Hi everybody! I received an email from one of you guys with a question about using a “midyear convention” when doing a DCF analysis. That’s something that is not explained a lot out there, so I thought it’d be nice if I showed you what’s that all about, mainly because it’s one of those tricks that investment bankers or a biased sell side research analyst will use to justify a higher valuation when doing a DCF.
The concept is pretty simple. Unless you have a monthly or quarterly model and use the XIRR function in Excel, when you make projections on an annual basis, DCF analyses assume that the cash flows occur as a lump sum at the end of the year, when it is more likely that those cash flows will occur throughout the year. To account for that, some guys use what it’s called the “midyear convention”. With this method, the analyst assumes that cash flows occur in the middle of the year. Consequently, those cash flows are discounted half a year instead of a whole year.
Take a look at the attached spreadsheet. What I’m doing here is presenting you with a simple EV calculation done by using the two methods: the end of year convention and the midyear convention. The cash flows are of course the same for both examples. I assumed unlevered free cash flows that start at $200 in year 1 and grow by 5% a year through year 7, and then I put a terminal value of $15,000 in year 7. I use a WACC rate of 12%.
What you have to do in the midyear convention method is simply discount the cash flows by one-half period less. So the 2013 cash flow will be discounted by 0.5 instead of 1, the 2014 cash flow will be discounted by 1.5 instead of 2 and so on. There you go! You can now start using the midyear convention. As you will quickly realize, all positive discounted cash flows using the midyear convention will be higher in comparison with the end of year convention. Thus, using the midyear convention will always give you a higher valuation, and it is one of those “tweaks” that bankers will try to use to justify higher valuations and get more fees so that they can buy Aston Martins, etc.
Please take a look at our Excel file for all the calculations. Remember that in order to open the file, you need to register and you will get a password for all the files in our site.
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