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← Series 79: Collection, Analysis & Evaluation of Data
Series 79 practice questionhardDCF Analysis

An investment banker is performing a DCF on a cyclical industrial company currently at peak earnings. Which of the following adjustments would be most appropriate?

  1. AApply a premium to the discount rate to account for cyclicality
  2. BUse the most recent fiscal year's EBITDA as the basis for all projected years
  3. CNormalize earnings across the cycle and use a mid-cycle projection as the baseline for the terminal year✓ Correct answer
  4. DShorten the projection period to 3 years to reduce forecast uncertainty
Explanation

Why C — Normalize earnings across the cycle and use a mid-cycle projection as the baseline for the terminal year

For cyclical companies, using peak earnings as the baseline would overstate the terminal value and overall DCF valuation. The best practice is to normalize earnings across the business cycle so the terminal value reflects sustainable mid-cycle profitability. This avoids embedding temporary peaks or troughs into the perpetuity calculation. Adjusting the discount rate alone does not adequately address the issue of using inflated cash flows in the terminal value.

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