
Occasionally, the percentage increase from mid-year discounting could seem insignificant for
smaller-sized companies, but at scale, the implications on the valuation and the gap between the
two methods become far more pronounced.
Because each annual cash flow amount is implied to have been earned mid-year, this increases the
valuation of the company in theory, as cash flows received earlier hold more value under the time
value of money.
Despite the adjustment, the practice of mid-year discounting remains an imperfect approach, since it
still does not take into account if cash flows reach the company more sporadically (rather than
evenly) through a given year. Nevertheless, mid-year discounting is still typically more practical (and
realistic) when compared to end-of-year discounting.

Mid-Year Convention: Seasonal and Cyclical Companies

While using the mid-year convention in DCF modeling has relatively become standard practice, it can
be improper for highly seasonal or cyclical companies.
Companies with inconsistent sales trends with irregular fluctuations necessitate a closer look before
using the mid-year discount.
For example, many retail companies experience seasonal patterns in consumer demand, and sales
are disproportionately received in the 3rd and 4th quarters around the holiday season.
Here, the unadjusted, period-end assumption could be a more accurate representation of the cash
flows of the retail company.

Step 1. DCF Model Assumptions (“Mid-Year Toggle”)

To add the mid-year convention into our stage 1 DCF model, we will first create a mid-year toggle
switch as seen at the top right corner of the image.
Also from the formula, we see that the logic in the “Period” cell is:
If the Mid-Year Toggle = 0, the output will be (Year # – 0.5)
If the Mid-Year Toggle = 1, the output will be (Year #)

Next, the discount factor formula will add 1 to the 10% discount rate, and raise it to the negative
exponent of 0.5 since the mid-year toggle is switched to “ON” here (i.e., input zero into the cell).

And to calculate the present value of the Year 1 cash flow, we multiply the .95 discount factor by
$100, which comes out to $95 as the PV.
Step 2. Mid-Year Convention Present Value (PV) Calculation
In the final section of our post, the output for the model with the mid-year convention set to “ON”
has been posted below:

And now, for comparison purposes, if the toggle was set to “OFF”:

Here, the periods are left unadjusted (i.e., no deduction of 0.5, implying the standard year-end
discounting convention), which has the impact of making the discount factor lower and thereby
decreasing the implied PV each year.

What is Discount Factor?

The Discount Factor is used to calculate what the value of receiving $1 at some point in the future
would be (the present value, or “PV”) based on the implied date of receipt and the discount rate
assumption.
How to Calculate Discount Factor?
The present value of a cash flow (i.e. the value of future cash in today’s dollars) is calculated by
multiplying the cash flow for each projected year by the discount factor, which is driven by
the discount rate and the matching time period.
Generally speaking, there are two approaches to calculating the discount factor, but in either case,
the discount factor is a function of the:
1. Discount Rate
2. Time Period
The discount rate can be thought of as representing the percentage of return that you could have
received by investing that dollar, if you had received it today.
The reason you would prefer to have $1 today than $1 three years from now is that if you received
the $1 three years from now, you would have missed out on a full three years when you could have
invested that $1 and ended up with more than $1 by the end of that time.

Discount Factor Formula

The first formula for the discount factor has been shown below.
Discount Factor = (1 + Discount Rate) ^ (– Period Number)
And the formula can be re-arranged as:
Discount Factor = 1 ÷ (1 + Discount Rate) ^ Period Number
Either formula could be used in Excel; however, we will be using the first formula in our example as
it is a bit more convenient (i.e., Excel re-arranges the formula itself in the first formula).

Quick Discount Factor Calculation Example

To arrive at the present value using the first approach, the factor would then be multiplied by the
cash flow to get the present value (“PV”).
Present Value (PV) = Cash Flow x Discount Factor
While the discount rate remains constant throughout the projection, the period number rising is
what causes the factor to decrease over time.
Note that the period can be whatever length you want (years, months, days, even hours) – but it is
critical to ensure that the period is aligned with the implied period of the discount rate.
Intuitively, the discount factor, which is always calculated by one divided by a figure, decreases the
cash flow values. This also ties back to what we discussed at the beginning, where receiving $1 today
is more valuable than receiving $1 in the future.
To tie this back to the example using $1, assuming a 10% discount rate and a one-year time horizon
– the discount factor would be calculated as:
0.91 = 1 / (1 + 10%) ^ 1
Next, the present value can be calculated using:
0.91 = $1 × 0.91
The example implies that $1 dollar received one year from the current period would be worth $0.91
in the present day.
The formula for the second approach is virtually identical, except for the absence of the negative
sign in front of the period number exponent.
Discount Factor = (1 + Discount Rate) ^ Period Number
Unlike the first approach, the present value formula this time around divides the cash flow by the
discount factor.
Present Value (PV) = Cash Flow ÷ Discount Factor
By entering the discount factor formula into the PV formula, the formula can be re-expressed as:
Present Value (PV) = Cash Flow ÷ (1 + Discount Rate) ^ Period Number
As opposed to decreasing over time, the factor increases in this case – thereby, the downward
adjustment on the present value becomes more apparent in later years.
Returning to the $1 dollar example with the same 10% discount rate and one-year time frame, the
calculation is:
1.1 = (1 + 10%) ^ 1
And upon applying this to the $1 in cash flow:
0.91 = 1 / 1.1
So, as we can see, both methods calculate the same present value for the $1 one year from today
($0.91).

Method 1. Discount Factor Calculation Example

In the hypothetical scenario we will be using, the company has the following financial profile:
Cash Flow: $100/Year
Discount Rate: 10%
For example, in 2021, the discount factor comes out to 0.91 after adding the 10% discount rate to 1
and then raising the amount to the exponent of -1, which is the matching time period.

The 0.91 is subsequently multiplied by the cash flow of $100 to get $91 as the PV of the 1st year cash
flow.

By the end of Year 5, we can see the discount factor drop in value from 0.91 to 0.62 by the end of
the forecast period due to the time value of money.

Method 2. Discount Factor Calculation Example

Recall how this time around, the cash flow will be divided by the discount factor to get the present
value.
And in contrast to the 1st approach, the factor will be in excess of 1.
For 2021, the discount rate of 10% is added to 1, which is raised to the exponent of 1, as that is the
first projected year. From doing so, the output is 1.10.
Conversely, the factor increases over time in the 2nd approach since the cash flows are being divided
by this >1 factor.
Then, the 1st year cash flow of $100 is divided by 1.10 to get $91 for the PV of the cash flow.

Here, in the finished output sheet below, the present values of the cash flows calculated under both
approaches result in the same figures.

Ultimately, it does not matter which approach you decide to take, because conceptually the
rationale and impact of the discount factor are exactly identical.

Stock Based Compensation in DCFs

A recent SeekingAlpha blog post questioned Amazon management’s definition of free cash flows
(FCF) and criticized its application in DCF valuation.  The author’s thesis is that Amazon stock is
overvalued because the definition of FCF that management uses – and that presumably is used by
stock analysts to arrive at a valuation for Amazon via a DCF analysis – ignores significant costs to
Amazon specifically related to stock based compensation (SBC), capital leases and working
capital. Of these three potential distortions in the DCF, the SBC is the least understood when we run
analyst training programs.

Stock based compensation in the DCF

In the SeekingAlpha post, the author asserted that SBC represents a true cost to existing equity
owners but is usually not fully reflected in the DCF.  This is correct. Investment bankers and stock
analysts routinely add back the non-cash SBC expense to net income when forecasting FCFs so no
cost is ever recognized in the DCF for future option and restricted stock grants .  This is quite
problematic for companies that have significant SBC, because a company that issues SBC is diluting
its existing owners. NYU Professor Aswath Damodaran argues that to fix this problem,
analysts should not add back SBC expense to net income when calculating FCFs, and instead should
treat it as if it were a cash expense:
“The stock-based compensation may not represent cash but it is so only because the company has
used a barter system to evade the cash flow effect. Put differently, if the company had issued the
options and restricted stock (that it was planning to give employees) to the market and then used
the cash proceeds to pay employees, we would have treated it as a cash expense… We have to hold
equity compensation to a different standard than we do non-cash expenses like depreciation, and be
less cavalier about adding them back.  Full
article: http://aswathdamodaran.blogspot.com/2014/02/stock-based-employee-compensation-
value.html
While this solution addresses the valuation impact of SBC to be issued in the future. What about
restricted stock and options issued in the past that have yet to vest? Analysts generally do a bit
better with this, including already-issued options and restricted stock in the share count used to
calculate fair value per share in the DCF. However it should be noted that most analysts ignore
unvested restricted stock and options as well as out-of-the-money options, leading to an
overvaluation of fair value per share. Professor Damodaran advocates for different approach here as
well:
“If a company has used options in the past to compensate employees and these options are still live,
they represent another claim on equity (besides that of the common stockholders) and the value of
this claim has to be netted out of the value of equity to arrive at the value of common stock. The
latter should then be divided by the actual number of shares outstanding to get to the value per
share. (Restricted stock should have no deadweight costs and can just be included in the outstanding
shares today).”
Putting it all together, let’s compare how analysts currently treat SBC and Damodaran’s suggested
fixes:
WHEN CALCULATING FCF USED IN DCF
What analysts usually do: Add back SBC
Damodaran approach: Don’t add back SBC
Bottom line: The problem with what analysts currently do is that they are systematically
overvaluing businesses by ignoring this expense. Damodaran’s solution is to treat SBC
expense as if it were a cash expense, arguing that unlike depreciation and other non cash
expenses, SBC expense represents a clear economic cost to the equity owners.
WHEN CALCULATING EQUITY VALUE PER SHARE…
What analysts usually do: Add the impact of already-issued dilutive securities to common
shares.
Options: In-the-$ vested options are included (using the treasury stock method). All other
options are ignored.
Restricted stock: Vested restricted stock is already included in common shares. Unvested
restricted stock is sometimes ignored by analysis; sometimes included.
Damodaran approach: Options: Calculate the value of options and reduce equity value by
this amount. Do not add options to common shares. Restricted stock: Vested restricted
stock is already included in common shares. Include all unvested restricted stock in the
share count (can apply some discount for forfeitures, etc.).
Bottom line: We don’t have as big a problem with the “wall Street” approach here. As long
as unvested restricted stock is included, Wall Street’s approach is (usually) going to be
 fine.  There are definitely problems with completely ignoring unvested options as well as
out of the $ options, but they pale in comparison to ignoring future SBC entirely.

How big of a problem is this, really?

When valuing companies without significant SBC doing it the “wrong” way is immaterial. But when
SBC is significant, the overvaluing can be significant.  A simple example will illustrate: Imagine you
are analyzing a company with the following facts (we have also included an Excel file with this
exercise here):
Current share price is $40
1 million shares of common stock (includes 0.1m vested restricted shares)
0.1m fully vested in-the-$ options with an exercise price of $4 per share
An additional 0.05m unvested options with the same $4 exercise price
All the options together have an intrinsic value of $3m
0.06m in unvested restricted stock
Annual forecast SBC expense of $1m, in perpetuity (no growth)
FCF = Earnings before interest after taxes (EBIAT) + D&A and noncash working capital
adjustments – reinvestments = $5m in perpetuity (no growth)
Adjusted FCF = FCF – stock based compensation expense = $5m – $1m = $4m
WACC is 10%
Company carries $5m in debt, $1m in cash
Step 1. How practitioners deal with expected future issuance of dilutive securities
Valuing company using FCF (The typical analyst approach):
Enterprise value = $5m/10% = $50m.
Equity value = $50m-$5m+$1m=$46m.
Valuing company using adjusted FCF (Damodaran’s approach):
Enterprise value = ($5m-$1m)/10% = $40m.
Equity value = $40m-$5m+$1m=$36m.
Now let’s turn to the issue of pre-existing SBC…
1. Most aggressive Street approach: Ignore the cost associated with SBC, only count actual shares,
vested restricted shares and vested options:
Diluted shares outstanding using the treasury stock method = 1m+ (0.1m – $0.4m/$40 per
share) = 1.09m.
Equity value = $50m-$5m+$1m=$46m.
Equity value per share = $46m / 1.09m = $42.20
Analysis: Notice that the impact of future dilution is completely missing.  It is not reflected in
the numerator (since we are adding back SBC thereby pretending that the company bears
no cost via eventual dilution from the issuance of SBC). It is also not reflected in the
deenominator – as we are only considering dilution from dilutive securities that have
already been issued. This is doubly aggressive – ignoring both dilution from future dilutive
securities that the company will issue and by ignoring unvested restricted stock and
options that have already been issued. This practice, which is quite common on the
street, obviously leads to an overvaluation by ignoring the impact of dilutive securities.
2. Most conservative Street approach: Reflect the cost of SBC via SBC expense, count actual shares,
all in-the-$ options and all restricted stock
Diluted shares outstanding using the treasury stock method = 1m+ 0.06m + (0.15m –
$0.6m/$40 per share) = 1.20m.
 Equity value = $40m-$5m+$1m=$36m.
Equity value per share = $36m / 1.20m = $30.13
Analysis: With this approach, the impact of future dilution is reflected in the numerator.  The
approach has us reflecting the dilutive effect of future stock issuances, perhaps counter
intuitively, as an expense that reduces cash flow.  It is counter intuitive because the
ultimate effect will be in future increases in the denominator (the share count).
Nevertheless, there is an elegance in the simplicity of simply valuing the dilutive securities
in an expense that reduces FCF and calling it a day.  And in comparison to the approach
above, it is far superior simply because it actually reflects future dilution somewhere.
With regards to dilution from already issued dilutive securities, this approach assumes all
unvested dilutive securities – both options and restricted stock will eventually be vested
and thus should be considered in the current dilutive share count. We prefer this
approach because it is more likely aligned with the rest of the valuation’s forecasts for
growth. In other words, if your model assumes the company will continue to grow, it is
reasonable to assume the vast majority of unvested options will eventually vest. This is
our preferred approach.
3. Damodaran’s approach: Reflect the cost of SBC  via SBC expense and value of options via a
reduction to equity value for option value , count only actual shares and restricted stock
Equity value after removing value of options = $36m – $3m = $33m
Diluted shares = 1m + 0.6m = 1.06m (ignore options in the denominator because you’re
counting their value in the numerator) 
Equity value per share = $33m / 1.06m = $31.13
The bottom line
The difference between approach #2 and #3 is not so significant as most of the difference is
attributable to the SBC add back issue. However, approach #1 is difficult to justify under any
circumstance where companies regularly issue options and restricted stock.
When analysts follow approach #1 (quite common) in DCF models, that means that a typical DCF for,
say, Amazon, whose stock based compensation packages enable it to attract top engineers will
reflect all the benefits from having great employees but will not reflect the cost that comes in the
form of inevitable and significant future dilution to current shareholders. This obviously leads to
overvaluation of companies that issue a lot of SBC.  Treating SBC as essentially cash compensation
(approach #2 or #3) is a simple elegant fix to get around this problem.

What is a Reverse DCF Model?

The Reverse DCF Model attempts to reverse-engineer the current share price of a company to
determine the assumptions implied by the market.
How Does a Reverse DCF Model Work?
In the traditional discounted cash flow model (DCF), the intrinsic value of a company is derived as
the sum of the present value of all future free cash flows (FCFs).
Using discretionary assumptions regarding a company’s future growth, profit margins, and risk
profile (i.e. its discount rate), the company’s future FCFs are estimated and can then discounted to
the present date.
A reverse DCF “inverts” the process by beginning with the company’s current share price, rather
than the other way around.
From the market price – the starting point of the reverse DCF – we can determine what set of
assumptions are “priced in” to justify the current share price, i.e. what assumptions are implicitly
embedded within the current market valuation of the company.
The reverse DCF is less about attempting to accurately project a company’s future performance and
more about understanding the underlying assumptions supporting the company’s current market
share price.
More specifically, the reverse DCF is designed to remove the bias inherent in all DCF valuation
models, and to provide straightforward insights into what the market is predicting.

1. Reverse DCF Model Operating Assumptions

Suppose a company generated $100 million in revenue in the trailing twelve months (TTM) period.
Regarding the assumptions necessary to calculate the company’s free cash flow to firm (FCFF), we
will use the following inputs:
EBIT Margin = 40.0%
Tax Rate = 21%
D&A % Capex = 80%
Capital Expenditures % of Revenue = 4%
Change in NWC = 2%
For the entire free cash flow (FCF) projection period – i.e. Stage 1 – the assumptions provided above
will be kept constant throughout (i.e. “straight-lined”).
From revenue, we’ll multiply our EBIT margin assumption to calculate EBIT for each period, which
will be tax-affected to calculate the net operating profit after taxes (NOPAT).
EBIT = % EBIT Margin × Revenue
NOPAT = % Tax Rate × EBIT

2. Financial Forecast and Free Cash Flow Calculation (FCFF)

In order to calculate the FCFF for years one to five, we’ll add D&A, subtract capital expenditures, and
finally subtract the change in net working capital (NWC).
FCFF = NOPAT + D&A – Capex – Change in NWC
The next step is to discount each FCFF to the present value by dividing the projected amount by (1 +
WACC) raised to the discount factor.
Our company’s WACC will be assumed to be 10%, while the discount factor will be the period
number minus 0.5, following the mid-year convention.
WACC = 10%
After all the FCFFs are discounted to the current date, the sum of the Stage 1 cash flows equals $161
million.

3. Terminal Value Calculation (TV)

For the terminal value calculation, we’ll use the perpetuity growth method and assume a long-
term growth rate of 2.5%.
Long-Term Growth Rate = 2.5%
We’ll then multiply the 2.5% growth rate by the final year’s FCF, which comes out to $53 million.
The terminal value in the final year equals the $53 million divided by our 10% WACC minus the 2.5%
growth rate.
Terminal Value in Final Year = $53 million / (10% – 2.5%) = $705 million
Since the DCF is based on the date of the valuation (i.e. as of the present date), the terminal value
must also be discounted to the present date by dividing the terminal value by (1 + WACC) ^ Discount
Factor.
Present Value of Terminal Value = $705 million / (1 + 10%) ^ 4.5
PV of Terminal Value = $459 million

4. Enterprise Value to Equity Value Bridge

The enterprise value (TEV) equals the sum of the projected FCFF values (Stage 1) and terminal value
(Stage 2).
Enterprise Value (TEV) = $161 million + $459 million = $620 million
To calculate equity value from enterprise value, we must deduct the net debt, i.e. total debt minus
cash.
We’ll assume the net debt of the company is $20 million.
Equity Value = $620 million – $20 million = $600 million

5. Reverse DCF Model Calculation Example

In the final part of our exercise, we’ll calculate the implied growth rate from our reverse DCF.
Let’s assume the company has 10 million diluted shares outstanding, with each share currently
trading at $60.00.
Diluted Shares Outstanding: 10 million
Current Market Share Price: $60.00
So the question our reverse DCF answers must answer is, “What revenue growth rate is the market
pricing into the current share price?”
Using the goal seek function in Excel, we’ll enter the following inputs:
Set cell: Implied Share Price (K21)
To value: $60.00 (Hard-Coded Input)
By changing cell: % 5-Year CAGR (E6)

6. Reverse DCF Implied Growth Rate Analysis

The implied growth rate comes out to 12.4%, which represents the revenue growth rate that the
market has priced into the share price of the company over the next five years.
Note that there are numerous variations of the reverse DCF, and our revenue growth rate model is
one of the simplest types.
The overall process is generally similar, but the reverse DCF can be further extended to estimate
other variables such as the reinvestment rate, return on invested capital (ROIC), NOPAT margin, and
WACC.
What is the Football Field Valuation?
One of the most common slides in an investment banking pitch book is the football field.
The football field is a floating bar chart in Excel that puts several valuation analyses side-by-side to
provide clients with the full context of a company’s value using a variety of methodologies and
assumptions.
A typical football field valuation matrix will include company value based on:
1. DCF valuation
2. LBO analysis
3. Comparable company analysis
4. Comparable transaction analysis
5. Trading 52-week high and low
6.  Liquidation analysis (optional)
7. Sum of the Parts Analysis (optional)

Football Field Valuation Chart: Role in Pitch Books

The purpose of the football field valuation is to create a visual summary of all the valuation analyses
that were performed on a company and to demonstrate a valuation range based on those valuation
methodologies.
The goal of the football field valuation chart summary is to sanity-check various methodologies
against one another.
For example, a comparable company analysis might show high valuations during strong equity
markets while an intrinsic DCF valuation might show a lower valuation.  The football field places
those alternative valuation approaches side by side when arriving at a valuation range. In addition to
being a staple of the investment banking pitch book, it is also used in fairness opinions.

What is Levered Free Cash Flow?

Levered Free Cash Flow (LFCF) is the residual cash belonging to only equity holders after deducting
operating costs, reinvestments (e.g. working capital and capital expenditures), and financial
obligations.
How to Calculate Levered Free Cash Flow?
Levered free cash flow, or “free cash flow to equity”, represents a company’s remaining cash flows
generated from its core operations once all spending obligations related to operating costs,
reinvestments, and debt-related payments are fulfilled.
Operating Costs: Cost of Goods Sold (COGS) and Operating Expenses (SG&A, R&D)
Reinvestments: Net Working Capital (NWC), Capital Expenditure (Capex)
Financial Obligations (Debt-Related): Mandatory Debt Amortization, Interest Expense
Once the items listed above are deducted, the leftover cash flow belongs to the shareholders of the
company, i.e. those in possession of shares that represent partial ownership stakes in the company’s
equity.
While the remaining proceeds technically belong to the shareholders, the allocation of the cash is at
management’s discretion.
Dividend Issuance: Cash Payments to Preferred and Common Equity Shareholders
Reinvestment: Reinvest the Funds into Operations (Working Capital, Capex)
Stock Buyback: Repurchase Previously Issued Shares to Reduce the Number of Shares in
Circulation
Thus, equity shareholders such as private equity firms pay close attention to the levered free cash
flow metric, since LFCF can be a proxy for the state of a company’s financial health.
Higher LFCF: More Discretionary Cash, Greater Debt Capacity, and Low Credit Risk
Low LFCF: Less Discretionary Cash and Less Debt Capacity, and High Credit Risk

What’s the Difference Between Levered Free Cash Flow vs. Unlevered Free Cash Flow?
Levered Free Cash Flow: LFCF is a “levered” measure of cash flow because of the inclusion of
expenses that stem from financing obligations, namely interest expense and mandatory
debt repayment. For instance, interest payments are received only by debt holders,
which are higher in priority than all equity holders in the capital structure. Since LFCF
pertains only to equity shareholders, the discount rate it pairs with is the cost of
equity (ke), which would be used to calculate the equity value in a levered DCF model.
The levered DCF is seldom used in practice, aside from for financial institutions, as the
core of their business model is oriented around lending (and earning interest income).
Unlevered Free Cash Flow: On the other hand, UFCF is an “unlevered” measure of cash flow
since the spending obligations deducted are applicable to all capital providers, i.e. both
debt lenders and equity holders. Instead of starting from net income – which is post-
interest and includes the tax savings from the interest tax shield – the calculation of UFCF
 starts from a capital-structure neutral metric, NOPAT, and does not account for any
repayment of debt obligations. Because UFCF represents all stakeholders, rather than
only one capital provider group, the corresponding discount rate is the weighted average
cost of capital (WACC), which calculates the enterprise value (TEV) in an unlevered DCF
model.

Levered Free Cash Flow Formula

The levered free cash flow formula is as follows.
Levered Free Cash Flow (LFCF) = Net Income + D&A – Change in NWC – Capex + Net Borrowing
Net Income: Net income, often referred to as the “bottom line”, is a company’s accounting
profit inclusive of all operating costs, including interest expense.
D&A: D&A stands for “depreciation and amortization”, which are non-cash expenses that
allocate an expenditure across the useful life of the fixed asset (PP&E) or intangible asset.
No actual cash outflow occurred, as D&A is an accrual accounting convention intended to
match the timing of an expense recognition with the period in which the benefit is
received, as opposed to recognizing the entire expenditure at one time in the period of
occurrence.
Change in NWC: The change in NWC tracks the net change in a company’s operating
assets (e.g. accounts receivable, inventory) and operating liabilities (e.g. accounts
payable, accrued expense) over a specified period.
Net Borrowing: The net borrowing is calculated by subtracting the amount of debt
repayment from the amount of debt borrowed (i.e. Debt Borrowing – Debt Repayment).
The debt borrowed is included here because the proceeds from the borrowing can be
used to distribute shareholder dividends or repurchase shares, which are corporate
actions directly relevant to equity holders.

Levered Free Cash Flow Calculation Example

Suppose you’re tasked with calculating the levered free cash flow of a company in 2022 given the
following set of assumptions.

Income Statement 2022A

Revenue $200 million

Less: COGS (100 million)

Gross Profit $100 million

Less: SG&A (40 million)

EBIT $60 million

Less: Interest, net (20 million)

EBT $40 million

Income Statement 2022A

Less: Taxes (10 million)

Net Income $30 million

Furthermore, the following values were obtained from the company’s cash flow statement (CFS).
D&A = $4 million
Change in NWC = $2 million
Capex = ($6 million)
Net Borrowing = ($10 million)
Starting from net income, the first adjustment is D&A, which is treated as an add-back since it is a
non-cash expense.
From there, we adjust for the change in NWC, which is a cash inflow given the positive value, i.e. the
company’s net working capital balance decreased from the year prior (creating a “source of cash”).
As a general rule, a year-over-year (YoY) increase in a company’s net working capital (NWC) is a
“cash outflow”, whereas a decrease in net working capital is a “cash inflow”.
The next step is to deduct the capital expenditure (Capex) in the period as well as the
mandatory debt amortization for the given period. Since the net borrowing is a negative value, that
means the company repaid more debt than it raised.
Once we input our assumptions into the levered free cash flow formula, we arrive at $20 million for
our company’s LFCF in 2022.
Levered Free Cash Flow (LFCF) = $30 million + $4 million + $2 million – $6 million – $10
million = $20 million
What is a Levered DCF Model?
The Levered DCF Model values a company by discounting the forecasted cash flows that belong only
to equity holders, excluding all cash flows to non-equity claims such as debt.

Levered DCF Model Training Guide

A discounted cash flow model (DCF) estimates the intrinsic value of a company by forecasting its free
cash flows (FCFs) and discounting them to the present date.
The standard DCF structure is a two-stage model, which consists of an explicit forecast period of 5 to
10 years and a terminal value assumption to arrive at the implied valuation.
The process of building a levered DCF model can be broken into the following five steps:
1. Forecast Free Cash Flow to Equity (FCFE): The company’s levered free cash flows – the
remaining cash flows that belong only to equity holders – are projected for five to ten
years.
2. Calculate Terminal Value: The value of all levered FCFs past the initial Stage 1 forecast
period must be estimated, i.e. the terminal value, using either the perpetuity growth
method or exit multiple approach.
3. Discount Stage 1 and Stage 2: Since the DCF represents the value of the company as of
the current date, both Stage 1 and Stage 2 must be discounted using the cost of equity
(ke) as the discount rate.
4. Equity Value Calculation: The sum of the discounted periods calculates the equity
value directly, i.e. all non-equity claims such as debt and minority interest are not
included within the equity value.
5. DCF-Derived Share Price: In the final step, the equity value is divided by the total diluted
shares outstanding as of the valuation date to arrive at the DCF-derived value per share,
which is then compared to the current market price per share.

Levered DCF and Free Cash Flow to Equity (FCFE)

For the levered DCF, the relevant projected cash flow is the free cash flow to equity (FCFE), which
represents the residual cash flows left over after payments to non-equity stakeholders, namely debt
providers, are deducted.
Free Cash Flow to Equity (FCFE) Formula
FCFE = Net Income + D&A – Change in NWC – Capital Expenditure + Mandatory Debt
Repayment
After interest expense and the mandatory debt repayment are subtracted from FCFE, these
remaining cash flows belong solely to equity owners.
Moreover, FCFE is indicative of the cash flows that can be distributed to shareholders as dividends,
used to repurchase shares (i.e. share buybacks), or kept as retained earnings to be reinvested into
sustaining current and future growth.
Calculating the FCFE begins with net income, which is adjusted for non-cash items and changes
in working capital, resulting in cash flow from operating activities (CFO).
From CFO, capital expenditures (capex) – the primary line item in the cash flow from investing
activities (CFI) section – is subtracted because it is a recurring, core expenditure of the company.
Finally, the cash inflows from new debt borrowings are added, net of any cash outflows related to
the repayment of debt.

Unlevered vs. Levered DCF Valuation Method

In theory, the levered and unlevered DCF should result in the same valuation – but in practice, it is
rather uncommon for the two values to be precisely equivalent.
Levered DCF: The levered DCF approach calculates the equity value directly, unlike the
unlevered DCF, which arrives at the enterprise value (and requires adjustments thereafter
to arrive at equity value).
Unlevered DCF: The unlevered DCF discounts the unlevered FCFs to arrive at the enterprise
value (TEV). From the enterprise value, net debt and any non-equity claims are subtracted
to calculate the equity value.
Another notable difference between the levered and unlevered DCF – other than the type of free
cash flow (FCF) projected – is the discount rate.
The discount rate represents the minimum required rate of return on an investment given its
specific risk profile, i.e. higher risk → higher expected return (and vice versa).
Levered DCF: The correct discount rate on FCFE is the cost of equity because these cash
flows belong to equity owners only and should thereby reflect the expected return (and
risk) of solely equity capital.
Unlevered DCF: In contrast, the weighted average cost of capital (WACC) is used for the
unlevered DCF since it reflects the required rate of return (and risk) to all providers of
capital, not just equity holders. The appropriate discount rate for an unlevered DCF is the
WACC since the rate must reflect the risk to all capital providers, inclusive of both debt
and equity capital providers.
In a levered DCF, to calculate equity value from the enterprise value, you would then add back net
debt (and for the reverse scenario, net debt would be subtracted to calculate enterprise value from
equity value).

Levered DCF Model Example Calculation

Suppose we’re using a levered DCF model to value a company that generated $100 million in
revenue during the trailing twelve months (TTM).
In the same time span, the company’s net income was $20 million, so its net margin was 20%.
For the entire forecast period – from Year 1 to Year 5 – the revenue growth rate will be assumed to
be 4.0% each year, whereas the net margin assumption will be kept constant at 20.0%.
Revenue Growth Rate = 4%
Net Margin = 20%
The other model assumptions that affect our free cash flow to equity (FCFE) calculation are the
following:
D&A = 85% of Capex
Capex = 5% of Revenue
Change in NWC = 1% of Revenue
Mandatory Debt Repayment = $2 million / Year
The FCFE is equal to net income adjusted for D&A, capex, change in NWC, and mandatory debt
repayment.
In the next step, each projected FCFE is discounted to the present date using the cost of equity,
which we’ll assume to be 12.5%.
Cost of Equity = 12.5%

Levered DCF Terminal Value – Perpetuity Growth and Exit Multiple Approach
The sum of the Stage 1 present value of the FCFE projection is $123 million.
We’ll now calculate the terminal value, where we have two options:
1. Perpetuity Growth Method
2. Exit Multiple Method
For the perpetuity growth method, we’ll assume the company’s long-term growth rate is 2.5%.
Next, the final year FCFE is grown by 2.5%, which comes out to $49 million.
Long-Term Growth Rate = 2.5%
Final Year FCF * (1 + g) = $49 million
To calculate the terminal value in the final year, we’ll divide $49 million by our 12.5% cost of equity
minus the 2.5% growth rate.
Terminal Value in Final Year = $49 million / (10% – 2.5%) = $493 million
The DCF is based on the current date on which the valuation is performed, meaning the terminal
value must also be discounted to the present date.
The present value of the terminal value is $290 million, which was calculated by dividing the
terminal value in the final year by (1 + ke) ^ Discount Factor.
Present Value of Terminal Value = $493 million / (1 + 12.5%) ^ 4.5
PV of Terminal Value = $290 million
The equity value is the sum of Stage 1 and Stage 2, i.e. $413 million.
If we assume the number of diluted shares outstanding is 10 million, the implied share price is
$41.28.
Implied Share Price = $413 million / 10 million = $41.28
As for the exit multiple method, we’ll assume the exit P/E multiple is 10.0x.
The reason we use the P/E multiple rather than the EV/EBITDA multiple is to ensure consistency is
maintained in the capital providers represented (in this case, only equityholders).
In other words, the P/E multiple is a post-debt levered metric, just like the FCFE and cost of equity.
The terminal year in the final year is equal to the exit P/E multiple times the final year net income.
Terminal Value in Final Year = $49 million * 10.0x = $498 million
Like the perpetuity growth method, we’ll discount the terminal value to the present date using the
same formula.
Present Value of Terminal Value = $293 million
By dividing the equity value by the diluted share count, the implied share price under the exit
multiple method is $41.57.

Trading and Transaction Comparables Guide

What is Relative Value?
Relative Value determines the approximate worth of an asset by comparing it to assets with similar
risk/return profiles and fundamental traits.

Relative Value: Asset Valuation Methodology

The relative value of an asset is derived from comparing it to a collection of similar assets, referred
to as a “peer group.”
If you were attempting to sell your home, you’d likely look into the estimated prices of similar
nearby homes in the same neighborhood.
Likewise, assets such as the shares of publicly traded companies can be valued under a similar
method.
The two main relative valuation methodologies are:
Comparable Company Analysis
Precedent Transactions
The accuracy of relative valuation depends directly on picking the “right” peer group of companies
or transactions (i.e. an “apples-to-apples” comparison).
In contrast, intrinsic valuation methods (e.g. DCF) value assets based on the fundamentals of the
company, such as the future cash flows and margins, while being independent of market prices.
Relative Value Method: Pros and Cons
The primary benefit to relative valuation methods is the ease of completing the analysis (i.e. in
comparison to intrinsic value methods like the DCF).
While there are exceptions, comps analyses tend to be less time-consuming and more convenient.
Relative valuation methods require less financial data, which often makes it the only viable method
for valuing private companies when information is limited.
Further, even if the company being valued has many publicly-traded competitors with many shares
characteristics, the comparison is still imperfect.
On the other hand, the fact that there are fewer explicit assumptions means that many assumptions
are made implicitly – i.e. NOT that there are fewer discretionary assumptions.
But rather, a core aspect to relative valuation is the belief that the market is correct, or at the very
least, provides useful guidelines for valuing a company.
The majority of the benefit to performing relative valuation stems from understanding the reasoning
behind why certain companies are priced higher than their close competitors – as well as for being a
“sanity check” for DCF valuations.

Comparable Company Analysis (Trading Comps)

The first relative valuation method we’ll discuss is comparable company analysis, or “trading comps”
– where a target company is valued using the valuation multiples of similar, public companies.
For comparable company analysis, the value of a company is obtained from comparisons to the
current share prices of similar companies in the market.
Examples of Valuation Multiples
EV/EBITDA
EV/EBIT
EV/Revenue
P/E Ratio
When selecting the peer group, the following traits are among those considered:
Business Characteristics: Product/Service Mix, Customer Type, Stage in Lifecycle
Financials: Revenue Historical and Projected Growth, Operating Margin and EBITDA Margin
Risks: Industry Headwinds (e.g. Regulations, Disruption), Competitive Landscape
Once the peer group and the appropriate valuation multiples are chosen, the median or mean
multiple of the peer group is applied to the corresponding metric of the target company to arrive at
the comps-derived relative value.

Precedent Transactions Analysis (Transaction Comps)

Another relative valuation method is called precedent transactions, or “transaction comps.”
While trading comps value a company based on the current share pricing by the market, transaction
comps derive the valuation of the target company by looking at prior M&A transactions involving
similar companies.
Compared to trading comps, transaction comps tend to be more challenging to complete if:
The amount of information available is limited (i.e. undisclosed transaction terms)
The volume of M&A deals within the industry is low (i.e. no comparable transactions)
The past transactions were closed several years ago (or more), making the data less useful
considering the economic and deal environment is different as of the current date

What is Multiples Analysis?

Investment bankers talk a lot about valuation multiples. In fact, almost everyone in finance talks
about multiples. Jim Cramer is probably talking about some company’s multiple right now.
Surprisingly, though, multiples and what they actually represent are deeply misunderstood by a
frightening number of investment bankers (including, believe it or not, those that may be
interviewing you on your super day).
So, let’s get right to it: “What is a multiple, really?”
I assume you’re comfortable with the basics: Multiples reflect the market’s perceptions of a
company’s growth prospects, so two companies with similar prospects and operating characteristics
should trade at similar multiples.  And, if one is trading at a lower multiple than its “comparable”
peers, then we can surmise that it is undervalued in the market.  But is that all there really is to it?
Why do multiples reflect a company’s growth prospects – and is that the only thing they reflect? 
What really underlies a multiple?  What does it really mean to say that Microsoft trades at a 23.0x
Share Price/EPS (P/E) multiple, or that Google trades at a 12.0x EV/EBITDA multiple?

Intrinsic Value (DCF) vs. Relative Value (Comps)

Before we look under the hood of a multiple, let’s take a step back.
A common investment banking interview question goes as follows:
“How do you value a company?”
To which, the prospective analyst or associate will be expected to respond that there are two major
approaches:
Intrinsic Valuation: The first one is called intrinsic valuation, which is where you calculate
the present value (PV) of expected future free cash flows in order to discount them to the
present date.
Relative Valuation: The other approach – relative valuation – involves merely looking at the
market values of comparable companies and applying those values to the company under
analysis.
The distinction seems stark: the intrinsic approach suggests that the value of, say, a hot dog stand
should fundamentally equal the present value of the cash flows it is expected to generate in the
future, while the relative approach suggests that the value of the hot dog stand can be derived by
looking at the value of comparable hot dog stands (perhaps one was sold recently and the purchase
price is observable).
What is the Role of Multiples in Valuation?
A market-based valuation approach is a form of relative valuation where the price of an asset is
determined by comparing it to its similar peers. Furthermore, multiples play a central role in relative
valuation.
In our hot dog stand example, suppose a comparable hot dog stand, Joe’s Dogs, was purchased for
$1 million several months prior to our hot dog stand being valued today.
If we know that Joe’s Dogs generated EBITDA of $100,000 in the last twelve months (LTM) prior to
acquisition (that’s an Enterprise Value / EBITDA multiple of 10.0x), and we know that our hot dog
stand generated LTM EBITDA of $400,000, we can apply the recently acquired EV/EBITDA multiple to
our company, and estimate that we should expect a value of somewhere around $4.0 million for our
hot dog stand today.
Arriving at value using multiples this way is a lot easier than projecting out cash flows each year and
calculating a present value.
That’s why multiples analysis is ubiquitous in our world. While investment bankers use multiples all
the time – in comparable company analysis, comparable transaction analysis, in LBO valuation, and
even DCF valuation,* there is often confusion about what these multiples actually represent.
But are these valuation methods really distinct?  If your gut tells you that there has to be some
connection, you’re right. But how do we reconcile valuing companies intrinsically with valuing
companies based on multiples?
Cash is King
Intrinsic valuation says the value of a business is a function of the free cash flows (see definition
below) that it can generate, plain and simple.  Say you are considering buying a business that will
generate $1,000 in cash every year forever.  Based on your calculation of the riskiness of the
business, you require an annual return of 10%.  As such you calculate that the most you would be
willing to pay for such a business is:

Expanding the discussion slightly, if you expect the business’s free cash flows to grow by 5% every

year, the calculation would change slightly to:

In fact, the general perpetual growth formula can be expressed as:

We can delve a little deeper into this formula by breaking down free cash flows and growth into their
component parts:
Free cash flows = NOPLAT [Net Operating Profit / Loss After Taxes] – Net Investment
Net Investment = Working Capital Investments + Capex + Intangible Asset – D&A
Growth rate = Return on invested capital (ROIC) * Investment rate
Investment rate = Net Investment / NOPLAT
Rearranging our value equation, we arrive at:

So where do multiples come in?  Well, let’s take a common multiple: EV/EBIT.  How does the
EV/EBIT multiple fit into our understanding of value?

Value Drivers of Multiples

First, let’s define EBIT relative to cash flow. Assuming you are the sole investor in the business for
now (i.e., no debt) NOPLAT and, consequently, free cash flows, can be restated as:
NOPLAT = EBIT * (1-tax rate[t])
Where:
Free cash flow = EBIT x (1-t) (1+g/ROIC)
Dividing both sides of our value equation by EBIT, we arrive at the definition of the EV/EBIT multiple:

Voila! All of a sudden, the drivers of a multiple become quite clear:

r: the higher the required return of a business, the lower the multiple
g: the higher the growth of a business, the higher the multiple
t: the higher the taxes on a business, the lower the multiple
ROIC: As long as ROIC is greater than the opportunity cost of capital (r), the higher the ROIC
of a business, the higher the multiple.
The Bottom Line on Market Multiples
Market multiples are a simple way to discuss value. But don’t be fooled by the mechanical simplicity.
When you are using multiples to value a company, you are implicitly saying quite a lot about your
assumptions for the company’s ROIC, reinvestment rate, discount rate, and future cash flow growth.
The mechanical simplicity just makes it very easy to forget all of those implicit assumptions.
When you compare one company’s multiple to another company’s multiple, if all the value drivers
are equivalent (discount rate, growth rate, ROIC, tax rate), then the multiples should equal.
However, if one or more of the drivers are different – say company A’s growth rate is higher than
company B’s, then company A’s multiple should be higher.
If it is not, then you can say that company B is overvalued relative to company A.
If company A’s multiple is appropriately higher than company B’s, you can say that company
A trades at a premium to company B to reflect higher long-term growth.
While tax rates and discount rates are generally equivalent across firms in similar industries, ROIC
and growth rates can be quite different, so in fairly-priced equity markets, companies with higher
multiples within a particular industry generally reflect different assumptions about ROIC, growth, or
a combination.
* Although the DCF is supposed to be a pure intrinsic value calculation, a common approach for
calculating the terminal value is to use an EBITDA multiple assumption.

What is a Valuation Multiple?

A Valuation Multiple is a ratio that reflects the valuation of a company in relation to a specific
financial metric. Usage of a valuation multiple – a standardized financial metric – facilitate
comparisons of value among peer companies with different characteristics, most notably size.

How to Calculate Valuation Multiples (Step-by-Step)

The basis of relative valuation is to approximate the value of an asset (i.e. the company) by looking
at how similar, comparable companies are valued by the market.
The median or mean of the industry peer group serves as a useful point of reference to determine
the worth of the target company.
A valuation using comps has the distinct advantage of reflecting “reality” since the value is based
on actual, readily observable trading prices.
However, the absolute value of companies – such as equity value or enterprise value – cannot be
compared on their own.
A simple analogy is comparing the prices of houses – the absolute prices of the houses themselves
provide minimal insights due to size differences between houses and other various factors.
Therefore, standardization of the valuation of companies is required to facilitate meaningful
comparisons that are actually practical.
Valuation Multiple Formula
A valuation multiple comprises two components:
Numerator: Value Measure (Enterprise Value or Equity Value)
Denominator: Value Driver – i.e. Financial or Operating Metric (EBITDA, EBIT, Revenue, etc.)
The numerator is going to be a measure of value, such as equity value or enterprise value, whereas
the denominator will be a financial (or operating) metric.
Valuation Multiple = Value Measure ÷ Value Driver
A mandatory rule is that the represented investor group in the numerator and the denominator
must match.
Note that for any valuation multiple to be meaningful, a contextual understanding of the target
company and its sector must be well-understood (e.g. fundamental drivers, competitive landscape,
industry trends).
Hence, operating metrics that are specific to an industry can also be used. For example, the number
of daily active users (DAUs) could be used for an internet company, as the metric could depict the
value of a company better than a standard profitability metric.

Types of Valuation Multiples: Numerator and Denominator

For a valuation multiple to be practical, the represented capital provider (e.g. equity shareholder,
debt lender) must match in the numerator and denominator.
Enterprise Value: If the numerator is enterprise value (TEV), metrics such as EBIT, EBITDA,
revenue, and unlevered free cash flow (FCFF) could be used as the denominator since all
of these metrics are unlevered (i.e. pre-debt). Thus, these metrics coincide with
enterprise value, which is the valuation of a company independent of the capital
structure.
Equity Value: Conversely, if the numerator is equity value, metrics such as net income,
levered free cash flow (FCFE), and earning per share (EPS) can be used since these are all
levered (i.e. post-debt) metrics.

Enterprise Value Multiples vs. Equity Value Multiples

In the chart below, some commonly used enterprise value and equity value-based valuation
multiples are listed:

Enterprise Value Multiples Equity Value Multiples

EV/EBITDA P/E Ratio

EV/EBIT PEG Ratio

EV/Revenue Price/Book Ratio (P/B)

Note that the denominator in these valuation multiples is what standardizes the absolute valuation
(enterprise value or equity value). Similarly, homes are often expressed in terms of sq. footage,
which helps standardize value for differently sized homes.
Based on the circumstances at hand, industry-specific multiples can oftentimes be used as well. For
example, EV/EBITDAR is frequently seen in the transportation industry (i.e. rental costs are added
back to EBITDA) while EV/(EBITDA – Capex) is frequently used for industrials and other capital-
intensive industries like manufacturing.
In practice, the EV/EBITDA multiple is the most commonly used, followed by EV/EBIT, especially in
the context of M&A.
The P/E ratio is typically used by retail investors, while P/B ratios are used far less often and normally
only seen when valuing financial institutions (i.e. banks).
When it comes to unprofitable companies, the EV/Revenue multiple is frequently used, as it’s
sometimes the only meaningful option (e.g. EBIT could be negative, making the multiple
meaningless).

Trailing vs. Forward Multiples: What is the Difference?

Oftentimes, you’ll come across comps sets with forward multiples. For example, “12.0x NTM
EBITDA”, which simply means the company is valued at 12.0x its projected EBITDA in the next twelve
months.
Using historical (LTM) profits have the advantage of being actual, proven results, which is important
because EBITDA, EBIT, and EPS forecasts are subjective and especially problematic for smaller public
firms, whose guidance is less reliable and harder to obtain.
That said, LTM suffers from the problem that historical results are typically distorted by non-
recurring expenses and income, misrepresenting the company’s future, recurring operating
performance.
When using LTM results, non-recurring items must be excluded to get a “clean” multiple. In addition,
companies are regularly acquired based on their future potential, making forward multiples more
relevant.
Therefore, rather than picking one, both LTM and forward multiples are often presented side-by-
side.

Comparable Companies Analysis Output Sheet (Source: 

WSP Trading Comps Course)

Step 1. Financial Assumptions and Equity Value Calculation

To start, we have three different companies with the following financial data:
Company A: $10.00 Share Price and 500mm Diluted Shares Outstanding
Company B: $15.00 Share Price and 450mm Diluted Shares Outstanding
Company C: $20.00 Share Price and 400mm Diluted Shares Outstanding
Since the equity market – otherwise known as the market capitalization – is equal to the share price
multiplied by the total diluted share count, we can calculate the market cap for each.
From Company A to C, the market caps are $5bn, $6.75bn, and $8bn, respectively.
Company A, Equity Value: $10.00 * 500mm = $5bn
 Company B, Equity Value: $15.00 * 450mm = $6.75bn
Company C, Equity Value: $20.00 * 400mm = $8bn

Step 2. Enterprise Value Calculation (TEV)

In the next part, we’ll add the net debt assumptions to the equity values of each company to
compute the enterprise value.
Company A, Enterprise Value: $5bn + $100mm = $5.1bn
Company B, Enterprise Value: $6.75bn + $350mm = $7.1bn
Company C, Enterprise Value: $8bn + $600mm = $8.6bn
Here, we’re just using the simplistic assumption that larger companies hold more debt on their
balance sheet.

Step 3. Valuation Multiples Calculation Example

Now, the valuation portion of our exercise (i.e. the numerator) is finished, and the remaining step is
to calculate the financial metrics (i.e. the denominator), which have been posted below:
We now have all the necessary inputs to calculate the valuation multiples.
The following formulas were used to compute the valuation multiples:
EV/Revenue = Enterprise Value ÷ LTM Revenue
EV/EBIT = Enterprise Value ÷ LTM EBIT
EV/EBITDA = Enterprise Value ÷ LTM EBITDA
P/E Ratio = Equity Value ÷ Net Income
PEG Ratio = P/E Ratio ÷ Expected EPS Growth Rate
In conclusion, multiples are shorthand valuation metrics used to standardize a company’s value on a
per-unit basis because absolute values can NOT be compared between different companies.
Given the company data in our modeling exercise was standardized, we can derive more informative
insights from the comparison.
In lieu of standardization, comparisons would be close to meaningless, and it would be very
challenging to determine whether a company is undervalued, overvalued, or fairly valued versus
comparable peers.
What is Comparable Company Analysis?
Comparable Company Analysis is a relative valuation method in which a company’s value is derived
from comparisons to the current stock prices of similar companies in the market.
Once the peer group of comparable companies and the appropriate valuation multiples have been
established, the median or mean multiple of the peer group is applied to the corresponding metric
of the target company to arrive at its comps-derived valuation.

Comparable Company Analysis: Training Tutorial

The premise of comparable company analysis is that similar companies provide an informative point
of reference that can be used to derive an estimated valuation of the target company.
The implied valuation from trading comps is not meant to be a precise measure, but rather to set
parameters for the target company based on the current market pricing of comparable companies.
A common analogy used to explain the concept of comps is the example of estimating the fair
market value (FMV) of a home. If you researched the estimated value of nearby houses using sites
such as Zillow, you’ve essentially performed a simple comps analysis.
However, the process and type of considerations become substantially more intricate when it comes
to valuing companies.
Valuation Multiple Analysis: Quick Review
A valuation multiple consists of a measure of value in the numerator, whereas the denominator is an
operating metric.
Numerator → Value Measure (e.g. Enterprise Value, Equity Value)
Denominator → Value Driver (e.g. EBITDA, EBIT, Net Income, EPS)
An important rule is that the represented investor group – in other words, the capital provider(s) –
must match on both the numerator and the denominator. Otherwise, the multiple cannot be used
due to a mismatch in representation.
For example, enterprise value represents all the providers of capital (e.g. equity, debt) while equity
value pertains only to common shareholders.
While the P/E ratio is widely recognized and used among retail investors and is also taught in
academia, the most commonly used multiples in the industry are based on enterprise value, as such
multiples are independent of the capital structure and focus on the core operations of the company.
Learn More → Valuation Multiple

Comparable Company Analysis Overview (Step-by-Step)

Step 1. Compile Peer Group → The first step is to select the peer group, which will be
composed of publicly traded comparable companies that are ideally competitors of the
target or operate in a similar industry.
Step 2. Industry Research → The next step is to collect applicable information from publicly
available sources related to the specific target company, as well as the ongoing industry
and market trends to understand the factors affecting how the market values companies
in a certain industry.
Step 3. Input Financial Data → Once an understanding of the industry is formed, the
subsequent step is to collect the financial data of each comparable company, making sure
to “scrub” (adjust) the financials for non-recurring items, accounting differences, leverage
differences, and any cyclicality or seasonality. If the situation requires, you may also need
to calendarize each company’s financials to standardize the dates (i.e. convert different
ending fiscal year dates to a common timeframe).
Step 4. Calculate Peer Group Multiples → With the financials input, the valuation multiples
can be calculated and compared against one another in the output sheet. As a general
convention, the multiples are typically displayed on a last twelve months (LTM) and the
next twelve months (NTM) basis, with the minimum, 25th percentile, median, mean, 75th
percentile, and the maximum of each metric also calculated and summarized.
Step 5. Apply Multiple to Target → In the final step, the median or mean multiple is applied
to the target’s corresponding metric to get the comps-derived value of the target. It is
important to not neglect the fundamental drivers impacting the valuation – otherwise,
it’ll be difficult to defend the rationale of why a target should be valued in the lower (or
higher) end of the range.
Comparable Company Analysis: Pros and Cons
The accuracy of trading comps analysis is contingent on the selection of comparable companies.
As a general rule, the more stringent the screening process for comparable companies is, the more
reliable the trading comps valuation is going to be.
If comparable companies are absent in the public markets, the screening process to put together a
peer group becomes less strict, which directly causes the comps valuation to lose credibility.
But while the implied valuation output from a trading comps analysis could be seen as a more
realistic assessment of market pricing (and are based upon actual prices in real-time), comps are
vulnerable to how the market can be wrong – and the market often does indeed misprice securities,
particularly for those with smaller followings and less trading volumes.
A common misconception is that comps do not require as many assumptions as a discounted cash
flow analysis (DCF). In fact, the same operating assumptions are made, but they are made implicitly
rather than being explicitly chosen assumptions.
The inherent assumption behind comparable company analysis is that the market consists of
rational investors.
But material disconnects between the pricing of securities and company fundamentals can still
occur, which increases the importance of not relying on a single valuation method.
Given these drawbacks, trading comps should be used in conjunction with the other valuation
methodologies like the DCF – as opposed to being a standalone method (i.e. “sanity check”).

Gathering Comps Set: Peer Group Selection Criteria

The set of companies chosen to be compared to one another is called the “peer group”.
To maximize the accuracy of the trading comps valuation, the peer group should consist of
companies that share various traits with the target company related to their business characteristics,
financials (i.e. cash flow drivers), and risks.
Peer Group Selection Criteria:
Business Characteristics: e.g. Product/Service Mix, Customer Type
Financials: e.g. Revenue Growth, Operating and EBITDA Margins
Risks: e.g. Changes in Regulatory Landscape, Industry Headwinds, Competitive Landscape
Under an ideal scenario, a target company is going to have an existing list of close competitors that
can serve as the starting point for setting up the peer group.
For instance, if we’re compiling comparable companies for Microsoft (NASDAQ: MSFT), the peer
group should consist of enterprise software companies with product offerings in relatively adjacent
domains:

Microsoft “Quick Comps” (Source: 

Capital IQ)
Selecting comparable companies that are operationally alike should be the prime objective and
where most of your time is spent when creating a peer group.
However, “pure-play” (exact) comparable companies are non-existent, so it’s important to remain
realistic and have a certain level of flexibility when screening and choosing peers, especially if the
target company operates in a niche area.

Enterprise Value vs. Equity Value Multiples

Enterprise value and equity value, as well as operating metrics like EBITDA, cannot be compared in
their absolute value forms. But upon being standardized by valuation multiples, comparisons are
viable across companies of various sizes and among other differences.
Returning to our CapIQ screenshot, after the “Company Name” column, the next two columns are:
1. Market Capitalization
2. Enterprise Value (TEV)
The four columns on the right are each populated with a different valuation multiple:
TEV/EBITDA
TEV/EBIT
TEV/Revenue
P/E Ratio

Non-Recurring Items Adjustments

One frequent mistake is to neglect the step of adjusting the financials of the peer group, which is
often referred to as “scrubbing” the financials.
To an extent, the financials of all companies are impacted by non-recurring income or expenses (i.e.
one-time integration costs for a new acquisition, and repair costs due to a recent hurricane).
Since our objective is to compare the core operations of each company in the peer group, it’d be
logical to remove the effects of these one-time line items that are NOT going to continue into the
future.

Step 1. Comparable Company Analysis Multiples

The process of “spreading comps” can be very time-consuming, with the majority of the time and
effort spent on researching the target company, compiling the right comparable companies, and
developing an understanding of the sector.
In comparison, building out the trading comps valuation model is rather simple. For our modeling
exercise, we’ll be going through the mechanics of valuing a company using trading comps analysis,
which should be straightforward because the valuation and operating assumptions are already
provided (i.e. the blue hard coded numbers).
In our illustrative scenario, we’ll be working with the following financial assumptions of five different
companies.

Since we’re given the valuation measures and financial metrics side-by-side, the calculation of
the LTM multiples should be straightforward.
The process of calculating each valuation multiple is repeated, in which the valuation measure is
divided by the corresponding operating metric of each company.
For instance, in the case of Company A’s TEV/EBITDA calculation, we divide the $1.4bn TEV by the
$200m in EBITDA to get 7.0x.
Minimum: “=MIN(Range of Multiples)”
25th Percentile: “=QUARTILE(Range of Multiples,1)”
Median: “=MEDIAN(Range of Multiples)”
Mean: “=AVERAGE(Range of Multiples)”
75th Percentile: “=QUARTILE(Range of Multiples,3)”
Maximum: “=MAX(Range of Multiples)”
The topic of whether to include or exclude the target company from the peer group is a frequent
topic of debate. From one viewpoint, the inclusion of the target as part of the peer group skews the
multiple towards the target’s current valuation.
However, considering the target is a part of the peer group, its exclusion from a “market-based”
valuation contradicts the notion that the market is “right” on average. Of course, should a target be
a private company, then it would not be (and in fact could not be) included in the calculation.

Step 2. Comparable Company Analysis Implied Valuation

In the next part of our tutorial, we’ll arrive at the valuation of the target by applying the median and
mean multiples derived from the peer group of comparable companies to the metrics of the target.
Once all the appropriate valuation multiples have been calculated, the median or mean multiple can
be applied to the target company to get an implied valuation.
A common question is whether the median or mean should be used.
Median: Using the median removes the distortion caused by outliers, which increases in
tandem with the number of comparable companies included.
Mean: In contrast, the mean can be the preferable option when the peer group is comprised
of only a few comparable companies (i.e. <5) with no clear outliers.
Continuing our TEV/EBITDA example, if we apply the 6.0x median TEV/EBITDA multiple to our
target’s EBITDA of $140m, the implied TEV comes out to $833m.
If we determine the appropriate multiple to use in our comparable company analysis is the
TEV/EBITDA multiple, the implied valuation of the target company is approximately $833m or $819m
based on the peer group median and mean, respectively.

What is Precedent Transaction Analysis?

Precedent Transaction Analysis estimates the implied value of a company by analyzing the recent
acquisition prices paid in comparable transactions.
Precedent Transaction Analysis: Acquisition Comps Tutorial
The premise of precedent transaction analysis – often used interchangeably with the term
“transaction comps” – is that similar transactions of comparable companies can serve as a useful
point of reference when valuing companies.
In short, precedent transaction analysis utilizes multiples to calculate the value of a target.
Thus, precedent transaction analysis is a method of valuing a company based on the purchase
multiples recently paid to acquire comparable companies.
Once the peer group of comparable transactions and the appropriate valuation multiples are
selected, either the median or mean multiple of the peer group is applied to the target’s
corresponding metric to arrive at a transaction comps-derived value.
The estimated valuation from transaction comps is not meant to be a precise calculation, but rather
establishes valuation parameters for the target company based on what other buyers paid for similar
companies.
From the perspective of a buyer and seller, as well as their advisors, the goal is to gain insight on:
1. Buy Side → “How much should we offer to purchase the company?”
2. Sell Side → “How much can we sell our company for?”
Based on the circumstances surrounding each transaction, a higher premium (or discount) could be
warranted, but the acquirer can benchmark against comparable transactions to ensure their offer
price is “reasonable” and most importantly, as a sanity check.

Quick Valuation Multiples Review: Enterprise Value vs. Equity Value

Just to briefly review, a valuation multiple is comprised of a value measure in the numerator –
i.e. enterprise value or equity value – whereas the denominator will be an operating metric like
EBITDA or EBIT.
It is important to ensure that the represented investor groups (i.e. the capital providers) must match
both the numerator and denominator.
Enterprise Value Multiple: TEV multiples are more practical due to being capital structure
neutral, i.e. the enterprise value represents all the providers of capital, such as debt and
equity holders.
Equity Value Multiple: On the other hand, equity value multiples represent the residual
value remaining just for common shareholders – for example, the P/E ratio.

Comparable Transactions Screening Criteria

The “peer group” in transaction comps analysis describes the collection of recent M&A transactions
involving companies with characteristics that are similar to that of the target.
When selecting which types of companies sufficiently meet the criteria to be placed in the peer
group, considerations include:
Business Characteristics: Product/Service Mix, Key End Markets Served, Customer Type (B2B,
B2C)
Financial Profile: Revenue Growth, Profit Margins (Operating and EBITDA Margins)
Risks: Regulatory Landscape, Competitive Landscape, Industry Headwinds or Tailwinds,
External Threats
However, “pure-play” transactions are virtually non-existent, so flexibility must be retained in the
screening process, especially for niche industries.
Particularly for precedent transaction analysis, it is important that the transactions occurred
relatively recently because dissimilar macroeconomic conditions can create significant differences in
valuations.
The necessary data to perform transaction comps can be acquired from the following sources:
Deal Announcement Press Releases
Merger Proxy and 8-Ks
Tender Office Documents (Schedule 14D-9, Schedule TO)
Financial Reports (10-K / 10-Q Filings)
Management Presentations
Equity Research Reports (M&A Commentary)

Precedent Transaction Analysis: Training Guide (Step-by-Step)

Step Description

Step 1. Compile The first step is to compile data on recent transactions that
Comparable closed within the same (or an adjacent) industry as the
Transactions target, i.e. ideally close competitors of the target.

Step 2. Market The next step is to gather as much relevant information as

Research possible from publicly available sources, as well as the
ongoing industry and market trends to understand which
specific factors impact the purchase multiples in a specific
industry.

Step 3. Input Once an understanding of the industry is formed, the next step
Financial Data is to organize the financial data of each comparable
transaction, making sure to “scrub” (adjust) the financials for
non-recurring items, accounting differences, leverage
differences, and any cyclicality or seasonality.
If needed, the company’s financials might need to be
calendarized to standardize the dates (i.e. different ending
fiscal year dates converted to match).

Step 4. Calculate After the financials are entered, the relevant valuation multiples
Peer Group can be calculated to be compared against one another in the
Multiples output sheet.
The general convention is to express the multiples on a last
twelve months (LTM) and next twelve months (NTM) basis,
Step Description

with the summarized data on the minimum, 25th percentile,

median, mean, 75th percentile, and maximum of each
metric.

Step 5. Apply In the final step, either the median or mean multiple is applied
Multiples to to the target’s corresponding metric to get the transaction
Target comps-derived value.
It is imperative to not neglect the fundamental drivers affecting
purchase prices, as well as any transactional considerations
to understand why one deal was priced higher (or lower)
than the peer average.

Transaction Comps Peer Group: Deal Considerations

When putting together a peer group for transaction comps, the following are examples of diligence
questions to keep in mind:
1. Transaction Rationale: What was the transaction rationale from both the buyer’s and
seller’s perspectives?
 Overpaying is a common occurrence in M&A, so the outcome of the deal
should be assessed.
2. Buyer Profile: Was the acquirer a strategic or a financial buyer?
 Strategic acquirers can afford to pay a greater control premium than financial
buyers because strategics can benefit can synergies.
3. Sale Process Dynamics: How competitive was the sale process?
 The more competitive the sale process, i.e. the more buyers that are serious
about acquiring the target, the greater the likelihood of a higher premium.
4. Auction vs. Negotiated Sale: Was the transaction an auction process or negotiated sale?
 In most cases, a sale structured as an auction will result in a higher purchase
price.
5. M&A Market Conditions: What were the market conditions at the time when the deal
closed?
 If the credit markets are healthy (i.e. if access to debt to partially fund the
deal or share price is relatively easy), then the buyer is more likely to pay a
higher price.
6. Transaction Nature: Was the transaction hostile or friendly?
 A hostile takeover tends to increase the purchase price, as either side does
not want to be on the losing end.
7. Purchase Consideration: What was the purchase consideration (e.g. all-cash, all-stock,
mixture)?
 A transaction in which the purchase consideration was stock rather than cash
is more likely to be valued less than an all-cash transaction since the
shareholder can benefit from the potential upside post-deal.
8. Industry Trends: If the industry is cyclical (or seasonal), did the transaction close at a high
or low point in the cycle?
 If the transaction occurred at an unusual time (e.g. cyclical peak or bottom,
seasonal swings), there can be a material impact on pricing.
Transaction Comps: Pros and Cons

Advantages Disadvantages

Implied value is determined by the The implicit assumption is that buyers

prices paid in real-life to are rationale, yet poor decisions
purchase similar companies are often made in M&A, namely
overpaying

Multiples-based approach with an Limited public information about

estimated “control premium” – M&A makes the process more
which can be very practical in challenging and time-consuming
terms of providing pricing
guidance

Comparable acquisitions can The necessity for transaction recency

function as a frame of reference and  occurrence in relatively
for participating parties, i.e. similar market conditions further
insights from similar deals reduces the pool of comps

Control Premium in M&A (%)

Transaction comps analysis typically yields the highest valuation because it looks at valuations for
companies that were acquired – meaning that a control premium is included in the offer price.
A control premium is defined as the amount that an acquirer paid over the unaffected market
trading share price of the company being acquired, typically expressed as a percentage.
As a practical matter, a control premium is necessary to incentivize existing shareholders to sell their
shares and forego their ownership.
Control premiums, or “purchase premiums,” are paid in the vast majority of M&A deals and can be
quite significant, i.e. can be as high as 25% to 50%+ above unaffected market prices.
In the absence of a reasonable control premium, it is unlikely that an acquirer will be able to obtain a
controlling stake in the acquisition target, i.e. the existing shareholders typically need an extra
incentive that compels them to give up their ownership.
Hence, the multiples derived from transaction comps (and the implied valuations) tend to be the
highest when compared to the valuations derived from trading comps or standalone DCF valuations.
A key benefit to transaction comps is that the analysis can provide insights into historical control
premiums, which can be valuable points of reference when negotiating the purchase price.

Precedent Transactions vs. Comparable Company Analysis

The credibility of a precedent transaction analysis is contingent on the selection of comparable
transactions that involve similar companies and occurred in similar market conditions.
However, finding comparable companies and their transaction comps tends to be much more
challenging than finding pure trading comps.
Unlike trading comps, where public companies are obligated to file their financial reports (10-Q, 10-
K) periodically, companies and M&A participants are under no obligation to publicly announce the
details of an M&A transaction.
The discretionary nature of information disclosure in M&A results in frequently “spotty” data.
But while the valuation range from a transaction comps analysis is often seen as a more realistic
assessment of the actual purchase prices paid, transaction comps are vulnerable to how buyers can
(and frequently do) make mistakes.
The phrase “less is more” and “quality of quantity” applies to transaction comps, since a handful of
truly comparable transactions will be more informative than a long list of random transactions
included purely for the sake of building a large peer group.

Transaction Comps Analysis Model Example

Suppose we are attempting to determine the valuation of a potential acquisition (”TargetCo”).
The financial data of TargetCo can be found below:
Current Share Price = $50.00
Total Shares Outstanding = 1 million
LTM Revenue = $50 million
LTM EBITDA = $10 million
LTM Net Income = $4 million
Net Debt = $2 million
Since earnings per share (EPS) is equal to net income divided by the number of shares outstanding,
TargetCo’s LTM EPS is $4.00.
LTM Earnings Per Share (EPS) = $4 million Net Income / 1 million Total Shares Oustanding
LTM EPS = $4.00
In the next step, we are provided with a table of the peer group’s valuation multiples.

TV / LTM
TV / LTM EBITDA Offer Price / EPS
Revenue

Comp 1 2.0x 10.0x 20.0x

Comp 2 1.6x 9.5x 18.5x

Comp 3 2.2x 12.0x 22.5x

Comp 4 2.4x 10.6x 21.0x

Comp 5 1.5x 8.8x 18.0x

In practice, the valuation multiples will be linked to other tabs where the metrics were calculated
separately, but for illustrative purposes, the numbers are just hard coded in our exercise.
Given those assumptions, we can now summarize the data of the comparable transactions using the
following Excel functions.
Comps Summary Table – Excel Functions
Minimum → “=MIN(Range of Multiples)”
25th Percentile → “=QUARTILE(Range of Multiples,1)”
Median: “=MEDIAN(Range of Multiples)”
Mean → “=AVERAGE(Range of Multiples)”
75th Percentile → “=QUARTILE(Range of Multiples,3)”
Maximum → “=MAX(Range of Multiples)”
Since there are no clear outliers, we’ll use the mean here – but whether we use the median or mean
does not make a meaningful difference.
We now have the necessary inputs to calculate the transaction value and implied offer value (i.e.
equity value) of TargetCo.
In order to get from the transaction value (TV) to the offer value (i.e. equity value), we must subtract
net debt.
Implied Offer Value = Transaction Value (TV) – Net Debt
Under the multiples derived from our comparable transactions analysis, we arrive at the following
approximate valuations.
1. TV / Revenue = $97 million – $2 million Net Debt = $95 million
2. TV / EBITDA = $102 million – $2 million Net Debt = $100 million
3. Offer Price / EPS = $80 million
According to our completed exercise, the implied offer value is an offer value in the range of $80
million to $100 million.

What is Control Premium?

The Control Premium (%) is the differential between the offer price per share and the acquisition
target’s unaffected market share price, prior to speculative rumors of a potential M&A transaction
and the official announcement.

Control Premium: Excess Purchase Price in M&A

In the context of mergers and acquisitions (M&A), the control premium is an approximation of the
“excess” paid over an acquisition target’s share price by the buyer.
Control premiums are necessary for acquisitions such as leveraged buyouts (LBOs) to close, as
existing shareholders require a monetary incentive to sell their shares, i.e. their ownership in the
target company.
In the absence of a sufficient control premium, it is unlikely for an acquirer to successfully obtain a
majority stake in the target.
Therefore, a reasonable premium is paid over the current share price in practically all acquisitions.
The control premium normally ranges from around 25% to 30%, but it can vary substantially from
deal-to-deal and be as high as 50% above the target’s share price.
From the viewpoint of the pre-deal shareholders, there must be a compelling reason for them to
give up their ownership — i.e. for the offer to be convincing enough, selling their shares must be
profitable.
Since precedent transaction analysis (or “transaction comps”) values companies using acquisition
prices for comparable companies, which factors in the control premium, the implied valuation is
most often the highest relative to that derived from a discounted cash flow (DCF) or trading comps.
Learn More → Investment Banking Guide

Causes of Control Premium in M&A Transactions

Numerous transaction-related factors influence the size of control premiums — and the following
variables listed below tend to increase the likelihood of a higher control premium.
Revenue or Cost Synergies
Competition Among Buyers
Inflated Valuation Environment
“Cheap” Financing Available
Hostile Takeover
Shareholders’ Reluctance to Pay
Strategic Acquirer
The control premium can also appear higher for companies whose stock prices have been
underperforming as of late.
Thus, the yearly average share price performance must also be examined to understand the details
regarding the transaction, not just the trading price a few days before rumors or news articles began
to circulate.
However, the transaction considerations surrounding each acquisition are unique, e.g. a certain
premium could be reasonable to a buyer that anticipates realizing significant synergies, whereas the
same premium can be irrational and considered to be overpaying to another buyer.

Strategic Buyers vs. Financial Buyers in M&A

The buyer profile is a notable factor that influences the size of the control premium, i.e. if the
acquirer is a strategic acquirer or a financial buyer.
Strategic Buyer: Generally, premiums are higher in deals involving a strategic acquirer (i.e. a
company acquiring another company) rather than deals where the acquirer is a financial
buyer (e.g. a private equity firm). The reason is strategic acquirers can usually benefit
from more synergies, which directly raises the maximum amount it is willing to pay up to
for the target.
Financial Buyer: Conversely, financial buyers cannot benefit from synergies — and
overpaying is a frequent mistake that results in disappointing investment returns
(e.g. internal rate of return, money-on-money multiple). However, add-on
acquisitions are an exception, as PE-backed portfolio companies are typically then
acquiring smaller companies and can afford to pay more since synergies can be realized.

Control Premium Formula

The control premium formula consists of the two inputs.
1. Offer Price Per Share: The acquirer’s offer to purchase the target on a per-share basis.
 2. Current “Normalized” Price Per Share: The share price of the target before news of the
acquisition leaked, which causes upward or downward share price movement based on
how the market perceives the deal.
The control premium equals the offer price per share divided by the current price per share, minus
one.
Control Premium % = (Offer Price Per Share ÷ Current “Unaffected” Price Per Share) – 1
The control premium is expressed in percentage form, so the resulting figure must be multiplied by
100.
Ensuring that the current share price is “normalized” and depicts the pre-deal market price is a
crucial step — otherwise, the current share price includes the (positive or negative) impact of
rumors that could have leaked to the public prior to the official announcement of the acquisition.

Acquisition Target Speculation Example: Peloton (NASDAQ: PTON)

As an illustrative example of how rumors can impact share price, Peloton (NASDAQ: PTON), a seller
of exercise bikes and remote classes, saw its share price appreciate substantially due to the
pandemic and work-from-home (WFH) trends.
But in early 2022, Peloton reported a disappointing Q2-22 earnings report (and slashed its full-year
outlook due to lack of demand and supply chain issues).
The market capitalization of Peloton fell by around $8 billion — which is quite a steep drop-off from
a market cap that peaked near $50 billion.
An article by the Wall Street Journal (WSJ) fueled rumors about a potential takeover, with a list of
suitors that included Amazon, Nike, Apple, and Disney.
Soon after, Peloton’s shares surged more than 20% in a single day after a weekend of non-stop
speculation spread by the journalists and news coverage.
Despite the reports of interest being preliminary and there being no proof that Peloton had officially
hired a sell-side advisor to consider a sale, its share price was nevertheless elevated due to
speculation among investors.
 “Amazon, Other Potential Suitors Explore Peloton Deal” (Source: 
WSJ) 

Premiums Paid Analysis: M&A Valuation Method

Premiums paid analysis is a type of valuation wherein an investment bank compiles data on
comparable transactions and the estimated premiums paid for each.
By taking the average of the historical premiums, an implied range can be used as a reference to
guide negotiations of an acquisition on behalf of their client, either on the buy-side or sell-side.
Seller’s Perspective: Since the past premiums paid on comparable deals were evaluated, the
seller can rest assured that their sale price was maximized.
Buyer’s Perspective: On the other side, the buyer can confirm their offer value was near
what others paid, i.e. as a “sanity check” that they did not needlessly overpay.

Purchase Price Allocation and Goodwill in M&A

As part of purchase price allocation, if a premium is paid in an acquisition, the acquirer recognizes
the difference between the offer price and fair value of the target’s assets as “goodwill” on
its balance sheet.
Goodwill captures the excess purchase price over the fair value of the target’s assets — otherwise,
the accounting equation would not remain true (i.e. assets would NOT equal to liabilities +
shareholders’ equity).
Periodically, the acquirer will evaluate their goodwill account to check for signs of impairment. If
deemed so, there will be an appropriate reduction to the goodwill line item on the balance sheet in
the current period, as well as a write-off expense recorded on the income statement.

LBO Control Premium Calculation Example

Suppose a company’s shares are currently trading at $80 per share in the open markets.
Moreover, a private equity firm is pursuing an acquisition (LBO) of the company with an offer price
of $100.
Amid negotiations, rumors around buyout interest are leaked, and the target’s share price rises to
$95 per share.
So our question is, “What is the control premium if the deal ends up closing?”
First off, we know the unaffected share price is $80 (prior to the news leaking).
Offer Price Per Share = $100
Current Price Per Share = $80
The control premium in this case can be calculated using the following formula:
Control Premium = ($100 / $80) – 1
Control Premium = 0.25, or 25%
Therefore, in our simple scenario, the acquirer paid a 25% premium over the unaffected share price.

What is EV/EBITDA?
The EV/EBITDA Multiple compares the total value of a company’s operations (EV) relative to its
earnings before interest, taxes, depreciation, and amortization (EBITDA).
In practice, the EV/EBITDA multiple is frequently used in relative valuation to compare different
companies in the same (or similar) sector.

How to Calculate EV/EBITDA Multiple (Step-by-Step)

The enterprise value represents the debt-inclusive value of a company’s operations (i.e. unlevered)
while EBITDA is also a capital structure neutral cash flow metric.
Conceptually, the EV/EBITDA multiple answers the question, “For each dollar of EBITDA generated
by a company, how much are investors currently willing to pay?”
 Enterprise Value (EV): The numerator, the enterprise value, calculates the value of a
company’s operations, i.e. how much the company’s operations are worth from the
perspective of all stakeholders, such as debt lenders and common shareholders.
EBITDA: EBITDA stands for “earnings before interest, taxes, depreciation, and amortization”,
and is a widely used proxy for a company’s core operating cash flows (i.e. unlevered).
Learn More → Enterprise Value Quick Primer
The EV/EBITDA multiple, or “enterprise value to EBITDA”, is thus widely used to benchmark
companies of varying degrees of financial leverage.
Enterprise Value Multiple: Since EV/EBITDA is categorized as an enterprise value multiple,
ensure that the numerator and denominator represent the same investor groups – which
in this case, is all investor groups (e.g. common and preferred equity shareholders, debt
lenders). In other words, the cash flows must pertain to all providers of capital. For
example, interest expense must NOT be deducted from the cash flow metric used here,
as it is specific to one investor group, the lenders.
Equity Value Multiple: Unlike a levered valuation multiple such as the price to earnings ratio
(P/E ratio), the EV/EBITDA multiple accounts for the debt sitting on a company’s balance
sheet. Therefore, the EV/EBITDA multiple is frequently used to value potential acquisition
targets in M&A because it quantifies the amount of debt that the acquirer must assume
(i.e. cash-free, debt-free).
If there are two virtually identical companies with their leverage ratios consisting of the sole
difference (i.e. percentage of debt in the total capitalization), you’d expect the two EV/EBITDA
multiples to be similar.
While these two companies are very unlikely to actually be the same, in theory, the enterprise value
and EBITDA metrics are each independent of capital structure decisions, and thus it makes sense
that they would have similar EV/EBITDA multiples.
The process of calculating the EV/EBITDA multiple can be broken into three steps:
Step 1. Calculate Enterprise Value (Equity Value + Net Debt)
Step 2. Calculate EBITDA (EBIT + D&A)
Step 3. Divide Enterprise Value (EV) by EBITDA

EV/EBITDA Formula
The formula for calculating the EV/EBITDA multiple is as follows.
EV/EBITDA = Enterprise Value ÷ EBITDA
At their simplest, the two metrics can be calculated using the following formulas:
Enterprise Value (EV) = Equity Value + Net Debt
EBITDA = EBIT + Depreciation + Amortization

EV to EBITDA Multiple: Definition, Interpretation and Issues

What is a Good EV/EBITDA? (High or Low)
Generally, the lower the EV to EBITDA ratio, the more attractive the company may be as a potential
investment.
Low EV to EBITDA Ratio: Potentially Undervalued by Market
High EV to EBITDA Ratio: Potentially Overvalued by Market
However, there are no set rules on what determines a low or high EV/EBITDA valuation multiple
because the answer is contingent on the industry that the target company (i.e. the business being
valued) operates within.
For example, an EV/EBITDA multiple of 10.0x could be viewed as being on the higher end for a
consumer goods company. However, a software company valued at 10.0x may even be on the lower
end of the valuation range commonly found in the software industry.
Therefore, interpretations of valuation multiples are all relative and require more in-depth analyses
before making a subjective decision on whether a company is undervalued, fairly valued, or
overvalued.
Additionally, for that reason, comparisons of a company’s EV to EBITDA multiple should only be
made among companies that share similar characteristics and operate in similar industries.

Enterprise Value to EBITDA Multiple: Pros and Cons

For the most part, much of the criticism surrounding the usage of the EV/EBITDA multiple is around
the EBITDA metric.
To many industry practitioners, EBITDA is not an accurate representation of a company’s true cash
flow profile and can be misleading at times, especially for companies that are highly capital
intensive.

EBITDA Pros EBITDA Cons

Convenient to Calculate and Widely Criticized for Being an Inaccurate

Used by Industry Practitioners (e.g. Proxy for Operating Cash Flow
 Equity Research Reports, Financial
News)

Adds-Back Non-Cash Expenses – e.g. Despite the D&A Add-Back –

Depreciation & Amortization (D&A) Remains Prone to Accrual
Accounting and Management
Discretion

Most Appropriate for Mature Less Appropriate for Capital

Companies Late in their Lifecycle Intensive Industries (i.e. Does
with Minimal Capital Expenditures NOT Account for Capital
(Capex) Expenditures)

In certain scenarios, adjusted valuation multiples such as EV/(EBITDA – Capex) can be used instead,
which is oftentimes seen in industries like the telecom industry where there is the need to account
for capital expenditures due to the sheer degree of impact that CapEx has on the cash flows of
companies in these types of industries.

Seth Klarman Commentary on EBITDA (Source: Margin of Safety)

There is also much debate regarding the topic of “adjusted” EBITDA about whether certain line items
should be added back or not.
One notable example would be stock-based compensation (SBC), as certain people view it as a
straightforward non-cash add back, whereas others focus more on the net dilutive impact it has.
But regardless of its shortcomings as a measure of profitability, EBITDA still removes the impact of
non-cash expenses (e.g. depreciation and amortization) and remains one of the most commonly
used proxies for operating cash flow.

Step 1. Operating Assumptions

In our example exercise, we’ll be assuming three different scenarios for comparability, with the
capital intensity of each company as the changing variable.
First, let’s begin with the financial data that applies to all companies (i.e. is being kept constant).
Enterprise Value (EV): $400m
LTM EBIT: $40m
For all three companies, the value of the operations is $400m, while their operating income (EBIT) in
the last twelve months (LTM) is $40m.
With those data points, we can calculate the EV/LTM EBIT using the simple formula:
EV/LTM EBIT = $400m EV / $40m LTM EBIT
 EV/LTM EBIT = 10.0x
All three companies have an EV/LTM EBIT multiple of 10.0x – but now, we must account for D&A.
1. Low Capital Intensity: D&A = $10m
2. Base Case: D&A = $25m
3. High Capital Intensity: D&A = $40m
From the pattern above, we can recognize that the more capital-intensive the company, the higher
the D&A expense.

Step 2. EV/EBITDA Calculation Example

Using those listed D&A figures, we can add the applicable amount to EBIT to calculate the EBITDA for
each company.
Company A (Low): EBITDA = $40m + $10m = $50m
Company B (Base): EBITDA = $40m + $25m = $65m
Company C (High): EBITDA = $40m + $40m = $80m
Now, we can calculate the EV/EBITDA multiples for each company on an LTM basis.
Company A: $400m EV ÷ $50m = 8.0x
Company B: $400m EV ÷ $65m = 6.2x
Company C: $400m EV ÷ $80m = 5.0x

Step 3. EV to EBITDA Multiple Analysis

So, from our example calculation, we can see just how impactful the non-cash add-back, D&A, can
be on the EV/EBITDA valuation multiple of a company.
At the EV/EBIT level, the three companies are all valued at 10.0x, yet the EV/EBITDA multiple shows
a different picture.
EBITDA is a non-GAAP measure, therefore it is imperative to remain consistent in the calculation of
EBITDA, as well as be aware of which specific items are being added back. Otherwise, the comps-
derived valuation is susceptible to being distorted by misleading, discretionary adjustments.
What is EV/EBIT?
The EV/EBIT Multiple is the ratio between enterprise value (EV) and earnings before interest and
taxes (EBIT).
Considered one of the most frequently used multiples for comparisons among companies, the
EV/EBIT multiple relies on operating income as the core driver of valuation.

How to Calculate EV/EBIT Multiple (Step-by-Step)

Calculating the EV/EBIT multiple, or “enterprise value to EBIT”, comprises dividing the total value of
the firm’s operations (i.e. enterprise value) by the company’s earnings before interest and taxes
(EBIT).
Enterprise Value → The total value of a company’s operations attributable to all
stakeholders (e.g. equity shareholders, preferred stockholders, debt lenders).
EBIT → Used interchangeably with the term “operating income”, EBIT represents the
recurring profits generated by a company’s core operating activities.

EV/EBIT Formula
The formula for calculating the EV/EBIT multiple is as follows.
EV/EBIT Multiple = Enterprise Value ÷ EBIT
As for all valuation multiples, the general guideline is that the value driver (the denominator) must
be consistent with the valuation measure (numerator) in terms of the providers of capital
represented.
The EV-to-EBIT multiple abides by this rule because operating income (EBIT), like enterprise value, is
considered a metric independent of capital structure (i.e., is applicable to all shareholders, both debt
and equity holders).
Like all multiples, comparisons should only be done between similar companies in the same (or
adjacent) sectors, as each industry has its own standards for what the average multiple would be.

EV/EBIT vs. EV/EBITDA Multiple: What is the Difference?

Similar to the EV/EBITDA multiple, EV/EBIT is independent of the capital structure of the company,
whereas multiples like the P/E ratio are impacted by financing decisions.
Since both multiples are unaffected by differences in capital structure, the two are arguably the most
commonly relied-upon multiples in relative valuation.
Further, the two multiples each factor in the operating efficiency of a company (i.e., the ability to
convert revenue into operating profits).
However, one noteworthy distinction is that EV/EBIT accounts
for depreciation and amortization (D&A).
If the difference in the D&A expense is marginal within the comps set, as in the case of low capital-
intensity industries (e.g. service-oriented industries like consulting), then both will be relatively close
to one another.
But in contrast, given significant differences in D&A within capital-intensive industries (e.g.
manufacturing, industrials), the fact that EV/EBIT recognizes D&A may make it a more accurate
measure of value.
The recognition of D&A is associated with matching the cash outflows with the utilization of the
assets across their useful life. While D&A is a non-cash expense and thereby added back on the cash
flow statement, D&A results from capital expenditures, which can be a significant (and regular)
outflow for certain companies.

EV to EBIT Multiple: Definition, Interpretation and Issues

Enterprise Value-to-EBIT Multiple Commentary Slide (Source: 

WSP Trading Comps Course)

Step 1. Operating Assumptions

In our hypothetical scenario, we’ll be comparing three different companies.
Of the three companies, two of them fall into the category of low capital intensity (i.e., having less
CapEx / D&A), while one of them consists of high capital intensity (i.e., greater CapEx / D&A).
Each company shares the following financial statistics:
Enterprise Value (EV): $1bn
LTM EBITDA: $100m
Step 2. EV/EBIT Calculation Example
Upon putting these two data points together, we get an EV/LTM EBITDA of 10.0x for all three
companies.
But recall from earlier, the EV/EBITDA multiple can neglect differences in capital intensity, which is
the differentiating factor between the companies under comparison.
Each company has a different amount of D&A expense, with the expense being lower for the first
two companies, given the reduced capital intensity.
Company (1): D&A = $5m
Company (2): D&A = $7m
Company (3): D&A = $60m
Clearly, the third company is an outlier due to its substantially greater D&A expense.

Next, the EV/EBIT multiple can be calculated by dividing the enterprise value (EV) by the EBIT, which
we’ll complete for each company in order from left to right.
Company 1 → $1bn ÷ $95m = 10.5x
Company 2 → $1bn ÷ $93m = 10.8x
Company 3 → $1bn ÷ $40m = 25.0x
Note how the multiples are not too different for the first two companies, as those two companies
are less capital intensive.
When it comes to valuing companies comprised of low capital intensity, the EV/EBIT multiple is still a
useful tool, but it tends to come out in the same ballpark as the EV/EBITDA multiple.
Step 3. EV/EBIT Ratio Comps Valuation Analysis
Based on the range provided, the company characterized by high capital intensity (and incurs more
D&A) is an outlier, and is less useful as a point of comparison versus the other two.
Equity analysts and investors often use the EV/EBITDA multiple, which excludes the impact of D&A.
But while the EV/EBITDA multiple can come in useful when comparing capital-intensive companies
with varying depreciation policies (i.e., discretionary useful life assumptions), the EV/EBIT multiple
does indeed account for and recognize the D&A expense and can arguably be a more accurate
measure of valuation.

What is EV/Revenue Multiple?

The EV/Revenue Multiple is a ratio that compares the total valuation of a firm’s operations
(enterprise value) to the amount of sales generated in a specified period (revenue).
Generally, the EV/Revenue multiple is used for companies with negative or limited profitability.
How to Calculate EV/Revenue Multiple (Step-by-Step)
To briefly review, valuation multiples are measures of a particular financial metric as a ratio of
another, with the intention of serving as a basis of comparison between different companies.
The EV/Revenue multiple is most applicable for early-stage companies with high growth. Oftentimes,
these types of companies are either unprofitable or have limited profitability, which inhibits the use
of certain multiples like the EV/EBITDA multiple.
For the EV/EBITDA, EV/EBIT, and other related multiples to be effective valuation tools, the
companies in the comps set must be near or in the mature stages of their life cycles with relatively
stable operations and positive earnings.
Otherwise, the median or mean calculated from the peer group of companies under comparison will
not be meaningful or provide minimal insight into how the market values specific qualities of
companies in the relevant industry.
In the case of the enterprise value-to-revenue multiple, the two components are as follows:
1. Enterprise Value (EV): The total valuation of the firm’s operating assets and liabilities.
2. Revenue: The annual sales of a company, which is most commonly expressed on a last
twelve months (LTM) or next twelve months (NTM) basis.
Learn More → Valuation Multiple

EV/Revenue Formula
A valuation multiple will consist of a metric depicting value (i.e. price) in the numerator, with a
metric tracking operating performance in the denominator.
The enterprise value to revenue multiple formula is as follows.
EV/Revenue Multiple = Enterprise Value ÷ Revenue
To reiterate from earlier, this particular multiple is typically used for companies unprofitable not
only at the net income level (the “bottom line”) but also at the operating income (EBIT)
and EBITDA line.
Since more time is required for the companies to normalize and develop to a more sustainable level
that is more practical in terms of comparability, the multiple could be extended for several projected
years (e.g. NFY + 1, so two years forward) if the circumstances are appropriate.
Learn More → Enterprise Value Quick Primer

EV / Revenue Multiple: Definition, Interpretation and Issues

Enterprise Value to Revenue Multiple in SaaS Industry Valuation
For a significant percentage of early-stage SaaS companies, venture investors can be forced to use
the EV/Revenue multiple to value potential investments.
Given the absence of profits and a subscription-based business model that makes near-term
profitability under accrual accounting a poor indicator of a company’s future prospects, it should not
come as a surprise that the EV/Revenue multiple is heavily relied upon for these types of high
growth companies, but ordinarily a “last resort” option rather than a preferential choice.

How to Interpret EV to Revenue Ratio (High vs. Low)

A higher EV/Revenue multiple relative to competitors implies the market believes that the company
can generate revenue more efficiently in the future (and are willing to pay a premium for each dollar
of sales).
For investors pursuing undervalued companies (e.g. public equities) to purchase and obtain more
profitable returns, the lower the EV/Revenue multiple, the better.
A lower multiple can signal that a company is potentially undervalued and a worthwhile investment
to pursue.
But one significant limitation of the metric is that paying for growth is a subjective decision and just
because a company’s multiple is high, it does NOT necessarily indicate the company is overvalued
(e.g. Tesla, Amazon).
Here, investors are pricing in the potential (and positive outlook) for the company to monetize its
customer base better, which can be a risky yet often profitable bet.
Additionally, the multiple places significant weight on revenue as the primary valuation driver.
While growth in sales is one of the most influential factors in corporate valuation, other
considerations like profitability and free cash flows (FCFs) gain more importance over time,
especially as companies mature.

EV to Revenue Multiple Calculation Example

In our example scenario, the company we’ll be looking at has an enterprise value (EV) of $500m,
which will grow by $10m in the subsequent periods.
Last Twelve Months (LTM): $500m EV
Next Fiscal Year (NFY): $510m EV
Two-Year Forward (NFY + 1): $520m EV
Since we have projected our numerator, the enterprise value, we can move onto the
denominator(s).
As of the last twelve months, the following operating assumptions are used:
Revenue (LTM): $200m
EBIT (LTM): – $50m
EBITDA (LTM): – $20m
For each period of the forecast, the revenue, EBIT, and EBITDA grow by a step function of $50m (i.e.
increase each year by said amount).
Now, all that remains is dividing the enterprise value (EV) by the applicable financial metric to
calculate the three valuation multiples.
For instance, to calculate the EV/Revenue multiple, we divide the enterprise value by the revenue
generated in the relevant period.
EV/Rev. (LTM): $500m / $200m = 2.5x
EV/Rev. (NFY): $510m / $250m = 2.0x
EV/Rev. (NFY + 1): $520m / $300m = 1.7x

From the completed output sheet posted below, we can observe how the revenue multiple remains
within a narrow range in all three periods.
In contrast, the EV/EBIT and EV/EBITDA multiples are not meaningful (NM) for the earlier periods
due to the company being unprofitable.
But once the company gradually begins to turn profitable, the reliance on a revenue multiple would
likely decline, as the current profitability (and potential for margin expansion) start to drive the
valuation increasingly more.
To conclude, the EV/Revenue – despite its numerous drawbacks – can nevertheless be a practical
measure of value and facilitate comparisons among high-growth, unprofitable companies.
Similar to most variations of multiples analysis, beyond just calculating the multiple itself, you should
also appraise a target company’s strategic positioning within a sector and gain insights into the
industry-specific factors that cause higher (or lower) valuations.

What is Revenue Multiple?

A Revenue Multiple measures the valuation of an asset, such as a company, relative to the amount
of revenue it generates. While revenue-based multiples are seldom used in practice and are
perceived as a last resort, unprofitable companies often have no other option.

How to Calculate Revenue Multiple (Step-by-Step)

A revenue multiple is a form of relative valuation, where an asset’s worth is estimated by comparing
it to the market’s pricing of comparable assets.
Usually, multiples with revenue as the denominator are most often used to value companies with
negative profit margins that cannot be valued by other traditional valuation
multiples (e.g. EV/EBITDA, EV/EBIT).
In general, a revenue-based valuation multiples is rarely used unless there are no other options
available (i.e. if the company is unprofitable).
The two most common variations are the following:
Enterprise Value-to-Revenue (EV/Revenue)
Price-to-Sales Ratio (P/S)
Learn More → Valuation Multiple

Revenue Multiple Formula

Starting off, the EV/Revenue is the ratio between a company’s enterprise value and revenue.
EV/Revenue = Enterprise Value ÷ Revenue
Next, the price-to-sales ratio is the ratio between a company’s market capitalization (“market cap”)
and sales.
Price-to-Sales (P/S) = Market Capitalization ÷ Sales
The distinction between the two multiples is related to the necessity for the numerator and
denominator to match in terms of the group of stakeholders represented.
EV/Revenue → Enterprise Value Multiple
Price-to-Sales → Equity Value Multiple
The EV/Revenue calculates the value of the firm’s operations to all stakeholders, such as debt and
equity investors. In other words, the calculated valuation is the company’s enterprise value, which
represents the total firm value, i.e. the value of a company from the perspective of all of its
stakeholders, such as its common equity shareholders, preferred stockholders, and debt lenders.
The price-to-sales ratio, in contrast, calculates the equity value, otherwise known as a
company’s market capitalization. Unlike the enterprise value, the market cap is the residual value of
a company from the viewpoint of solely common shareholders.

Revenue Multiples: Pros and Cons

In comparison to earnings multiples, such as EV/EBITDA, revenue-based multiples are less prone to
discretionary accounting decisions by management that can skew results.
While earnings multiples are used far more frequently in practice, one major drawback is that
decisions such as the useful life assumption on depreciation, inventory recognition policies, and
research and development (R&D) spending can all influence the resulting implied valuation.
Revenue multiples can be used for companies that are either unprofitable or have limited
profitability, which is their primary use case.
The lack of profitability could be the result of the company being in the early stages of its lifecycle
(i.e. startups), or the company may currently be struggling to turn a profit.
On the other hand, revenue-based multiples neglect profitability, which arguably is the most
important factor that determines the long-term sustainability of a company.
All companies, at some point, must become profitable for their free cash flows (FCFs) to fund their
day-to-day operations and spending requirements. Often, revenue-based multiples can attach a
premium to high-growth companies without consideration of their profit margins and cost
management.

SaaS Valuation Multiples and Unprofitable Startups

For early-stage companies exhibiting high growth, an earnings multiple is not feasible if the company
is not yet profitable.
Oftentimes, the companies valued using revenue-based multiples are startups or late-stage growth
companies in very competitive markets that recently became publicly traded.
In the latter case, the competition in the market causes companies to prioritize growth and
increased scale over profitability.
While not optimal, a company’s negative earnings limit the ability to use traditional valuation
multiples, forcing reliance on other options.

Revenue Multiple Calculation Example

Suppose a company’s shares are currently priced at $10.00 each, with 5 million shares in circulation
on a diluted basis.
Current Share Price = $10.00
Diluted Shares Outstanding = 5 million
Given those two assumptions, the company’s market capitalization is $50 million.
Market Capitalization = $10.00 × 5 million = $50 million
We’ll also assume the company’s net debt balance (i.e. total debt less cash) is $10 million and its
revenue for the fiscal year 2021 is $20 million.
Net Debt = $10 million
Revenue = $20 million
The fact that the company’s net debt is half of its total revenue suggests operations are funded via
external financing, i.e. debt, rather than its own cash flows.
After adding the company’s net debt to its market capitalization, i.e. equity value, the enterprise
value (TEV) comes out to be $60 million.
Enterprise Value (TEV) = $50 million + $10 million = $60 million
We calculate the EV/Revenue and price-to-sales ratios as the following:
EV/Revenue = $60 million ÷ $20 million = 3.0x
Price-to-Sales = $50 million ÷ $20 million = 2.5x

What is EV/FCF?
The EV/FCF valuation multiple is a ratio comparing a company’s enterprise value (EV) to its free cash
flow to firm (FCFF).

How to Calculate EV/FCF?

The EV/FCF multiple is the ratio between enterprise value and free cash flow.
Enterprise Value (EV): The enterprise value measures the value of a company’s operations
from the perspective of all capital providers, such as debt lenders, common shareholders,
and preferred stockholders.
Free Cash Flow (FCF): Since the numerator is enterprise value, an unlevered metric, the free
cash flow to firm (FCFF) is the appropriate metric to use. FCFF, or “unlevered free cash
 flow,” is the FCF generated by a company’s core operations that belongs to all
stakeholders.
To ensure consistency in the valuation multiple – with respect to the group(s) of capital providers
represented – it is necessary for the cash flow metric to be free cash flow to firm (FCFF). Otherwise,
there is a mismatch in stakeholder representation in the numerator and denominator.
For instance, the free cash flow to equity (FCFE) metric reflects the cash flows attributable to only
equity holders, i.e. post-interest and mandatory debt repayments.
Thus, the corresponding measure of value in the numerator should be equity value (or “market
cap”), instead of enterprise value.

EV/FCF Formula
The formula to calculate the EV/FCF multiple is as follows.
EV/FCF = Enterprise Value ÷ Free Cash Flow to Firm (FCFF)
The two inputs are calculated using the following formulas.
Enterprise Value (TEV) = Equity Value + Net Debt + Preferred Stock + Minority Interest
Free Cash Flow to Firm (FCFF) = NOPAT + D&A – Increase in NWC – Capex

How to Interpret EV/FCF?

The EV/FCF multiple answers the question, “For each dollar of unlevered free cash flow (FCFF)
generated by a company, how much are investors currently willing to pay?”
Thus, the higher the EV/FCF ratio, the greater the premium attached to a dollar of a company’s
unlevered free cash flow (and vice versa).
However, the downside to using the EV/FCF multiple is that a company’s free cash flow to firm
(FCFF) tends to fluctuate substantially over time.
Based on the timing of certain events, such as periodic capital expenditures and cyclicality (or
seasonality) in working capital levels, the EV/FCF multiple can become distorted. In effect, the ratio
tends to be less practical for comparisons, which is the core premise of relative valuation.
Furthermore, the calculation of free cash flow to firm (FCFF) contains more discretionary decisions
with less standardization among practitioners, even more so than non-GAAP metrics like EBITDA
(and adjusted EBITDA).
For that reason, valuation multiples such as EV/EBITDA and EV/EBIT are far more prevalent in usage.

What’s the Difference Between EV/FCF vs. Unlevered FCF Yield?

The EV/FCF valuation multiple is the inverse of the unlevered FCF yield metric.
Unlevered FCF Yield (%) = Free Cash Flow to Firm (FCFF) ÷ Enterprise Value
The unlevered FCF yield metric reflects the cash remaining that is attributable to all providers of
capital (e.g. debt and equity), expressed in percentage form.

Step 1. Enterprise Value Calculation (EV)

Suppose you’re tasked with calculating the EV/FCF multiple of a company given the following set of
assumptions.
Latest Closing Share Price = $40.00
Total Diluted Shares Outstanding = 20 million
Net Debt = 200 million
By multiplying the share price by the total diluted shares outstanding, the equity value of the
company is $800 million.
Equity Value = $40.00 × 20 million = $800 million
To move from equity value to enterprise value (EV), we’ll add net debt, resulting in an enterprise
value of $1 billion.
Enterprise Value (EV) = $800 million + $200 million = $1 billion

Step 2. Free Cash Flow to Firm Calculation (FCFF)

In the next step, we’ll calculate our company’s free cash flow to firm (FCFF) using the following set of
assumptions.
EBIT = $160 million
Tax Rate = 25%
Depreciation and Amortization (D&A) = $4 million
Capital Expenditure (Capex) = ($5 million)
(Increase) / Decrease in NWC = ($2 million)
The starting point of the FCFF is NOPAT, which we’ll calculate by tax-affecting EBIT.
NOPAT = $160 million – ($160 million × 25%) = $120 million
From NOPAT, we’ll add D&A, subtract Capex, and subtract an increase in NWC to arrive at our
company’s free cash flow to firm (FCFF).
Free Cash Flow to Firm (FCFF) = $120 million + $4 million – $5 million – $2 million = $117
million

Step 3. EV/FCF Calculation Example

With our two inputs calculated, the final step is to divide our company’s enterprise value by its free
cash flow to firm (FCFF), which returns an EV/FCF multiple of 8.5x.
EV/FCF = $1 billion ÷ $117 million = 8.5x

What is EV/Invested Capital?

EV/Invested Capital is a valuation multiple that compares the enterprise value of a company in
relation to its invested capital, i.e. the sum of fixed assets and net working capital (NWC).
How to Calculate EV/Invested Capital?
The EV/Invested Capital (EV/IC) multiple is the ratio between a company’s enterprise value and its
invested capital.
Enterprise Value (EV): The enterprise value (EV), the numerator of this multiple, represents
the value of a company’s operations from the perspective of all stakeholders, i.e. all
group(s) of capital providers.
Invested Capital (IC): The invested capital (IC), the denominator of this multiple, refers to
the total fixed assets and net working capital (NWC) belonging to the company.
The numerator and denominator in a valuation multiple must match in terms of the represented
stakeholders, e.g. debt lenders, preferred stockholders, and/or common shareholders.
Since the invested capital (IC) metric – i.e. the sum of a company’s fixed assets and net working
capital (NWC) – pertains to all providers of capital, the rule is met.
The EV/invested capital multiple can be thought of as the enterprise value of a company, expressed
on the basis of each dollar of invested capital – i.e. the capital provided by its stakeholders – spent
on fixed assets (i.e. capital expenditure) and net working capital (NWC).

EV/Invested Capital Formula

The formula to calculate the EV/invested capital multiple is as follows.
EV/Invested Capital = Enterprise Value ÷ Invested Capital
Enterprise Value (EV) = Equity Value + Net Debt
Invested Capital (IC) = Fixed Assets + Net Working Capital (NWC)
Note that there is an alternative calculation of the EV/IC multiple, where “Invested Capital” is the
sum of total shareholders’ equity and total debt.
Invested Capital (IC) = Total Shareholders’ Equity + Total Debt
In that case, the EV/IC multiple describes enterprise value on the basis of each and every dollar
provided by shareholders and lenders, whereas the prior method – where invested capital is the sum
of a company’s fixed assets and net working capital (NWC) – only accounts for the spending on
operating items that actually drive future revenue generation.

EV/IC Multiple: Industry Cyclicality and Capital Intensity

Compared to other enterprise value multiples, such as EV/EBITDA or EV/EBIT, the EV/invested
capital multiple is not used as frequently.
The enterprise value to invested capital multiple is most applicable to companies with capital-
intensive business models, in which its historical and future revenue generation stems primarily
from the productivity of its fixed asset base.
The EV/IC multiple remains more stable in periods of cyclicality when the cash flows and earnings of
an entire industry – most often in capital-intensive industries such as oil and gas (O&G) – fluctuate
substantially.
While other valuation multiples like the price to earnings ratio (P/E) and EV/EBITDA can easily
become distorted from the prevailing market conditions, the EV/IC multiple has historically proven
to be a more independent (and thus a more reliable) measure of the state of current market pricing.

Step 1. Enterprise Value Calculation (EV)

Suppose you’re tasked with calculating the EV/Invested Capital of a manufacturing company given
the following assumptions.
Latest Closing Share Price = $30.00
Total Diluted Shares Outstanding = 60 million
Net Debt = $200 million
The equity value of the manufacturer can be determined by multiplying the share price by its total
diluted share count, which comes out to $1.8 billion.
Equity Value = $30.00 × 60 million = $1.8 billion
Next, adding net debt to the company’s equity value results in an enterprise value (EV) of $2 billion.
Enterprise Value (EV) = $1.8 billion + $200 million = $2 billion

Step 2. Invested Capital Calculation (IC)

For our assumptions regarding invested capital, we’ll assume the manufacturer has an outstanding
fixed asset balance of $700 million and net working capital (NWC) of $100 million.
Fixed Assets, net = $700 million
Net Working Capital (NWC) = $100 million
The sum of the two items is $800 million, which represents the invested capital portion of the
calculation.
Invested Capital (IC) = $700 million + $100 million = $800 million

Step 3. EV/Invested Capital Calculation Example

Upon dividing the manufacturer’s enterprise value (EV) by its invested capital (IC), the resulting
EV/invested capital multiple is 2.5x.
EV/Invested Capital = $2 billion ÷ $800 million = 2.5x

What is P/E Ratio?

The P/E Ratio, or “price-to-earnings ratio”, is a common valuation metric used to measure a
company’s equity value in relation to its net earnings.
Simply put, the P/E ratio of a company represents the amount that investors are currently willing to
pay for a dollar of the company’s net profit.

How to Calculate P/E Ratio?

Often referred to as the “earnings multiple,” the P/E ratio measures a company’s share price relative
to its earnings per share (EPS).
Once calculated, the price-to-earnings ratio of a company is then typically compared to its peer
group.
If you’re evaluating a potential investment, comparisons to other companies in the same industry
can be helpful in determining whether a stock is currently undervalued or overvalued.
Calculating the P/E ratio involves dividing the latest closing share price by its earnings per share, with
the EPS calculation consisting of the company’s net income (“bottom line”) divided by its total
number of shares outstanding.
Earnings Per Share (EPS) = Net Income ÷ Total Number of Diluted Shares Outstanding

P/E Ratio Formula

The formula for calculating the price-to-earnings ratio is as follows.
P/E Ratio = Market Share Price ÷ Earnings Per Share (EPS)
To account for the fact that a company could’ve issued potentially dilutive securities in the past,
the diluted share count should be used — otherwise, the EPS figure is likely to be overstated.
The market price of the shares issued by a company tells you how much investors are currently
willing to pay for ownership of the shares.
When combined with EPS, the P/E ratio helps gauge if the market price accurately reflects the
company’s earnings (or earnings potential).
The price to earnings ratio can also be calculated by dividing the company’s equity value (i.e. market
capitalization) by its net income.
Price to Earnings Ratio (P/E) = Equity Value ÷ Net Income
While the two formulas we’ve discussed thus far are conceptually the same, the answers usually
vary marginally from one another due to a minor discrepancy:
Earnings Per Share (EPS): The earnings per share (EPS) metric is calculated by using the
weighted average number of shares (i.e. beginning and ending period average).
Net Income: In contrast, the net income is the accounting profitability of a company that
measures operating performance across a period of time.

Quick P/E Ratio Calculation Example

For instance, let’s suppose that a company’s latest closing share price is $20.00 and its diluted EPS in
the last twelve months (LTM) is $2.00.
P/E Ratio = $20.00 Share Price ÷ $2.00 Diluted EPS = 10.0x
The market is currently willing to pay $10 for each dollar of earnings generated by the company. Said
differently, it would take approximately 10 years of accumulated net earnings to recoup the initial
investment.

Trailing vs. Forward PE Ratio: What is the Difference?

There are two common variations of the P/E ratio:
1. Trailing P/E Ratio: The price-to-earnings ratio is calculated using the earnings from the
actual performance in the last twelve months (LTM).
2. Forward P/E Ratio: The price-to-earnings ratio is calculated using the upcoming,
forecasted net earnings of a company.

What are the Pros and Cons of P/E Ratio?

Using a P/E ratio is most appropriate for mature, low-growth companies with positive net earnings.
The price-to-earnings ratio can be rather meaningless for early-stage companies that are barely
profitable or not yet profitable.
Here, the P/E ratio would be a significantly large multiple and not be comparable to industry peers
(i.e. as a complete outlier) — or even come out to be a negative number.
Either way, the P/E ratio would not be meaningful or practical for comparison purposes.
The price-to-earnings ratio uses EPS (or net income) in its formula, which comes with two major
pitfalls:
1. Accrual Accounting: EPS and net income are measures of profit under accrual
accounting, and are thereby prone to differences caused by management discretion (e.g.
depreciation useful life assumptions)
2. Skewed by Growth: For high-growth companies, the P/E ratio is likely going to be on the
higher end, which does NOT necessarily mean that the company is overvalued — instead,
the valuation multiple could very well be reasonably justified (i.e. investors expect the
company to increase its profitability in the future)

P/E Ratio Chart: Definition, Interpretation and Issues

 Price to Earnings Commentary Slide (Source: 
WSP Trading Comps Course)

What is a Good P/E Ratio?

Determining whether a company is undervalued, overvalued, or correctly priced by the market
requires more in-depth analysis and benchmarking to a variety of valuation multiples of comparable
peers.
High P/E Ratio: A higher ratio relative to that of peers can be interpreted as a potential sign
that the shares of the companies are overvalued — or that investors are projecting the
company’s earnings to rise.
Low P/E Ratio: A lower ratio relative to that of peers suggests that the company is either
undervalued or that investors expect its earnings to decline, which tends to coincide with
declining growth as the company reaches maturity.
While the P/E ratio is inadequate by itself, it can be a very useful metric when the situation is
appropriate and if supplemented with other metrics, namely when compared to the target
company’s industry peers.

How Does Debt Impact P/E Ratio?

The price-to-earnings ratio of similar companies could vary significantly due to differences in
financing (i.e. leverage).
If a company borrows more debt, the EPS (denominator) declines from the higher interest expense.
The extent of the share price impact largely depends on how the debt is used.
For example, increased risk and interest expense could cause the price-to-earnings ratio to decline,
while well-structured reinvestment for growth could cause the P/E ratio to increase and offset the
downsides of using debt.
For companies, the reliance on more debt financing adds more risk to equity investors, especially
considering their position at the bottom of the capital structure.
If there are two identical companies, investors are more likely to value the highly levered
company at a lower P/E ratio, given the higher leverage-related risks.
In practice, the P/E ratio is a widely used valuation multiple but has its limitations in being affected
by differing reporting standards, growth rates, and the capital structure of the companies being
compared.
Similar to all other financial metrics, the price-to-earning ratio should not be used alone to make
investment decisions.

1. Operating Assumptions
Suppose we’re tasked with calculating the price to earnings ratio of a hypothetical company given
the following assumptions:
Latest Closing Share Price = $10.00
Last Twelve Months (LTM) Net Income = $40mm
Next Twelve Months (NTM) Net Income = $60mm
Total Diluted Shares Outstanding = 50m — Both in LTM and NTM

2. Diluted Earnings Per Share Calculation (EPS)

In the next step, one input for calculating the P/E ratio is diluted EPS, which we’ll compute by
dividing net income in both periods (i.e. LTM and NTM basis) by the diluted share count.
Diluted EPS (LTM) = $40m Net Income ÷ 50mm Shares = $0.80
Diluted EPS (NTM) = $60m Net Income ÷ 50mm Shares = $1.20

3. P/E Ratio Calculation Analysis Example

Next, we can divide the latest closing share price by the diluted EPS we just calculated in the prior
step.
Trailing P/E Ratio = $10.00 Share Price ÷ $0.80 Diluted EPS = 12.5x
Forward P/E Ratio = $10.00 Share Price ÷ $1.20 Diluted EPS = 8.3x
Upon doing so, we arrive at 12.5x on the trailing basis and 8.3x on the forward basis, as shown
below.

What is the Forward P/E Ratio?

The Forward P/E Ratio is a variation of the price-to-earnings ratio in which a company’s forecasted
earnings per share (EPS) is used rather than its historical EPS.

How to Calculate Forward P/E Ratio (Step-by-Step)

The forward P/E ratio shows the relationship of a company’s price (today) to its forecasted earnings
per share (EPS).
The question answered by the forward P/E ratio is:
“How much are investors willing to pay today for a dollar of a company’s future earnings?”
A forward variation is sometimes used because a company’s future earnings could reflect its real
financial performance more accurately, i.e. the company’s future profitability is likely to change
substantially in the near term.
Most often, the companies valued using the forward multiples are high-growth companies that have
either yet to break even or are barely profitable today.
The implicit assumption is that in the coming year, the company will figure out methods to monetize
its customer base better and become more profitable.

Forward Multiples and Growth Cycle

High-growth companies typically prioritize acquiring new customers and achieving out-sized growth
at all costs, even if it means enduring an unsustainable cash burn rate.
The historical earnings are thereby assumed to be more-so “experimental” regarding identifying
their target customer profile and improving their go-to-market strategies for customer acquisition.
These companies can regularly afford to do so due to having a “cushion” to fall back on, i.e. existing
investors (or new investors) to provide them with more capital if needed.

Forward P/E Ratio Formula

The formula for calculating the forward P/E ratio divides a company’s share price by its estimated
earnings per share (EPS).
Forward P/E = Current Share Price ÷ Forecasted EPS

Forward PE Ratio vs. Trailing PE Ratio

By contrast, the trailing price-to-earnings ratio (P/E) – the more prevalent P/E ratio – relies on a
company’s historical EPS reported in a past period.
Trailing P/E = Current Share Price ÷ Historical EPS
The advantage of using the trailing P/E ratio is that the earnings metric is not based on discretionary
forward-looking assumptions, as the EPS figure can be confirmed as factual based on historical
performance.

Pros and Cons of Forward Multiples

Certain unprofitable companies have no other option but to use forward P/E ratios, as a negative
EPS would make the ratio meaningless.
However, forward valuation multiples are not used exclusively for unprofitable companies, as often
both the trailing and forward P/E ratios are often presented side by side.
One distinct benefit to forward P/E ratios is that the underlying company’s financials are
“normalized,” e.g. the effects of non-recurring items are removed.
The limitation to the forward P/E ratio is its reliance on forecasting estimated earnings, causing it to
be subject to bias (and perhaps leading to an implied value that deviates from reality).
Since forward P/E ratios are based on the subjective opinions of different equity analysts, the ratios
can vary substantially from person to person, as each individual has their own unique perspective on
a company’s growth potential.

Forward PE Calculation Example

Suppose a company’s market share price is currently $30.00 as of the latest closing date.
The company’s earnings per share (EPS) in 2021 – i.e. on a last twelve months (LTM) basis – was
reported a loss of ten cents.
Current Share Price = $30.00
EPS 2021A = ($0.10)
Based on estimates from equity analysts, the company’s EPS is expected to reach $0.50 in 2022 and
then $1.50 in 2023.
EPS 2022E = $0.50
EPS 2023E = $1.50
Using the current share price, the trailing, one-year forward, and two-year forward P/E ratio can be
calculated.
Trailing P/E = $30.00 / ($0.10) = NM
One-Year Forward P/E = $30.00 / $0.50 = 60.0x
Two-Year Forward P/E = $30.00 / $1.50 = 20.0x
The trailing P/E is not meaningful (i.e. “NM”) because of the negative EPS figure.
The EPS in the one-year forward P/E is no longer negative, but since the company is still barely
profitable, the calculated 60.0x P/E ratio is still not too useful.
The two-year forward P/E comes out to 20.0x, which is more practical for performing valuation
analysis and for comparisons against industry peers.
The longer the forecast, the more a company’s earnings tend to normalize over time and converge
towards the industry average, which is why multiples decline as a company matures.
However, the fact that the two-year forward EPS is from a projection model that was based on
discretionary assumptions causes it to be less credible.
What is Trailing P/E Ratio?
The Trailing P/E Ratio is calculated by dividing a company’s current share price by its most recent
reported earnings per share (EPS), i.e. the latest fiscal year EPS or the last twelve months (LTM) EPS.

How to Calculate Trailing P/E Ratio ?

The trailing price-to-earnings ratio is based on a company’s historical earnings per share (EPS) as
reported in the latest period and is the most common variation of the P/E ratio.
If equity analysts are discussing the price-to-earnings ratio, it would be reasonable to assume that
they are referring to the trailing price-to-earnings ratio.
The trailing P/E metric compares a company’s price as of the latest closing date to its most recently
reported earnings per share (EPS).
The question answered by the trailing price-to-earnings is:
“How much is the market willing to pay today for a dollar of a company’s current earnings?”
In general, the historical valuation ratios tend to be most practical for mature companies exhibiting
low-single-digit growth.
Learn More → Valuation Multiple

Trailing P/E Ratio Formula

Calculating the trailing P/E ratio involves dividing a company’s current share price by its historical
earnings per share (EPS).
Trailing P/E = Current Share Price ÷ Historical EPS
Where:
 Current Share Price: The current share price is the closing share price as of the latest trading
date.
Historical EPS: The historical EPS is the EPS value as announced in the latest fiscal year (10-K)
or the latest LTM period based on the company’s most recent quarterly report (10-Q).

Trailing P/E Ratio vs. Forward P/E Ratio: What is the Difference?
The main benefit of using a trailing P/E ratio is that unlike the forward P/E ratio – which relies on
forward-looking earnings estimates – the trailing variation is based on historical reported data from
the company.
While there can be adjustments made that can cause the trailing P/E to differ between different
equity analysts, the variance is much less than that of the forward-looking earnings estimates across
different equity analysts.
Trailing P/E ratios are based on the reported financial statements of a company (“backward-
looking”), not the subjective opinions of the market, which is prone to bias (“forward-looking”).
But sometimes, a forward P/E ratio can be more practical if a company’s future earnings reflect its
true financial performance more accurately. For instance, a high-growth company’s profitability
could change significantly in the upcoming periods, despite perhaps showing low-profit margins in
current periods.
Unprofitable companies are unable to use the trailing P/E ratio because a negative ratio causes it to
be meaningless. In such cases, the only option would be to use a forward multiple.
One drawback to trailing P/E ratios is that the financials of a company can be skewed by non-
recurring items. In contrast, a forward P/E ratio would be adjusted to portray the normalized
operating performance of the company.

Trailing PE Ratio Calculation Example

Suppose a company’s latest closing share price was $50.00.
The most recent earnings report for the company was for its fiscal year 2021 performance, in which
it announced earnings per share (EPS) of $3.25.
Current Share Price = $50.00
Earnings Per Share (EPS) = $3.25
Using those two assumptions, the trailing P/E ratio can be calculated by dividing the current share
price by the historical EPS.
Trailing P/E = $50.00 / $3.25 = 15.4x
The company’s P/E on a trailing basis is 15.4x, so investors are willing to pay $15.40 for a dollar of
the company’s current earnings.
The 15.4x multiple would need to be compared against the company’s industry peers to determine if
it is undervalued, fairly valued, or overvalued.
What is the Justified P/E Ratio?
The Justified P/E Ratio is a variation of the price-to-earnings ratio linked to the Gordon Growth
Model (GGM) in an effort to better understand a company’s underlying performance.

How to Calculate Justified P/E Ratio?

The justified P/E ratio can be thought of as an adjusted variation of the traditional price-to-earnings
ratio that aligns with the Gordon Growth Model (GGM).
The Gordon Growth Model (GGM) states that a company’s share price is a function of its next
dividend payment divided by its cost of equity less the long-term sustainable dividend growth rate.
Current Share Price (Po) = [Do * (1 + g)] / (k – g)
Where:
Do = Current Dividend Per Share (DPS)
g = Sustainable Dividend Growth Rate
k = Cost of Equity
Moreover, if we divide both sides by the EPS – the current share price and the dividend per share
(DPS) – we are left with the justified P/E ratio.

Justified P/E Ratio Formula

The formula to calculate the justified P/E ratio is as follows.
Justified P/E Ratio = [(DPS / EPS) * (1 + g)] / (k – g)
Note how the “(DPS / EPS)” component is the dividend payout ratio %.
Since the payout ratio is expressed in the form of a percentage, the GGM formula is effectively
converted into the justified P/E ratio.
Trailing: If the EPS used is the current period historical EPS, the justified P/E is on a “trailing”
basis.
Forward: If the EPS used is the forecasted EPS for a future period, the justified P/E is on a
“forward” basis.

Core Value Drivers of the Justified P/E Ratio

The fundamental drivers that impact the justified P/E are the following:
1) Inverse Relationship with Cost of Equity
Higher Cost of Equity → Lower P/E
Lower Cost of Equity → Higher P/E
2) Direct Relationship with Dividend Growth Rate
Higher Dividend Growth Rate → Higher P/E
Lower Dividend Growth Rate → Lower P/E
3) Direct Relationship with Dividend Payout Ratio (%)
Higher Payout Ratio % → Higher P/E
Lower Payout Ratio % → Lower P/E
Therefore, the justified P/E ratio indicates that a company’s share price should rise from a lower cost
of equity, higher dividend growth rate, and higher payout ratio.

1. Current Share Price Calculation Example

Suppose a company paid a dividend per share (DPS) of $1.00 in the most recent reporting period.
Dividend Per Share (Do) = $1.00
Sustainable Dividend Growth Rate = 2%
As for the rest of our model assumptions, the company’s cost of equity is 10% and the sustainable
dividend growth rate is 2.0%
Dividend Growth Rate (g) = 2%
Cost of Equity (ke) = 10%
If we grow the current dividend by the growth rate assumption, the next year’s dividend is $1.02.
Next Year Dividend Per Share (D1) = $1.00 * (1 + 2%) = $1.02
Using those assumptions, the justified share price comes out as $12.75.
Current Share Price (Po) = $1.02 /(10% – 2%) = $12.75

2. Justified P/E Ratio Calculation Example

In the next part, we will calculate the justified P/E ratio.
However, we are missing one assumption, the reported earnings per share (EPS) of our company in
the past year – which we’ll assume was $2.00.
Earnings Per Share (EPS) = $2.00
But if we were to divide both sides by EPS, we can calculate the justified P/E ratio.
Justified P/E Ratio = [($1.00 / $2.00) * (1 + 2%)] / (10% – 2%) = 6.4x
In closing, we can cross-check the implied share price from the justified P/E and the current share
price to ensure our calculation is correct.
After multiplying the justified P/E of 6.4x by the historical EPS of $2.00, we calculate the implied
current share price as $12.75, which matches the Po from earlier.
Implied Current Share Price (Po) = 6.4x * $2.00 = $12.75

What is Price to Book Ratio?

The Price to Book (P/B Ratio) measures the market capitalization of a company relative to its book
value of equity. Widely used among the value investing crowd, the P/B ratio can be used to identify
undervalued stocks in the market.

How to Calculate Price to Book Ratio (P/B)?

The price to book ratio, often abbreviated as the “P/B ratio”, compares the current
market capitalization (i.e. equity value) to its accounting book value.
Market Capitalization → The market capitalization is calculated as the current share price
multiplied by the total number of diluted shares outstanding. Conceptually, the market
cap represents the pricing of a company’s equity according to the market, i.e. what
investors currently believe the company to be worth.
Book Value (BV) → The book value (BV) on the other hand, is the net difference between
the carrying asset value on the balance sheet less the company’s total liabilities. The book
value reflects the value of the assets that a company’s shareholders would receive if the
company was hypothetically liquidated (and the book value of equity is an accounting
metric, rather than based on the market value).
Since the book value of equity is a levered metric (post-debt), the equity value is used as the point of
comparison, rather than the enterprise value, to avoid a mismatch in the represented capital
provider(s).
For the most part, any financially sound company should expect its market value to be greater than
its book value, since equities are priced in the open market based on the forward-looking anticipated
growth of the company.
If the market valuation of a company is less than its book value of equity, that means the market
does not believe the company is worth the value on its accounting books. Yet in reality, a company’s
book value of equity is seldom lower than its market value of equity, barring unusual circumstances.

Price to Book Ratio Formula (P/B)

The price to book ratio (P/B) is calculated by dividing a company’s market capitalization by its book
value of equity as of the latest reporting period.
Price to Book Ratio (P/B) = Market Capitalization ÷ Book Value of Equity
Or, alternatively, the P/B ratio can also be calculated by dividing the latest closing share price of the
company by its most recent book value per share.
Price to Book Ratio (P/B) = Market Share Price ÷ Book Value of Equity Per Share

What is a Good Price to Book Ratio?

The norm for the P/B varies by industry, but a P/B ratio under 1.0x tends to be viewed favorably and
as a potential indication that the company’s shares are currently undervalued.
While P/B ratios on the lower end can generally suggest a company is undervalued and P/B ratios on
the higher end can mean the company is overvalued — a closer examination is still required before
any investment decision can be made. From a different perspective, underperformance can lead to
lower P/B ratios, as the market value (i.e. the numerator) should rightfully decrease.
P/B Ratio < 1.0x → A sub-1.0x P/B ratio should NOT be immediately interpreted as a sign
that the company is undervalued (and is an opportunistic investment). In fact, a low P/B
ratio can indicate problems with the company that could lead to value deterioration in
the coming years (i.e. a “red flag”).
P/B Ratio > 1.0x → Companies with P/B ratios far exceeding 1.0x could be a function of
recent positive performance and a more optimistic outlook on the company’s future
outlook by investors.
The price to book ratio is more appropriate for mature companies, like the P/E ratio, and is
especially accurate for those that are asset-heavy (e.g. manufacturing, industrials).
The P/B ratio is also typically avoided for companies composed mostly of intangible assets (e.g.
software companies) since most of their value is tied to its intangible assets, which are not recorded
on a company’s books until the occurrence of an event such as an acquisition.
Price to Book Ratio Summary: Definition, Description and Issues

1. Price to Book Ratio Calculation Example (Market Cap Approach)

For our example exercise calculating the P/B ratio, we’ll be going through the steps for the two
approaches we mentioned earlier.
The shared assumptions are listed below:
Latest Closing Share Price = $25.00
Total Diluted Shares Outstanding = 100 million
With those two provided metrics, we can calculate the market capitalization as $2.5bn
Market Capitalization = Latest Closing Share Price × Total Diluted Shares Outstanding
Market Capitalization = $25.00 × 100 million = $2.5 billion
Now that the calculation for the numerator is done, we can now move to the denominator.
The assumptions for the book value of equity can be found below:
Assets = $5 billion
Liabilities = $4 billion
Upon subtracting Liabilities from Assets, we can calculate the book value of equity (BVE).
Book Value of Equity (BVE) = Assets – Liabilities
BVE = $5 billion – $4 billion = $1 billion
The final step of our price to book ratio calculation under the first approach is to divide our
company’s market cap by its book value of equity (BVE).
P/B Ratio = Market Capitalization ÷ Book Value of Equity
P/B Ratio = $2.5 billion ÷ $1 billion = 2.5x
2. P/B Ratio Calculation Example (Share Price Approach)
In the next part of our exercise, we’ll calculate the P/B ratio using the share price approach, so the
corresponding metric is the book value of equity per share (BVPS).
Since we already have the latest closing share price, the only remaining step is to adjust the book
value of equity (BVE) to a per-share basis.
Book Value Per Share (BVPS) = $1 billion ÷ $100 million = $10.00
In our last step, we’ll divide the current share price by the BVE per share.
P/B Ratio = Latest Closing Share Price ÷ Book Value Per Share
P/B Ratio = $25.00 ÷ $10.00 = 2.5x

Like the first approach, in which we divided the market capitalization by the book value of equity, we
arrive at a P/B ratio of 2.5x.
In conclusion, whether the company is undervalued, fairly valued, or overvalued will depend on how
the company’s ratios compare with the industry average multiples, as well as the fundamentals of
the company.
To reiterate from earlier, the P/B ratio is a screening tool for finding potentially undervalued stocks,
but the metric should always be supplemented with in-depth analyses of the underlying value
drivers.
What is Price to Sales?
The Price to Sales Ratio measures the value of a company in relation to the total amount of annual
sales it has recently generated.

How to Calculate the Price to Sales Ratio?

Often referred to as the “sales multiple”, the P/S ratio is a valuation multiple based on the market
value that investors place on the revenue belonging to a company.
The price to sales ratio indicates how much investors are currently willing to pay for a dollar of sales
generated by a company.
In short, the P/S ratio tells us how much value the market places on the sales of a specific company,
which is determined by the quality of revenue (i.e. customer type, recurring vs. one-time), as well as
expected performance.
Higher P/S ratios can often serve as an indication that the market is currently willing to pay a
premium for each dollar of sales.
Learn More → Valuation Multiple

Price to Sales Ratio Formula (P/S)

The price to sales ratio (P/S) can be calculated by dividing the latest closing share price by its sales
per share as of the latest reporting period — which is ordinarily the latest fiscal year, or an
annualized figure (i.e. trailing twelve months with a stub-period adjustment).
Formula
Price to Sales Ratio (P/S) = Latest Closing Share Price ÷ Revenue Per Share
Another method to calculate the P/S ratio involves dividing the market capitalization (i.e. total equity
value) by the total sales of the company.
Formula
Price to Sales Ratio (P/S) = Market Capitalization ÷ Annual Revenue

How to Interpret Price to Sales Ratio (High or Low)

A low price-to-sales ratio relative to industry peers could mean that the shares of the company are
currently undervalued.
The standard acceptable range of the P/S ratio varies across industries.
Hence, benchmarking the ratio must be done among similar, comparable companies.
Alternatively, a ratio in excess of its peer group could indicate the target company is overvalued.
The major downside of the price-to-sales ratio that tends to reduce its reliability is that the P/S ratio
does NOT factor in the profitability of companies.
While the main advantage of using the P/S ratio is that it can be used to value companies that are
yet to be profitable at the operating income (EBIT), EBITDA, or net income line, this fact is also the
main drawback.
Since the price-to-sales ratio neglects the current or future earnings of companies, the metric can be
misleading for unprofitable companies.
Additionally, the P/S ratio fails to account for the leverage of the company being evaluated – which
is why many prefer to use the EV/Revenue multiple.

Price to Sales Ratio Calculation Example (P/S)

In our hypothetical scenario, in which we’ll calculate the price-to-sales ratio, we’ll compare three
different companies.
For all three companies – Company A, B, and C – we’ll use the following assumptions:
Latest Closing Share Price: $20.00
Diluted Shares Outstanding: 100mm
With those two assumptions, we can calculate the market capitalization for each company.
Market Capitalization = $20.00 Share Price × 100mm Diluted Shares Outstanding
Market Capitalization = $2bn
Next, we’ll list the assumptions related to each company’s sales and net income in the last twelve
months (LTM).
Company A: Sales of $1.5bn and Net Income of $250mm
Company B: Sales of $1.3bn and Net Income of $50mm
Company C: Sales of $1.1bn and Net Income of -$150mm
If we compute the P/E ratio for our example peer group, we’d get:
Company A: $2bn ÷ 250mm = 8.0x
Company B: $2bn ÷ 50mm = 40.0x
Company C: $2bn ÷ -150mm = NM
From the list above, the P/E ratios provide minimal insight into the valuation of the three companies.
The P/E ratio tends to be most useful for mature, stable companies. But here, Company B and C each
have P/E ratios that are not meaningful due to being barely profitable or not profitable.
If we calculate the P/S ratios for these same three companies, we can obtain a better understanding
of how the market is valuing each in comparison to one another.
Company A: $2bn ÷ 1.5bn = 1.3x
Company B: $2bn ÷ 1.3bn = 1.5x
Company C: $2bn ÷ 1.1bn = 1.8x
In closing, we can see how the price-to-sales ratios are typically in a more compact range, which
helps make comparisons more practical, unlike the P/E ratios that can deviate far from one another.
From the example we just completed, it’s clear why the price-to-sales ratio is frequently used (or
oftentimes is the only option) for companies struggling to get past the break-even point or are
unprofitable.

What is PEG Ratio?

The PEG Ratio, shorthand for “price/earnings-to-growth,” is a valuation metric that standardizes the
P/E ratio against a company’s expected growth rate.
Unlike the traditional price-to-earnings ratio (P/E), which tends to be used more frequently among
investors, the PEG ratio accounts for the future growth of the company.

How to Calculate PEG Ratio?

The price/earnings-to-growth ratio, or “PEG ratio”, addresses one of the primary weaknesses of
the price-to-earnings (P/E) ratio, which is the lack of consideration for future growth.
Because the P/E ratio is adjusted for the expected earnings growth rate, the PEG ratio can be viewed
as a more accurate indicator of a company’s true value.
In effect, investors can use the ratio to make more well-informed decisions on whether the market
valuation of a stock is currently undervalued or overvalued.
But similar to the P/E ratio, there are two notable pitfalls to the metric:
1. Positive Net Earnings → The company must have positive net income (the “bottom line”)
2. Later-Stage of Lifecycle → While growth is considered in the formula, companies with
significant volatility in growth may not be suited for usage of the metric
For the reasons mentioned above, the ratio is most appropriate for mature, low to mid-level growth
companies, and near meaningless for those with negative earnings or negative projected growth.
Additionally, the ratio uses an accounting measure of profit, net income. Often, accounting profits
can be misleading at times due to the:
Inclusion of Non-Cash Expenses (e.g. Depreciation & Amortization)
Differences in Accounting Treatment (e.g. Straight-Line Depreciation, Revenue / Cost
Recognition Policies)
Overall, accounting measures of profits are prone to discretionary management decisions, which
creates room for the “manipulation” of profits to paint a misleading depiction of the
company’s profitability.

PEG Ratio Formula

The PEG formula consists of calculating the P/E ratio and then dividing it by the long-term
expected EPS growth rate for the next couple of years.
PEG Ratio = P/E Ratio ÷ Expected EPS Growth Rate
It is essential to use a long-term growth rate that is considered sustainable.
While historical growth rates could be used (or at least referenced), intuitively it would not make
much sense as investors value companies based on future growth, NOT historical growth – albeit the
two are closely related.
Note that companies often issue potentially dilutive securities to shareholders and employees. Thus,
the total diluted shares outstanding must be used to avoid inflating the earnings per share (EPS)
figure.

PEG Ratio: Definition, Interpretation and Issues

 Price/Earnings-to-Growth (PEG) Ratio Commentary Slide (Source: 
WSP Trading Comps Course)

What is a Good PEG Ratio?

As a general rule of thumb, if a company’s PEG ratio exceeds 1.0x, the stock is considered to be
overvalued, whereas a company with a PEG of less than 1.0x is considered to be undervalued.
Besides being an internal measure, the ratio can be compared to a company’s industry peer group,
Unlike a standard P/E ratio, the PEG allows for comparisons across a broader range of company
types, notably between companies with different growth rates.
However, this does not mean that a company with an EPS growing at 2% can necessarily be
compared to a company with EPS growth forecasted at growing 50% year-over-year.
Instead, the differences in growth rates should be relatively reasonable – or, said differently,
companies should be at similar stages in their lifecycles to warrant a meaningful comparison.
Higher PEG Ratio → Higher ratios in comparison to peers could be interpreted as a
*potential* sign that the stock is overvalued (i.e. the market is placing too much value on
the future growth of the company)
Lower PEG Ratio → Lower ratios in comparison to peers is a *potential* sign that the
company might be undervalued and/or the market is neglecting the expected earnings
growth

Simple PEG Ratio Calculation Example

For instance, if a company’s latest closing share price is $5.00 and its diluted EPS in the last twelve
months (LTM) is $2.00, we can compute the P/E ratio as follows:
P/E Ratio = $30 Share Price / $5.00 Diluted EPS
P/E Ratio = 6.0x
Assuming the company’s expected EPS growth rate is 2.0%, the ratio can be calculated as:
PEG Ratio = 6.0x P/E Ratio / 4.0% EPS Growth Rate = 1.5x
Based on our calculated ratio of 1.5x, the company would be deemed overvalued since it exceeds
1.0x.

Price/Earnings-to-Growth Ratio Calculation Analysis

Let’s get started – below are the assumptions we’ll be using for all three cases for Companies A, B,
and C:
Latest Closing Share Price = $100.00
Earnings Per Share (EPS) = $10.00
With that said, the P/E ratio can be calculated by just dividing the share price by the EPS.
P/E Ratio = $100.00 / $10.00
P/E Ratio = 10.0x
As of the present day, the market is willing to pay $10 for one dollar of these companies’ earnings.
The remaining step is to divide the P/E ratio by the EPS growth rate (g), which is where the
differences amongst each of the companies lie.
Company A: g = 10.0%
Company B: g = 15.0%
Company C: g = 5.0%
From those assumptions, Company A is our base case, Company B is our upside case (i.e. high
growth), and Company C is our downside case (i.e. low growth).
The calculation in Excel has been shown below.
Once the process is done for each scenario (Company A, B, and C), we get the following PEG ratios:
Company A = 1.0x
Company B = 0.7x
Company C = 2.0x
While there are further complexities that must be taken into consideration, from our exercise, we’d
interpret these findings are:
Company A is fairly valued (i.e. neither undervalued nor overvalued)
Company B is undervalued and potentially a profitable investment
Company C is overvalued and a potential “sell” if a portfolio holding
If we were to rely solely on the P/E ratio, each company would have a P/E ratio of 10.0x.
But upon adjusting for the differences in the expected EPS growth rates, we derive more insights
into the market values of the three companies.
In conclusion, a screenshot of the finished output sheet can be found below.

What is Price to Cash Flow?

The Price to Cash Flow Ratio (P/CF) evaluates the valuation of a company’s stock by comparing its
share price to the amount of operating cash flow produced.
Unlike the price-to-earnings ratio (P/E), the P/CF ratio removes the impact of non-cash items such as
depreciation & amortization (D&A), which makes the metric less prone to manipulation via
discretionary accounting decisions.
How to Calculate Price to Cash Flow Ratio (P/CF)?
The price to cash flow ratio (P/CF) is a common method used to assess the market valuation of
publicly-traded companies, or more specifically, to decide if a company is undervalued or
overvalued.
The P/CF ratio formula compares the equity value (i.e. market capitalization) of a company to its
operating cash flows.
Market Capitalization: The market capitalization (or “market cap”) is calculated by
multiplying the latest closing share price by the total number of diluted shares
outstanding.
Cash Flow from Operations (CFO): While operating cash flow typically refers to cash from
operations from the cash flow statement (CFS), other variations of levered cash flow
metrics could be used, instead. On the cash from operations (CFO) section of the CFS, the
starting line item is net income, which is adjusted for non-cash items like D&A and
changes in net working capital (NWC).
In short, the P/CF represents the amount that investors are currently willing to pay for each dollar of
operating cash flow generated by the company.

Price to Cash Flow Ratio Formula (P/CF)

The formula for P/CF is simply the market capitalization divided by the operating cash flows of the
company.
Price to Cash Flow (P/CF) = Market Capitalization ÷ Cash Flow from Operations
Alternatively, P/CF can be calculated on a per-share basis, in which the latest closing share price is
divided by the operating cash flow per share.
Price-to-Cash Flow (P/CF) = Share Price ÷ Operating Cash Flow Per Share
To calculate the operating cash flow per share, there are two financial metrics required:
1. Cash from Operations (CFO): The company’s annual operating cash flow.
2. Total Diluted Shares Outstanding: The total number of total outstanding shares,
inclusive of the effect of potentially dilutive securities like options and convertible debt.
By dividing the two figures, we arrive at the operating cash flow on a per-share basis, which must be
done to match the numerator (i.e. the market share price).
Note that the share price used in the formula must reflect a “normalized” share price; i.e., that there
are no abnormal, share price movements temporarily affecting the current market valuation.
Otherwise, the P/CF will be skewed by one-time, non-recurring events (e.g. news leakage of
potential M&A).

What is a Good Price to Cash Flow Ratio?

The P/CF is most useful for evaluating companies that have positive operating cash flow but are not
profitable on an accrual accounting basis due to non-cash charges.
In other words, a company could have negative net income yet be profitable (in terms of generating
positive cash flows) after non-cash expenses are added back.
Following the adjustments to net income, which is the purpose of the top section of the cash flow
statement, we can get a much better sense of the company’s profitability.
Regarding the general rules for interpreting the P/CF ratio:
Low P/CF Ratio: The company’s shares could potentially be undervalued by the market – but
further analysis is required.
High P/CF Ratio: The company’s share price could potentially be overvalued by the market,
but again, there might be a particular reason as to why the company is trading at a higher
valuation than peer companies. Further analysis is still required.

Price to Cash Flow (P/CF) vs. Price to Earnings (P/E)

Equity analysts and investors often prefer the P/CF ratio over the price-to-earnings (P/E) since
accounting profits – the net earnings of a company – can be manipulated more easily than operating
cash flow.
Hence, certain analysts prefer the P/CF ratio over the P/E ratio, since they view P/CF as a more
accurate depiction of a company’s earnings.
P/CF is especially useful for companies with positive free cash flow, which we are defining as cash
from operations (CFO), but are not profitable at the net income line because of substantial non-cash
charges.
Non-cash charges are added back to the cash flow statement in the cash from operations section to
reflect that they are not actual outflows of cash. For example, depreciation is added back because
the real outflow of cash occurred on the date of the capital expenditure (Capex).
To comply with accrual accounting rules, the purchase of fixed assets must be spread across
the useful life of the asset. The issue, however, is that the useful life assumption can be discretionary
and thereby creates the opportunity for misleading accounting practices.
Either way, both the P/CF and P/E ratios are used widely among retail investors, primarily for their
convenience and ease of calculating.

P/CF Ratio Limitations

Capital Expenditure (Capex): The main limitation of the P/CF ratio is the fact that capital
expenditures (Capex) are not removed from operating cash flow. Considering the
significant impact Capex has on the cash flows of a company, the ratio of a company can
be skewed by the exclusion of Capex.
Limited or Lack of Profitability: Next, similar to the P/E ratio, the P/CF ratio cannot be used
for truly unprofitable companies, even after adjusting for non-cash expenses. In such
scenarios, the P/CF will not be meaningful and other revenue-based metrics such as the
price-to-sales multiple would be more useful.
Early-Stage Companies: Further, for companies in their very early stages of development,
high P/CF ratios are going to be the norm, and comparisons to mature companies in
different stages in their lifecycles will not be too informative. High-growth companies are
mostly valued based on their future growth prospects and the potential to someday
become more profitable once growth slows down. Depending on the industry, the
average P/CF will be different, although a lower ratio is generally considered to be a sign
that the company is relatively undervalued.

1. P/CF Ratio Model Assumptions

In our example scenario, we have two companies that we’ll refer to as “Company A” and “Company
B”.
For both companies, we’ll be using the following financial assumptions:
Latest Closing Share Price = $30.00
Total Diluted Shares Outstanding = 100m
From those two assumptions, we can calculate the market capitalization of both companies by
multiplying the share price and diluted share count.
Market Capitalization = $30.00 × 100m = $3bn
As for the next step, we’ll calculate the denominator using the following operating assumptions:
Net Income = $250m
Depreciation & Amortization (D&A):
Company A D&A = $250m
Company B D&A = $85m
Increase in Net Working Capital (NWC) = –$20m
Based on the stated assumptions above, the only difference between the two companies is the D&A
amount ($250m vs $85m).
In effect, cash from operations (CFO) for Company A is equal to $240m while CFO is $315m for
Company B.

2. Price to Cash Flow Calculation Example

At this point, we have the required data points to calculate the P/CF ratio.
But to see the benefit of the P/CF ratio over the P/E ratio, we’ll first calculate the P/E ratio by
dividing the market capitalization by net income.

Price to Earnings Ratio (P/E) = $3bn ÷ $250m = 12.0x

Then, we’ll calculate the P/CF ratio by dividing the market capitalization by cash from operations
(CFO), as opposed to net income.
Company A – Price-to-Cash Flow Ratio (P/CF) = $3bn ÷ $240m = 12.5x
Company B – Price-to-Cash Flow Ratio (P/CF) = $3bn ÷ $315m = 9.5x

To confirm our calculation is done correctly, we can use the share price approach to check our P/CF
ratios.
Upon dividing the latest closing share price by the operating cash flow per share, we get 12.5x and
9.5x for Company A and Company B once again.
For either company, the P/E ratio comes out to 12.0x, but the P/CF is 12.5x for Company A while
being 9.5x for Company B.
The difference is caused by the non-cash add-back of depreciation and amortization (D&A).
In closing, the more the net income of a company varies from its cash from operations (CFO), the
more insightful the price to cash flow (P/CF) ratio will be.

What is P/FCF?
The P/FCF multiple compares a company’s equity value (i.e. market capitalization) relative to its free
cash flow to equity (FCFE), or levered free cash flow.

How to Calculate P/FCF?

The P/FCF multiple, or “price to free cash flow”, is the ratio between a company’s equity value and
free cash flow.
 Equity Value: The equity value, also known as “market cap”, represents how much a
company is worth from the perspective of only one capital provider group, the common
shareholders.
Free Cash Flow (FCF): Because the numerator is a levered metric – i.e. at its simplest, the
equity value is equal to enterprise value minus net debt – the free cash flow to
equity (FCFE) is the corresponding cash flow metric. Often referred to as “levered free
cash flow”, FCFE is the cash flows generated by a company that belong to only common
shareholders.
In order for a valuation multiple to be practical, the stakeholder(s) represented must match between
the numerator and denominator; otherwise, there is an inconsistency in the ratio.
The equity value of a company is equal to the product of a company’s share price and its total
number of diluted shares outstanding, i.e. debt in the capital structure is not part of the calculation.
On that note, the free cash flow to equity (FCFE) is the right metric to use alongside equity value,
since FCFE is also attributable to solely common shareholders.
Unlike the free cash flow to firm (FCFF) – the cash flows applicable to all stakeholders in a company’s
capital structure – FCFE is calculated after adjusting for non-equity payments such as mandatory
debt amortization and interest expense (and the residual cash flows then belong to the equity
holders).

P/FCF Formula
The formula to calculate the P/FCF multiple is as follows.
P/FCF = Equity Value ÷ Free Cash Flow to Equity (FCFE)
The numerator, equity value, is calculated by multiplying the latest closing share price by the total
diluted share count.
Equity Value = Market Share Price × Total Number of Diluted Shares Outstanding
As for the denominator, free cash flow to equity (FCFE), the calculation starts with net income – a
post-interest profit metric – which is then adjusted for non-cash items (D&A), change in net working
capital (NWC), capital expenditure (Capex), and debt repayments.
Free Cash Flow to Equity (FCFE) = Net Income + D&A – Change in NWC – Capex – Mandatory Debt
Repayment
Note: If the company raised more debt capital, the proceeds are a net addition to FCFE, since the
newly obtained cash can be used to issue shareholders dividends or repurchase shares.

How to Interpret Price to Free Cash Flow Ratio?

The P/FCF ratio answers the question, “For each dollar of a company’s levered free cash flow (FCFE),
how much are investors in the market currently willing to pay?”
Therefore, the higher the P/FCF multiple, the more of a premium at which the market values the
company on a FCFE-basis (and vice versa for a lower P/FCF multiple).
There are two downsides to using the P/FCF multiple:
1. Fluctuations in FCFE: The free cash flow to equity (FCFE) of a company fluctuates across
different periods. For instance, FCFE can be far lower if the principal on a debt obligation
was repaid. In addition, the outflow of cash from capital expenditures (Capex) occurs
periodically, as opposed to on a consistent basis, and a company’s working capital levels
can vary based on seasonal and cyclical patterns.
2. Levered Multiple: The calculation of FCFE begins with net income, which can be
distorted by discretionary decisions of management, such as the capital structure
decision (i.e. reliance on debt or equity financing) and taxes. Hence, unlevered valuation
multiples tend to be used far more frequently in practice, since only the core operating
 activities are reflected (e.g. EV/EBITDA, EV/EBIT). In contrast, levered multiples (e.g. P/E
ratio, P/B ratio) can be skewed by the shortcomings of accrual accounting.
3. Lack of Standardization: Opinions can differ on the correct calculation of FCFE, especially
in terms of the adjustments used to “normalize” the non-GAAP metric. In effect, the use-
case of the P/FCF multiple is negatively affected by its GAAP components like net income
(e.g. post-interest, interest tax shield, tax jurisdiction, non-operating items), as well as
these non-GAAP adjustments.

What’s the Difference Between P/FCF vs. Levered FCF Yield?

The EV/FCF multiple is the inverse of the levered FCF yield metric.
The levered FCF yield metric, expressed as a percentage, represents the remaining cash flows that
can benefit equity shareholders, after any debt payments.
Levered FCF Yield (%) = Free Cash Flow to Equity (FCFE) ÷ Equity Value

Step 1. Equity Value Calculation (Market Capitalization)

Suppose you’re tasked with calculating the P/FCF multiple of a company using the following
assumptions.
Latest Closing Share Price = $50.00
Total Diluted Shares Outstanding = 20 million
Upon multiplying the company’s current market share price by its total number of diluted shares
outstanding, the equity value of the company comes out to $1 billion.
Equity Value = $50.00 × 20 million = $1 billion

Step 2. Free Cash Flow to Equity Calculation (FCFE)

With the calculation of our numerator complete, we’ll now determine our company’s free cash flow
to equity (FCFE).
The assumptions we’ll use in our calculation are the following:
Net Income = $200 million
Depreciation and Amortization (D&A) = $30 million
Capital Expenditure (Capex) = ($32 million)
(Increase) / Decrease in NWC = ($2 million)
Mandatory Debt Repayment = ($10 million)
Upon entering our assumptions into the free cash flow to equity (FCFE) formula, we get a result of
$186 million.
Free Cash Flow to Equity (FCFE) = $200 million + $30 million – $32 million – $2 million – $10
million = $186 million

Step 3. P/FCF Calculation Example

In the final section of our exercise, we’ll divide our company’s equity value by its free cash flow to
equity (FCFE).
EV/FCF = $1 billion ÷ $186 million = 5.4x
What is the Shiller PE Ratio?
The Shiller PE, or “CAPE ratio” is a variation of the price to earnings ratio adjusted to remove the
effects of cyclicality, i.e. the fluctuations in the earnings of companies over different business cycles.

How to Calculate Shiller PE Ratio (Step-by-Step)

The Shiller PE, or CAPE ratio, refers to the “Cyclically Adjusted Price to Earnings Ratio”, and the rise
in its usage is attributed to Robert Shiller, a Nobel Prize-winning economist and renowned professor
at Yale University.
Unlike the traditional price to earnings ratio (P/E), the CAPE ratio attempts to eliminate fluctuations
that can skew corporate earnings, i.e. “smoothen” the reported earnings of companies.
In practice, the use-case of the CAPE ratio is to track broad market indices, namely the S&P 500
index.
Traditional P/E Ratio → The traditional P/E ratio uses the reported earnings per share (EPS)
from the trailing twelve months as the denominator.
CAPE Ratio (Shiller PE 10) → Conversely, the CAPE ratio is unique in that the average annual
earnings per share (EPS) over the trailing ten years is used, instead.
However, taking the average of a company’s reported EPS figures in the past ten years neglects a
critical factor that affects the financial performance of all corporations, which is inflation.
In economics, the term “inflation” is a measure of the rate of change in the pricing of goods and
services within a country across a specified time frame.
While there is significant criticism (and controversy) surrounding the methodology by which inflation
is measured, the Consumer Price Index (CPI) remains the most common measure of inflation in the
U.S.
The process of calculating the Shiller PE ratio can be broken into a four-step process:
Step 1 → Gather the Annual Earnings of the S&P Companies in the Trailing 10 Years
Step 2 → Adjust Each of the Historical Earnings by Inflation (i.e. CPI)
Step 3 → Calculate the Average Annual Earnings for the 10-Year Time Horizon
Step 4 → Divide the 10-Year Average Earnings by the Current Price of the S&P Index

Shiller PE Formula (CAPE Ratio)

The formula used to calculate the Shiller PE ratio is as follows.
Shiller PE Ratio = Current Share Price ÷ Inflation Adjusted Earnings, 10-Year Average
The CAPE ratio most often serves as a market indicator, so the share price refers to the market price
of a stock market index.

Shiller PE Ratio vs. Traditional P/E Ratio

The difference between the Shiller P/E ratio and the traditional P/E ratio is the time period covered
in the numerator, as we mentioned earlier.
In the following section, we’ll discuss the reason that the traditional P/E ratio can be deceiving to
investors at times.
The drawback to the traditional P/E ratio comes down to the concept of cyclicality, which describes
the fluctuations in economic activity over time.
Certain sectors might be less prone to the negative effects of cyclicality, i.e. “defensive” sectors,” but
the recurring pattern of periods of economic expansion and contraction are natural and, for the
most part, inevitable in a free market.
Economic Expansion → Suppose the S&P 500 is currently in a phase of economic expansion,
where corporations are reporting strong earnings and beating market expectations.
Because the denominator, i.e. the earnings of the companies, is higher, the P/E ratio on
an annual basis artificially declines.
Economic Contraction → On the other hand, if the S&P 500 is undergoing an economic
contraction and the economy is on the verge of entering a recession, the earnings of
companies would be underwhelming. The impact on the P/E ratio is the reverse as in the
prior scenario, as the lower earnings in the denominator can cause an artificially higher
P/E ratio.
Hence, companies that are barely profitable often exhibit P/E ratios so high that usage of the metric
is not informative. But by no means does the high P/E ratio necessarily signal that the company in
question is currently overvalued by the market.
The solution offered by the Shiller P/E ratio is to bypass these cyclical periods by calculating the
historical ten-year average, with the proper adjustments made to account for the effects of inflation.

Average vs. Trends in Earnings Per Share (EPS)

While Professor Robert Shiller may be credited for formally presenting the metric to the Federal
Reserve and using it in academia, the concept of using a “normalized”, average figure for the
earnings metric was not a novel idea.
For instance, Benjamin Graham recommended the necessity to use an average of past earnings in his
book, Security Analysis. Graham emphasized that tracking recent trends can be informative yet
insufficient by itself to make an investment decision, i.e. the long-term “bigger picture” must also be
understood to avoid mistakes related to only looking at short-term cyclical patterns.
What are the Limitations to the CAPE Ratio?
There are many vocal critics of the Shiller P/E ratio, who point to the following shortcomings:
Overly-Conservative: In general, the most common theme tends to be that the ratio is too
conservative, while others cite that trait as one of the main reasons to track it.
Backward-Looking: Given the calculation is backward-looking, many practitioners and those
in academia view the ratio as impractical for forecasting future market performance.
 Accrual Accounting Drawbacks (GAAP): Another source of criticism is the reliance on
earnings per share (EPS), which is calculated using net income, i.e. the accounting profits
of a company in accordance with the Generally Accepted Accounting Principles (GAAP).
Prudence Principle: Per GAAP accounting standards, the prudence concept dictates that a
company’s financial statements are required to be conservative with regard to not
overestimating revenue while not understating its costs.
Lagging Indicator: Therefore, many perceive the CAPE ratio as a lagging market indicator
that is better suited for understanding the past and current market sentiment, yet not a
reliable predictor of future market performance (i.e. bear market or bull market).
Changing Rules and Norms: Not to mention, accounting rules change over time, as well as
corporate actions (e.g. the prevalence of stock buybacks in the modern day).
Note: Profession Shiller has released more alternative data sets in response (Source: Yale Economics
Online Data)

S&P 500 Shiller PE Index Chart by Month (2022)

What is Price to Tangible Book Value?
The Price to Tangible Book Value (P/TBV) ratio measures a company’s market capitalization relative
to its book value of equity, net of intangible assets.

How to Calculate Price to Tangible Book Value?

The price to tangible book value, or P/TBV, is an equity valuation ratio that compares a company’s
market value of equity to its tangible book value (TBV).
Market Capitalization → The market capitalization, or “equity value”, of a company is the
total value of its common shares outstanding to its equity holders. In short, the market
cap is the fair value of a company’s common equity, i.e. the market value of equity, which
is set by the latest transactions in the public markets, as of the present date.
Tangible Book Value (TBV) → The tangible book value (TBV) measures how much a
company’s tangible assets are worth, net of intangible assets, which refer to non-physical
assets (e.g. goodwill, intellectual property, trademarks, copyright, patents). Contrary to
the market cap, the tangible book value (TBV) is an adjusted accounting metric, where
the recorded value of a company’s intangible assets is deducted from the book value of
equity (BVE).
Since the tangible book value (TBV) metric removes the value of intangible assets, i.e. non-physical
assets, the TBV is a closer representation of the remaining net value belonging to common equity
holders post-liquidation, i.e. once all outstanding liabilities on the balance sheet, such as debt, are
repaid in full.
For example, the recognition of goodwill on a company’s balance sheet is a required accrual
accounting convention intended to capture the excess purchase price paid in excess of the acquired
asset’s fair market value (FMV).
Therefore, the tangible book value (TBV) is a more conservative approximation of the value of a
post-liquidation company because all outstanding debt and liabilities like accounts payable (A/P) are
of higher priority relative to claims held by common shareholders.
The drawback, however, is that TBV is still a rough estimation of a company’s
hypothetical liquidation value, as certain intangible assets can in fact possess value and be sold in a
liquidation proceeding. In addition, the liquidation value of tangible assets is rarely ever actually
equivalent to the value as recorded on the balance sheet.

Price to Tangible Book Value Formula (P/TBV)

The formula used to calculate the price to tangible book value ratio (P/TBV) is as follows.
Price to Tangible Book Value (P/TBV) = Market Capitalization ÷ Tangible Book Value (TBV)
Market Capitalization = Latest Closing Share Price × Total Number of Diluted Shares
Outstanding
Tangible Book Value (TBV) = (Total Assets – Intangible Assets) – Total Liabilities
Alternatively, the price to tangible book value ratio (P/TBV) can also be expressed on a per-share
basis.
Price to Tangible Book Value (P/TBV) = Market Share Price ÷ Tangible Book Value Per Share
(TBVPS)
Market Share Price = Market Capitalization ÷ Total Number of Diluted Shares Outstanding
Tangible Book Value Per Share (TBVPS) = Tangible Book Value (TBV) ÷ Total Number of
Diluted Shares Outstanding

Price to Book Ratio (P/B) vs. Price to Tangible Book Value (P/TBV)
The price to book (P/B) and price to tangible book value (P/TBV) are near-identical valuation ratios
that compare a market value metric to a bookkeeping metric.
Price to Book (P/B Ratio) → The P/B ratio compares a company’s market value of equity (i.e.
market capitalization) relative to its book value of equity (BVE). The book value of equity
(BVE) is equal to a company’s total assets minus its total liabilities, so the metric is
inclusive of intangible assets.
Price to Tangible Book Value (P/TBV) → The P/TBV is virtually identical to the P/B ratio,
aside from the additional step of removing the value of intangible assets. For companies
with significant amounts of intangible assets recorded on their balance sheets, the P/BV
can be distorted and potentially misleading, which is where a more conservative measure
like the P/TBV ratio can be more appropriate.
The formula used to calculate the price to book ratio (P/B) is as follows.
Price to Book Ratio (P/B) = Market Capitalization ÷ Book Value of Equity (BVE)
Like the price to book ratio, a lower price to tangible book value ratio is interpreted as a positive sign
that the underlying company could potentially be undervalued (or vice versa for higher ratios).
Lower P/TBV Ratio → Potentially Undervalued Market Pricing
Higher P/TBV Ratio → Potentially Overvalued Market Pricing

1. Market Value and Balance Sheet Assumptions

Suppose you’re tasked with calculating the price to tangible book value of a company given the
following market value and balance sheet assumptions.
Market Value Assumptions
Latest Closing Share Price = $25.00
Total Number of Diluted Shares Outstanding = 10 million
Balance Sheet Financial Assumptions
Total Assets = $200 million
Goodwill and Intangible Assets = $50 million
Total Liabilities = $100 million

2. Price to Tangible Book Value Calculation Example

Our first step is to determine our company’s market capitalization, which is the product of its share
price as of the latest trading date and its total share count on a diluted basis.
Upon multiplying the company’s most recent share price by the number of its total diluted shares
outstanding, we arrive at a market cap of $250 million.
Market Capitalization = $25.00 × 10 million = $250 million
In the next step, we’ll calculate our company’s tangible book value (TBV), starting with the deduction
of goodwill and intangible assets from total assets.
Total Tangible Assets = $200 million – $50 million = $150 million
From there, the next step is to net the company’s total tangible assets against its total liabilities,
which returns a tangible book value (TBV) of $50 million.
Tangible Book Value (TBV) = $150 million – $100 million = $50 million
After dividing our company’s market capitalization by its tangible book value (TBV), the implied price
to tangible book value ratio (P/TBV) is 5.0x.
Price to Tangible Book Value (P/TBV) = $250 million ÷ $50 million = 5.0x

3. P/TBV Ratio Analysis Example

In the final section of our exercise, we’ll compare the P/TBV ratio we calculated in the prior step to
the price to book ratio (P/B) using the same assumptions.
The numerator, the market capitalization, is still $250 million, but the denominator is not adjusted
for intangible assets in this case.
Instead, we’ll subtract the company’s total liabilities from the company’s total assets to calculate the
book value of equity (BVE) as $100 million.
Book Value of Equity (BVE) = $200 million – $100 million = $100 million
With our two inputs determined, the only step left is to divide the market cap by the book value to
arrive at a price to book ratio (P/B) of 2.5x.
Price to Book (P/B Ratio) = $250 million ÷ $100 million = 2.5x
In comparison to the price to book ratio (P/B), the price to tangible book value ratio (P/TBV) is
double that value, which reflects how the P/TBV can be a more practical tool to better understand
the current market valuation of a company in certain circumstances.

What is LTM vs. NTM Multiples?

Last Twelve Months (LTM) or Next Twelve Months (NTM) are two standard forms in which
valuation multiples are presented in trading and transaction comps analyses. While LTM multiples
are backward-looking and based on historical performance, NTM multiples are formulated from
projected figures.
LTM vs. NTM Multiples: Valuation Multiples Introduction
Multiples in relative valuation consist of a measure of value in the numerator and a metric capturing
financial performance in the denominator.
Numerator (Valuation): Enterprise Value, Equity Value.
Denominator (Performance): EBITDA, EBIT, Revenue, Net Income.
To ensure the comparisons are apples-to-apples, equity value must be matched with metrics that
pertain solely to equity shareholders, while enterprise value must match with metrics applicable to
all stakeholders (e.g. common and preferred equity shareholders, lenders / debt holders)

LTM Multiples Definition

LTM stands for Last Twelve Months. LTM multiples refer to metrics representing past operating
performance. For example, the amount of EBITDA generated by a company in the past twelve
months would be classified as a LTM metric.
Alternatively, LTM multiple can be used interchangeably with the term “trailing twelve months”, or
TTM.
In terms of presentation, both “LTM” and “TTM” can routinely be found in comps sheets.
LTM = “Last Twelve Months”
TTM = “Trailing Twelve Months”

NTM Multiples Definition

NTM, on the other hand, stands for Next Twelve Months. Multiples denoted as NTM means the
selected metric is based on the projected performance in the coming twelve months.
Therefore, a NTM multiple is considered a “forward multiple”, since the valuation is based on a
forecast, rather than actual historical financial results.
Companies are also often acquired based on their future prospects (e.g. future revenue growth,
margin improvements), which causes forward multiples to become more applicable in M&A
scenarios.

LTM vs. NTM Multiples: Cyclicality Risk

Three other scenarios that require heavier reliance on NTM multiples are companies that
demonstrate:
 1. Significantly high growth (i.e. early stage growth companies) in which the company is
growing at a pace where it’ll be significantly different one year from the prior year
2. Cyclicality that causes the company’s financial performance to vary (sometimes
dramatically) year-by-year.
3. Seasonality in financial performance that requires a full yearly cycle to be captured in the
operating metric (e.g. to avoid double-counting the holiday season for a clothing
retailer).
Under the given contextual situations, historical multiples (LTM) are unlikely to represent the real
value of the companies being valued, making them impractical to use.
Instead, forward multiples (NTM) would reflect a more accurate valuation while being more
intuitive, as they provide a better picture of the company’s ongoing performance.

LTM vs. NTM Multiples: Trailing and Forward Valuation

From the view of many practitioners, especially those investing in technology-related and high-
growth sectors, forward multiples (NTM) are preferred because they account for projected growth.
For high-growth companies, LTM can be a poor proxy that fails to factor in projected growth due to:
Non-Recurring Expenses
One-Time Cash Inflows
Net Operating Losses (NOLs)
Most importantly, valuation is forward-looking for the most part – albeit historical performance can
serve as the insightful basis to reference when creating the forecast.
However, past performance is NOT future performance, and the circumstances of a company (and
industry) can change in an instant, especially in the digital age.
LTM multiples, such as LTM EBITDA, are usually used for transactions like leveraged buyouts (LBOs).
However, LTM EBITDA is typically broken-down and scrutinized on a line-by-line basis.

LTM vs. NTM Multiples Trade-Offs

When deciding between using a LTM or a forward multiple, there are some trade-offs to be aware
of.
LTM multiples have the advantage of being based off of actual, factual results. For example, the fact
that a company generated $200mm in revenue under accrual accounting standards can be found in
its formally audited financial statements (i.e. even if analysts “scrub” and make adjustments to this
figure later on).
But LTM multiples suffer from the issue that historical results can be, and quite often are, distorted
by non-recurring expenses such as restructuring expenses and legal settlements, as well as non-
recurring income (e.g. non-core asset sales).
In effect, the inclusion of such items can cause the metrics of companies to be misconstrued (and
thus, misleading to investors).
One goal of relative valuation is to use multiples that properly account for the target company’s
core, recurring operating performance.
To reiterate from earlier, historical metrics must be adjusted to exclude non-recurring items.
Forward multiples have the drawback of being subjective measures, where discretionary decisions
can cause substantial differences in valuations.
Since projected EBITDA, EBIT, and EPS are all forecasts based on individual judgment, as well as
management guidance, these figures tend to be less reliable relative to historical performance.
Hence, both LTM and forward multiples (e.g. NTM) are typically presented side-by-side, rather than
picking one instead of another, as the decision is not mutually exclusive.

LTM vs. NTM Multiples Calculation Example

For our example LTM vs NTM multiple calculations, we’ll assume the hypothetical buyout of a
company affected by the break-out of COVID, with the peak negative impact occurring in 2020.
The target company had the following valuation data as of fiscal year 2020, which should reflect an
underperformance caused by COVID.
LTM Enterprise Value (EV): $200mm
LTM EBITDA: $20mm
In terms of the forward multiples valuation data:
NTM EV: $280mm
NTM EBITDA: $40mm
And for the 2-year forward data points:
NTM + 1 EV: $285mm
NTM + 1 EBITDA: $45mm
With those assumptions stated, we can calculate the EV / EBITDA multiples for each period.
EV / EBITDA (LTM): 10.0x
EV / EBITDA (NTM): 7.0x
EV / EBITDA (NTM + 1): 6.3x
From the multiples listed above, we can distinguish the LTM multiple as an outlier from the three
periods.
Given the COVID-19 impact on EBITDA – which would be considered a one-time, non-recurring event
– an acquirer would likely make an offer to purchase the hypothetical target company using a NTM
multiple.
The true, normalized valuation multiple of the target appears to be around the 6.0x to 7.0x range,
rather than around 10.0x.
The expansion of the LTM EV/EBITDA multiple can be attributed to the compressed EBITDA (and a
comparatively steadier enterprise value – i.e. overall valuation remained relatively steady despite
the reduction in EBITDA), which falsely inflates the valuation multiple.
Either the purchaser would bid off the NTM multiple, or adjust the LTM EBITDA by removing the
“one-time” COVID-related impacts to normalize the multiple (i.e. Adjusted EBITDA).
Upon doing so, the LTM multiple would converge closer to the approximate valuation range implied
by the NTM and NTM + 1 multiples.
What is LTM?
LTM is shorthand for “last twelve months” and refers to the timeframe comprised of the financial
performance of the most recent twelve-month period.

What is the Definition of Last Twelve Months (LTM)?

In finance, last twelve-month (LTM) metrics – often used interchangeably with “trailing twelve
months” (TTM) – are used to measure a company’s most recent financial state.
Typically, LTM financial metrics are calculated for a certain event such as an acquisition, or an
investor seeking to evaluate the operating performance of a company in the prior twelve months.
The LTM income statement of a company is ordinarily compiled in full, but the two critical financial
metrics in M&A tend to be:
LTM Revenue: The net sales generated from the operations of the company over the most
recent four quarters.
LTM EBITDA: The operating income of the company, expressed on a trailing twelve-month
basis.
In particular, many transaction offer prices are based on a purchase multiple of EBITDA – hence, the
widespread usage of the LTM EBITDA metric in M&A.
But to ensure the LTM EBITDA or LTM revenue of a company reflects past performance and not an
anomaly regarding its financial state, the EBITDA margin (%) can be compared across historical
periods and the compound annual growth rate (CAGR) can annualize the growth rate across multiple
periods.

How to Calculate LTM Revenue?

The following steps are used to calculate a company’s LTM financial data:
Step 1 → Find the Last Annual Filing Financial Data
Step 2 → Add the Most Recent Year-to-Date (YTD) Data
Step 3 → Subtract the Prior Year YTD Data Corresponding to the Prior Step

LTM Formula
The formula for calculating a company’s last twelve months financials (LTM) is as follows.
Last Twelve Months (LTM) = Last Fiscal Year Financial Data + Recent Year-to-Date Data – Prior YTD
Data
The process of adding the period beyond the fiscal year ending date (and subtracting the matching
period) is called the “stub period” adjustment.
If the company is publicly traded, the latest annual filing data can be found in its 10-K filings,
whereas the most recent YTD and corresponding YTD financial metrics to deduct can be found in
the 10-Q filings.

LTM Revenue Calculation Example

Suppose a company has reported $10 billion in revenue in the fiscal year 2021. But in Q-1 of 2022, it
reported quarterly revenue of $4 billion.
The subsequent step is to source the corresponding quarterly revenue – i.e. revenue from Q-1 of
2020 – which we’ll assume was $2 billion.
Here, in our illustrative example, the LTM revenue of the company is $12 billion.
LTM Revenue = $10 billion + $4 billion – $2 billion = $12 billion
The $12 billion in revenue is the amount of revenue generated in the preceding twelve months.

LTM vs. NTM Revenue: What is the Difference?

Historical vs. Pro Forma Performance: In contrast to historical financials, NTM financials –
i.e. “next twelve months” – are more insightful for expected future performance.
Scrubbed Financials: Both metrics are “scrubbed” to remove any distorting impacts from
non-recurring or non-core items. More specifically, in the M&A context, the LTM/NTM
EBITDA of a company is typically adjusted for non-recurring items and does NOT align
directly with U.S. GAAP, but the financials are more representative of the actual
performance of the company.
M&A Purchase Multiple: The purchase multiple in M&A can be based on either the
historical or projected basis (NTM EBITDA), but there must be a specific rationale as to
why one was chosen. For example, a high-growth software company could potentially
focus on NTM financials if its projected performance and growth trajectory are
substantially distinct from its LTM financials.

What is TTM?
The Trailing Twelve Months (TTM) portrays a company’s financial performance across the past four
quarters, i.e. the most recent 12-month period.

How to Calculate TTM Revenue?

The trailing twelve months (TTM) refers to a company’s financial performance in the most recent 12-
month period.
TTM stands for “trailing twelve months” and is a backward-looking metric that captures the
financial performance of a company in its latest four reporting quarters.
In effect, a metric on a trailing twelve months basis, such as TTM revenue, is meant to show the
current state of a company’s growth trajectory.
The process of adjusting a financial metric like revenue by adding the most recent period past the
latest reported fiscal year and subsequently deducting the matching period is referred to as the
“stub period”.
The required financial filings to perform such a calculation are the company’s latest 10-K, most
recent quarterly filing(s), and the corresponding filings from the year prior.
To calculate a company’s revenue on a TTM basis, the following three steps can be followed.
Step 1 → Compile Annual Report (10-K) and Latest Quarterly Reports (10-Q)
Step 2 → Add the Year-to-Date (YTD) Data to the Fiscal Year Data
Step 3 → Subtract the YTD Data from the Prior Year

Trailing Twelve Months Formula (TTM)

The formula for calculating a financial metric on a trailing twelve-month basis is as follows.
Trailing Twelve Months (TTM) = Latest Fiscal Year Data + YTD Data – Prior YTD Data
For example, if two quarters have passed since the latest fiscal year, the quarterly data that we
would deduct is the first two quarters from the prior year.

TTM Revenue Calculation Example

Suppose you’re tasked with calculating the revenue of a company on a trailing twelve-month basis.
In the recent quarters leading up to the end of fiscal year 2022, the company’s revenue has grown
significantly.
Historical Revenue:
Q1, 2022 = $20 million
Q2, 2022 = $25 million
Q3, 2022 = $40 million
Q4, 2022 = $60 million
The company brought in $145 million in revenue to wrap up the fiscal year.
FY, 2022 = $145 million
In the most recent quarter, Q-1 of 2023, the company reported $75 million in quarterly revenue.
Q1, 2023 = $75 million
In order to calculate the TTM revenue of our company, we’ll start with our fiscal year 2022 revenue,
add the Q1 2023 revenue, and subtract the Q4 2022 revenue.
TTM Revenue = FY-22 Revenue + Q1-23 Revenue – Q1-22 Revenue
TTM Revenue = $145 million + $75 million – $20 million = $200 million
Our company’s trailing twelve months (TTM) revenue amounts to $200 million, which reflects its
financial performance and growth profile far more accurately than its fiscal year 2022 revenue of
$145 million.

What is Forward Multiple?

A Forward Multiple is a valuation ratio that reflects a company’s value on the basis of an estimated
financial metric, i.e. forecasted earnings performance.
How to Calculate Forward Multiple?
The forward multiple is most often used to determine the valuation of a high growth company that is
either unprofitable as of the present date, or the market is valuing the company based on its
expected earnings in the future.
Given this context, it can be reasonable – or sometimes the only choice – to value a high-growth,
unprofitable company based on its expected future profitability as opposed to its actual historical
performance.
Unprofitable (or Limited Profitability): If a company is currently unprofitable, usage of
traditional valuation multiples, such as EV/EBITDA and EV/EBIT, can be out of the
question because the negative denominator causes the multiple to be impractical, i.e.
“not meaningful”.
Forward-Looking Market Pricing: For companies exhibiting high growth and operating in
hyper-competitive markets, the priority must be on revenue growth in lieu of
profitability. Of course, the company must eventually become profitable to sustain
operations, however, the competition in certain industries can force participants to
prioritize growth, including acquiring more customers, securing long-term contracts, and
running effective sales and marketing campaigns, which are each costly endeavors that
can erode a company’s margins.

Forward Multiple Formula

The formula to calculate a forward multiple is as follows.
Forward Multiple = Value Measure ÷ Estimated Value Driver
Where:
Value Measure: Enterprise Value (TEV) or Equity Value
Value Driver: Forecasted Financial Metric (e.g. EBIT, EBITDA, Net Income)
The rule for all valuation multiples, whether on a historical or forward basis, is that the numerator
and denominator must match in terms of the capital providers represented.
Enterprise Value: e.g. EBIT, EBITDA, FCFF, NOPAT
Equity Value: e.g. Net Income, Book Value of Equity (BVE), FCFE

Valuation Multiple: Forward Multiples vs. Historical Multiples

Historical Multiple: The traditional valuation multiple is based on historical performance,
such as LTM EBITDA or LTM EBIT. Historical multiples, or “trailing multiples”, portray how
much investors are willing to pay for a dollar of past earnings.
Forward Multiple: In contrast, a forward multiple reflects the amount that investors are
willing to pay for a dollar of future earnings. The benefit to using a forward multiple is
that in reality, market valuations price in future expectations more than historical
performance, albeit the two are closely intertwined. For instance, if a financially sound,
 profitable SaaS company trading at a premium were to suddenly announce that its future
growth outlook seems unfavorable, and its profit margins should reduce substantially in
the coming years, the company’s share price would plummet post-announcement,
regardless of its past profitability and historical margins.

What’s the Difference Between Forward-Looking and Backward-Looking Multiples?

Forward Multiples: Considering the forward-looking aspect inherent to corporate valuation
– both on an intrinsic basis (e.g. DCF) and comps-derived basis (i.e. trading comps,
transaction comps) – a credible case could be made that forward multiples should hold
more merit than backward-looking multiples. But projection models are prone to bias and
are ultimately estimates at the end of the day, which makes forecasted earnings less
reliable with a lack of consistency.
Historical Multiples: In comparison, a company’s historical performance can easily be
confirmed via company reports and formal filings with the SEC. All forecast models
regarding a company’s future financial performance require discretionary assumptions,
and thus there are large discrepancies in future estimates. Moreover, forward multiples
are commonly based on a company’s estimated next twelve months (NTM) performance,
but can be extended even further out. The issue, however, is that the further out the
forecast period, the less credible the valuation becomes because more uncertainty and
external risks emerge. Historical multiples, or “backward-looking multiples”, do not suffer
from those types of risks since the value driver is based upon actual financial data, not
estimates.

Forward Multiples in Valuation of Software Companies

Forward multiples tend to be most common for software companies (SaaS), where the abundance of
capital from venture capital (VC) and growth equity firms – coupled with their disruptive business
models – results in prioritizing growth at all costs and capturing as much market share from existing
incumbents as plausible.
For example, a SaaS company can be valued at a relatively high forward multiple because the
market’s expectation is that the company can achieve its goals in terms of growth and market share,
followed by becoming more profitable over time as its business model becomes more efficient.
Furthermore, the market might anticipate its margins to expand as a result of reduced spending as
its nearest competitors become less of a concern over time (i.e. competition cools down) as well as
the company coming up with more effective strategies at monetizing their user bases (and recurring
revenue via long-term customer contracts).
In certain markets, a consolidation phase can occur where competitors can become acquisition
targets, as in the case of Postmates and Uber in late 2020.

What are the Determinants of Forward Multiple in SaaS Industry?

In 2020, venture capitalist Tomasz Tunguz performed a linear regression analysis on sixty publicly
traded SaaS companies to identify which factors determined the forward multiple of these high-
growth software companies.
The key takeaways from the findings were that revenue growth and sales efficiency had the highest
correlation, 0.81 and 0.75, respectively.
On the other hand, the other factors like cash flow margin, net income margin, and gross margin
were irrelevant, for the most part.
Over the long run, improvements to profit metrics certainly become critical, but growth and sales
efficiency dictate forward multiples in the market, even for publicly-listed companies.
SaaS Forward PE Multiple Calculation Example
Suppose you’re tasked with calculating the forward multiples of a SaaS company that is currently
unprofitable.
The company’s market share price – as of the latest closing date – is $50.00, with a total of 20 million
shares in circulation.
Market Share Price = $50.00
Diluted Shares Outstanding = 20 million
By multiplying the share price and diluted share count, the implied equity value of our software
company is $1 billion.
Equity Value = $50.00 × 20 million = $1 billion
In fiscal year 2022, the company incurred a net loss of $100 million, but the consensus among equity
analysts is that management’s plans to increase profitability in the coming years are promising and
likely to materialize.
Net Income, 2022A (t=0) = ($100 million)
In the next fiscal year, 2023, the expected earnings is $10 million – thus, the company will barely
break even – but its net earnings will expand significantly and reach $100 million in 2024.
Net Income, 2023E (t+1) = $10 million
Net Income, 2024E (t+2) = $100 million
The forward PE ratio can be calculated by dividing the company’s equity value (or “market cap”) by
the net income in each period.
Forward PE Ratio, 2022A: The actual reported earnings are negative, so the historical PE
ratio is negative and thus not applicable (“NA”).
Forward PE Ratio, 2023E: Given the marginally positive net income, the forward PE ratio is
100.0x and not meaningful (“NM”).
Forward PE Ratio, 2024E: The estimated net income is $100 million, which returns a forward
PE ratio of 10.0x and reflects the use-case of a forward multiple, since only this ratio can
be practically used for purposes of relative valuation.
What is Calendarization?
Calendarization is the adjustment of a company’s financial data and operating performance to align
with the calendar year-end date, i.e. December 31.

Calendarization: Financial Statement Adjustments

By setting a consistent year-end date, the standardized financial metrics can be compared
to that of industry peers.
Calendarization is the process of adjusting a company’s financials for the ending fiscal dates to match
the calendar year.
Under U.S. GAAP accounting, public companies must file quarterly reports on their financial
performance (10-Q), including a comprehensive end-of-year report (10-K).
Most companies file their year-end reports with December 31 as the fiscal year (FY) ending date,
aligning with the calendar year.
Certain companies, however, opt to report on a different schedule, such as Apple (NASDAQ: AAPL),
which files its 10-K at the end of September.

Apple Fiscal Year Ending Date (Source: 

10-K) 

Calendarization in Comps Analysis

To compare the financial data among different companies – particularly in comparable company
analysis – it is necessary to align the fiscal year ending dates among the entire peer group.
In such cases, the operating metric in the valuation multiple – e.g. EBITDA, EBIT – must be adjusted
so that the metric covers identical time frames among companies.
Without normalized year-end dates, the valuation multiples will be skewed and likely cause less
reliable conclusions due to the inconsistencies, i.e. the performance reflected is spread across
different periods (and thus, not truly “comparable”).
Calendarization is especially important for industries with high seasonality (e.g. retail), as full-year
performance tends to be heavily concentrated around the holidays and may vary from year to year.
Calendarization Formula
The steps involved in calendarization are relatively straightforward, as illustrated by the formula
for revenue shown below.
Formula
Calendarized Revenue = [Month × FYA Revenue ÷ 12] × [(12 – Month) × NFY Revenue ÷ 12]
Where:
Month: Fiscal Year Ending Month
FYA: Fiscal Year Actual
NFY: Next Fiscal Year
Here, the term “Month” refers to the month the company’s fiscal year ends, e.g. if the fiscal year
ends on June 30, the month will be six.

Calendarization Calculation Example

Suppose a company has a fiscal year ending date of September 30, and you are given the task of
calendarizing its revenue.
In FY-2021, the company generated $80 million in revenue, which is projected to grow to $100
million in the following year.
2021A Revenue: $80m
2022E Revenue: $100m
To calculate the “Year 1 Calendarized Revenue” – i.e. fiscal year ending 12/31/21 – we must adjust
the financials so that 75% of the data is contributed by 2021A and the remaining 25% stems from
2022E.
2021A (%): 9 ÷ 12 = 75%
2022E (%): (12 – 9) ÷ 12 = 25%
Given those adjustment factors (%), we’ll multiply the percentage by the corresponding revenue
amount.
FYA: $80m × 75% = $60m
NFY: $100m × 25% = $25m
The calendarized revenue for the first adjusted year equals the sum of the two figures above, which
comes out to $85 million.

What is Year to Date?

YTD stands for “year to date” and represents the time period from the beginning of the fiscal year to
the present date.
How to Calculate YTD Financials?
Year to date, often abbreviated as “YTD”, refers to the period between the beginning date of the
fiscal year to the current date, or the most recent reporting period, such as the latest quarterly
report.
By measuring YTD performance, a company can assess its performance to date and determine how
its current trajectory compares to its prior periods and internal forecasts, as well as for
benchmarking purposes with comparable companies in either the same or an adjacent industry.
The trend of the company’s sales performance, or alternatively the returns on a portfolio, can be
useful for understanding the current state of its performance and if adjustments are necessary in
order to reach the goals set by the management team.
For most companies, the starting date of the fiscal year tends to be January 1st, however, there are
companies such as Apple (AAPL) with fiscal years that begin on different dates.

Apple Fiscal Year Ending Date Example (Source: 

Apple 10-K)

YTD Formula
The formula to calculate year to date (YTD) performance or returns is as follows.
Year to Date (YTD) = [(Current Period Value – Beginning of Period Value)] ÷ Beginning of Period
Value)

YTD Returns Calculation Example

In order to convert the decimal value into a percentage, the resulting figure must be multiplied by
100.
For example, if an investor’s portfolio was worth $200,000 at the beginning of 2022 and is currently
worth $220,000 in the middle of 2022, the year to date return is calculated as 10%.
Year to Date (YTD) = [($220,000 – $200,000) ÷ $200,000) = 0.10, or 10%
Learn More → Hedge Fund Primer

S&P 500 YTD Returns Graph

The S&P 500, or “Standard and Poor’s 500”, is a stock market index tracking the performance of
approximately 500 publicly-traded companies based in the U.S.
The screenshot of the graph below reflects the YTD returns of the S&P 500 index as of the latest
closing date, November 23, 2022.

S&P 500 Index YTD Returns (Source: 

S&P Dow Jones Indices)

Step 1. Income Statement Operating Assumptions

Suppose a company is measuring its year-to-date financial performance to compare its revenue and
earnings figures to that of its last fiscal year, 2021.
The company’s 2021 fiscal year and the quarterly income statement metrics are as follows.

Income Statement 2021A Q1-2022 Q2-2022 Q3-2022

Revenue $100 million $26 million $30 million $34 million

Less: COGS (40) million (8) million (10) million (12) million
Income Statement 2021A Q1-2022 Q2-2022 Q3-2022

Gross Profit $60 million $18 million $20 million $22 million

Less: SG&A (20) million (4) million (5) million (6) million

EBIT $40 million $14 million $15 million $16 million

Less: Interest (5) million (1) million (1) million (1) million

EBT $35 million $13 million $14 million $15 million

Taxes (@ 25% Tax Rate) (9) million (3) million (4) million (4) million

Net Income $26 million $10 million $11 million $11 million

Step 2. YTD Financials Calculation

By taking the sum of the quarterly figures, we can arrive at our company’s 2022 year to date metrics.
Q1 to Q3 2022 Financials
Revenue = $90 million
COGS = (30) million
Gross Profit = $60 million
SG&A = (15) million
EBIT = $45 million
Interest = (3) million
EBT = $42 million
Taxes = (11) million
Net Income = $32 million
Note that year to date (YTD) financials could also refer to the last four quarters. If that is the case,
we would add the financials from Q4-2021. But in our modeling exercise, we’re attempting to gauge
the progress of only Q-1 to Q-3 2022 performance to determine how it is tracking compared to fiscal
year 2021.
By comparing the performance of three quarters to a full fiscal year, a company can quantify the
difference to set targets for Q-4 2022 performance.

Step 3. YTD Revenue and Earnings Metrics Analysis (%)

If we divide the ending values from above by the beginning values (2021A), we can determine how
the company is performing to date.
We’ll focus on the company’s revenue and earnings metrics:
Revenue (%) → We can see that the company’s revenue is currently only off by 10% (with
one more quarter to go) and thus should easily surpass its 2021 amount ($90 million vs.
$100 million).
Gross Profit (%) → Next, the amount of gross profits generated in the first three quarters of
2022 is equivalent to the total gross profit in 2021 ($60 million vs. $60 million).
EBIT (%) → The operating income, or “EBIT”, from the first three quarters has already
exceeded the 2021 amount by approximately 12.5% ($45 million vs. $50 million).
Net Income (%) → Finally, the company’s year to date net income, i.e. the “bottom line”, is
up by roughly 20% ($32 million vs. $26 million).