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.
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• 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).
The debt repayment/additions schedule just reshuffles the deckchairs. One option is to allow the
net available cash flow to carrying through to balancing debt or excess cash, and just leave it
there. But if you feel a need to assume something, ask what you would do if you were the
company. Would they repay their debt or build up cash? And if they repay debt, which type of
debt would they be likely choose? One approach might be to assume that the company repays
its most costly debt if it is able to do so.
In terms of effective interest rates on debt and cash, this should be the actual interest rate the
company pays (receives) for each category of debt (cash). Note that this may differ from Kd
used for WACC, which should be the rate at which the company could borrow in the market
today. One reason for a difference between Kd and the effective interest rate could be that the
company has some long term debt put in place years ago at rates that vary from current rates.
Remember that the effective interest rates you assume do not impact the DCF valuation, where
only Kd for WACC matters.
There is no need to bother calculating WACC going backward historically, unless you particularly
want to look at the ROIC-WACC spread.