Tips for Valuators & Stub Years
I read the May 2011 QuickRead â€“ â€śTips for Valuatorsâ€ť concerning stub years. I have run into this issue several times and I have seen it misapplied many times and I am glad you wrote about the topic.
I noticed two points in the article that I believe need further clarification. The first thing that I noticed in the article is that the PV factors need to be modified as well if you are discounting them using a stub year.Â The present value factors in the article are straight factors calculated using a mid-year discounting convention that have not been adjusted for the stub period.Â The adjusted formula that should be used can be found in Pratt and Grabowskiâ€™s Cost of Capital: Applications and Examples Third Edition on page 33. I have developed a spreadsheet that calculates present value factors under any scenario that is helpful whenever I need to verify if the present value factors of opposing council are correct.Â It has come in handy on numerous occasions and I would recommend that everyone have a similar tool at their disposal.
The second issue is the â€śTerm 2017â€ť information. If in fact that was meant to be a terminal year calculation then it was discounted to present value using the wrong discount rate.Â The terminal value should be discounted using the same discount rate that was used for the previous years after tax cash flow.
T. Eric Blocher CPA, CVA, Principal
McKonly & Asbury, LLP
. . . and you might find a radically changed value if you actually calculate further, per another note:
I read with interest Richard Claywellâ€™s recent article on using a â€śStub yearâ€ť or date other than the companyâ€™s fiscal year end. In our practice, we deal with this issue on a regular basis.
While I agree with the authorâ€™s analysis that the first illustration in the article incorrectly fails to take the stub year into consideration, I would argue that the second illustration simply corrects one element in the equation, and it might helpful to readers to show how a fully corrected and adjusted computation of value plays out.
I have extended the analysis a bit further to illustrate what our firmâ€™s practice is regarding the stub year calculation in a mid-period DCF approach [detail excluded in this blog post â€”Ed. ] In this example, the initial cash flow term is seven months, hence the proper mid-period discount term should be seven months times 0.5 (annualized to 7/12 times 0.5) or 0.2917.
The real heavy lifting comes with the calculation of the second year term. The proper formula for this calculation is to double the stub year term (0.2917 times 2) and then add 0.5, resulting in 1.0834. This accounts for the actual passage of time of only 7 months before the start of the second year. The term then increases by 1.0 for each subsequent year of the DCF analysis â€“ so the term for year three would be 2.0834, and the term for year four would be 3.0834.
By the way, the latest version of Jim Hitchnerâ€™s Financial Valuation Applications and Models, 3rd EditionÂ illustrates this methodology (pages 145-146). I recommend it, if you donâ€™t have it already.
Art Marshall, ASA, CBA, AVA