Kgw Model - How to Deal with Selected Items

FINM 3005 Corporate Valuation

KGW Model - How to Deal with Selected Items

General Comments

This note aims to give some guidance on forming projections for selected items appearing in the “Forecast Drivers” sheet of the KGW model. When doing so, there are some general principles to bear in mind:

• Commence by trying to understand the nature of the item. Drill into the company accounts if necessary.
• Items that matter most are those which either absorb or release cash flow when changed, such that they feed through into free cash flow (as this means they will impact the DCF valuation). To see if this is the case, change the item and look to see if FCF also changes in either the “Results” or “Valuation Summary” sheet.
• Items that do not affect FCF may still impact the balance sheet or reported profits, and possibly ROIC. They are relevant to the extent that this matters for evaluating the company.
• If the item is insignificant to the valuation, no need to spend lots of time worrying about it. Go for simplest treatment, state what you have done (perhaps via placing a note within the model), and move on.
• Possible treatments include the following:

• Keep the item unchanged
• Change at some notional rate, e.g. historic growth rate, inflation
• Tie to the size of the business, e.g. model relative to revenue or other relevant item
• Directly forecast the item’s value

• The history of the item may provide clues on the appropriate approach and likely range.

Comments on Selected Items

• Goodwill and Intangibles – Investment in these items impacts FCF. In case of goodwill, it will be the balance paid for acquisitions that is not accounted for elsewhere. Assume no change, unless you are incorporating new acquisitions. In the case of intangibles, only allow for additions if you want to assume that the company will be investing in some intangible, e.g. buying brands. Amortization will impact profits but not FCF: mimic what the company does.
• Other operating assets (and liabilities) – Changes here will impact FCF, in a similar fashion to what happens for capex (or reductions in accounts receivable). The question to ask is whether the company needs to invest cash in the asset as the business grows (or whether some cash can be released by increasing the liability). In most instances, tying the value to revenues will be the most appropriate treatment.
• Non-operating assets, investments – Irrelevant to valuation, to the extent that these items involve non-operating items (which are valued separately). Keep unchanged, unless there is a good reason to do otherwise.
• Retirement asset / liability – Changes are nearly impossible to forecast. Keep unchanged.
• Ongoing operating provision – Although notionally a non-cash item, any assumed changes in this item do impact FCF under the way the KGW model works. So you do need to worry about it. The model assumes that increases in these provisions are charged against EBITA, but are non-cash in nature. Hence the change in provision is added it back to FCF. Implicitly, the “other costs” and hence margins within the model are assumed to include this item historically, so you need it to keep things consistent through time. In most cases, tying the change in the provision to the change in revenues will be a satisfactory treatment.
• Other provisions – For forecasting purposes, in many instances these provisions will be either be irrelevant or insignificant. So just keep the value unchanged. If it looks like they might matter, then do some investigation.
• Investment in operating leases – KGW treats this as a surrogate form of capex, i.e. it impacts FCF. Similarly, a reduction is treated like a sale of assets. Rather than change operating leases, it may be simpler to keep them steady and use PPE / capex as the vehicles for adjusting the asset base. Keeping leases unchanged equates to assuming that the leases are just rolled over, and the company finances all new asset purchases on-balance sheet.

Debt, cash and associated interest rates (Debt Finance and WACC section)

The assumptions made here are not critical to the valuation, given that the current market value of debt is deducted from EV when estimating the value of equity. The future shape of debt and cash, and the associated interest payments on these amounts, only really matter for earnings (hence PE valuations, etc).