Academic journal article European Research Studies

How to Value a Seasonal Company's Discounting Cash Flows

Academic journal article European Research Studies

How to Value a Seasonal Company's Discounting Cash Flows

Article excerpt

1. Introduction

Little attention has been paid to the impact of seasonality on the valuation of companies. Damodaran (1994), Brealey and Myers (2000), Penman (2001), and Copeland (2000) do not even include the terms "seasonal" or "seasonality" in their indexes.

We may define seasonality of cash flows as the variance of the monthly cash flows of a company. We normally say that a company exhibits a seasonality pattern when the variance of the monthly cash flows is high.

Seasonality normally is due to sales (as in the case of toy factories), to purchases (as in the case of edible oil producers) or to production decisions. When valuing companies, seasonality affects the calculation of the Free Cash Flows throughout the increase of Working Capital Requirements.

When valuing seasonal companies using annual data (instead of monthly data) it is necessary to make some adjustments. The errors derived of using annual data without adjustments for valuing companies are big.

In this paper we will use the example of Russoil, a company that buys sunflower seeds to produce and sell oil. The sales of sunflower oil are stable along the year, but the company has a policy of buying all its annual needs of seeds in December. Section 1 describes the company and provides the expected monthly balance sheets, P&Ls and cash flows. Section 2 provides the valuation of the company using monthly data. Section 3 values the company using annual data without adjustments and shows that it understates the true value in a 45% if the valuation is done at the end of December, and overstates the true value in a 38% if the valuation is done at the end of November. Sections 3.1 and 3.2 show the adjustments needed to perform a correct valuation using annual data. We define a correct valuation as one that provides the same value as the valuation using monthly data. Section 4 shows that the error of adjusting the annual data only by using average debt and average working capital requirements ranges from -17.9% to 8.5%. Section 5 presents how the valuation should be modified if the company holds excess inventories that are a liquid commodity. We argue that if the inventories are a very liquid commodity, then it is not correct to treat the excess inventories as working capital requirements. We call excess inventories to those over a minimum or safety inventory. When excess inventories are financed with debt, they are equivalent to a set of futures contracts. We point out that to buy futures contracts on a very liquid commodity is identical to buy the commodity borrowing money. Therefore, the debt incurred in the financing of these future contracts should not be considered financial debt in the valuation. That is exactly what Russoil does: buys the seeds in December borrowing money. We show that not considering it undervalues the company between 12% and 14%. Section 6 concludes.

2. Description of Russoil, a Seasonal Company

Russoil is a seasonal company that buys seeds and produces sunflower oil. The seasonality is due to the fact that the seeds are purchased and paid in December. Table 1 shows the projected balance sheets and P&Ls for the first months of the company. The company does not own fixed assets. The company has a policy of having $140,000 as minimum cash and of canceling the debt at least one month every year.

Sales are expected to grow at a monthly rate of 1% until December 2008. From that moment, sales are expected to remain constant until November 2010 when the company will be liquidated. Cost of sales is 75% of sales. 80% of the cost of sales is the cost of seeds. The remaining 20% is mainly labor costs. General expenses are expected to be 16% of sales. Seeds are paid cash and sales are collected cash. The company has not account receivables nor accounts payable. The company pays 0.5% monthly interest on the debt. Corporate taxes are 40%.

Figure 1 shows the seasonality of the inventories and of the debt. …

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