How to value a seasonal company by discounting cash flows
The correct way of valuing seasonal companies by cash flow discounting is to use monthly data. It is possible to use annual data, but it requires some adjustments. In this paper the author shows that when using annual data in the context of the adjusted present value (APV), the calculations of the value of the unlevered equity (Vu) and the value of the tax shields (VTS) must be adjusted. However, the debt that has to be substracted to calculate the equity value does not need to be adjusted. The author derives the adjustments to be made. The errors due to using annual data without making the adjustments are big. Adjusting the calculations only by using average debt and average working capital requirements does not provide a good approximation. When the inventories are a liquid commodity such as grain or seeds, it is not correct to consider all of them as working capital requirements. Excess inventories financed with debt are equivalent to a set of futures contracts. The author shows that not considering them as such leads to an undervaluation of the company. This paper values a company in which the seasonality is due to the purchases of raw materials: the company buys and pays for all raw materials in the month of December. It is shown that the equity value calculated using annual data without making the adjustments understates the true value by 45% if the valuation is done at the end of December, and overstates the true value by 38% if the valuation is done at the end of November. The error due to adjusting only by using average debt and average working capital requirements ranges from -17.9% to 8.5%.
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