A Tutorial on the McKinsey Model for Valuation of Companies

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A Tutorial on the McKinsey Model for
Valuation of Companies
L. Peter Jennergren ∗
Fourth revision, August 26, 2002
SSE/EFI Working Paper Series in Business Administration No. 1998:1
All steps of the McKinsey model are outlined. Essential steps are: calculation
of free cash flow, forecasting of future accounting data (profit and loss accounts and
balance sheets), and discounting of free cash flow. There is particular emphasis on
forecasting those balance sheet items which relate to Property, Plant, and Equip-
ment. There is an exemplifying valuation included (of a company called McKay),
as an illustration.
Key words: Valuation, free cash flow, discounting, accounting data
JEL classification: G31, M41, C60
∗Stockholm School of Economics, Box 6501, S - 11383 Stockholm, Sweden. The author is indebted to
Joakim Levin, Per Olsson, Kenth Skogsvik, and Tomas Hjelstr¨
om for discussions and comments. Minor
corrections made September 29, 2004, and February 9, 2005.

This tutorial explains all the steps of the McKinsey valuation model, also referred to
as the discounted cash flow model and described in Tom Copeland, Tim Koller, and Jack
Murrin: Valuation: Measuring and Managing the Value of Companies (Wiley, New York;
1st ed. 1990, 2nd ed. 1994, 3rd ed. 2000). The purpose is to enable the reader to set up a
complete valuation model of his/her own, at least for a company with a simple structure
(e. g., a company that does not consist of several business units and is not involved in
extensive foreign operations). The discussion proceeds by means of an extended valuation
example. The company that is subject to the valuation exercise is the McKay company.
The McKay example in this tutorial is somewhat similar to the Preston example (con-
cerning a trucking company) in Copeland et al. 1990, Copeland et al. 1994. However,
certain simplifications have been made, for easier understanding of the model. In par-
ticular, the capital structure of McKay is composed only of equity and debt (i. e., no
convertible bonds, etc.). The purpose of the McKay example is merely to present all
essential aspects of the McKinsey model as simply as possible. Some of the historical
income statement and balance sheet data have been taken from the Preston example.
However, the forecasted income statements and balance sheets are totally different from
Preston’s. All monetary units are unspecified in this tutorial (in the Preston example in
Copeland et al. 1990, Copeland et al. 1994, they are millions of US dollars).
This tutorial is intended as a guided tour through one particular implementation of
the McKinsey model and should therefore be viewed only as exemplifying: This is one way
to set up a valuation model. Some modelling choices that have been made will be pointed
out later on. However, it should be noted right away that the specification given below
of net Property, Plant, and Equipment (PPE) as driven by revenues is actually taken
from Copeland et al. 2000. The previous editions of this book contain two alternative
model specifications relating to investment in PPE (cf. Section 15 below; cf. also Levin
and Olsson 1995).
In one respect, this tutorial is an extension of Copeland et al. 2000: It contains a more
detailed discussion of capital expenditures, i. e., the mechanism whereby cash is absorbed
by investments in PPE. This mechanism centers on two particular forecast assumptions,
[this year’s net PPE/revenues] and [depreciation/last year’s net PPE].1 It is explained
below how those assumptions can be specified at least somewhat consistently.
On a
related note, the treatment of deferred income taxes is somewhat different, and also more
detailed, compared to Copeland et al. 2000. In particular, deferred income taxes are
related to a forecast ratio [timing differences/this year’s net PPE], and it is suggested
how to set that ratio.
1Square brackets are used to indicate specific ratios that appear in tables in the spreadsheet file.

There is also another extension in this tutorial: An alternative valuation model is
included, too, the abnormal earnings model. That is, McKay is valued through that
model as well.
The McKay valuation is set up as a spreadsheet file in Excel named MCK 1.XLS.
That file is an integral part of this tutorial. The model consists of the following parts (as
can be seen by loading the file):
Table 1. Historical income statements,
Table 2. Historical balance sheets,
Table 3. Historical free cash flow,
Table 4. Historical ratios for forecast assumptions,
Table 5. Forecasted income statements,
Table 6. Forecasted balance sheets,
Table 7. Forecasted free cash flow,
Table 8. Forecast assumptions,
Value calculations.
Tables in the spreadsheet file and in the file printout that is included in this tutorial are
hence indicated by numerals, like Table 1. Tables in the tutorial text are indicated by
capital letters, like Table A.
The outline of this tutorial is as follows: Section 2 gives an overview of essential model
features. Section 3 summarizes the calculation of free cash flow. Section 4 is an introduc-
tion to forecasting financial statements and also discusses forecast assumptions relating
to operations and working capital. Sections 5, 6, and 7 deal with the specification of
the forecast ratios [this year’s net PPE/revenues], [depreciation/last year’s net PPE], and
[retirements/last year’s net PPE]. Section 8 considers forecast assumptions about taxes.
Further forecast assumptions, relating to discount rates and financing, are discussed in
Section 9. Section 10 outlines the construction of forecasted financial statements and
free cash flow, given that all forecast assumptions have been fixed. Section 11 outlines a
slightly different version of the McKay example, with another system for accounting for
deferred income taxes.2 The discounting procedure is explained in Section 12. Section 13
gives results from a sensitivity analysis, i. e., computed values of McKay’s equity when cer-
tain forecast assumptions are revised. Section 14 discusses the abnormal earnings model
and indicates how McKay’s equity can be valued by that model. Section 15 discusses
two further discounted cash flow model versions, one of which may in a certain sense be
considered “exact”. The purpose is to get a feeling for the goodness of valuations derived
2This version of the McKay example is contained in the Excel file MCK 1B.XLS. A printout from that
file is also included in this tutorial. The two versions of the McKay example are equivalent as regards
cash flow and resulting value. In other words, it is only the procedure for computing free cash flow that
differs (slightly) between them.

by means of the McKinsey model, in particular the sensitivity to changes in certain model
parameters. Section 16 contains concluding remarks. There are two appendices. Appen-
dix 1 discusses how a data base from Statistics Sweden can be used as an aid in specifying
parameters related to the forecast ratios [this year’s net PPE/revenues], [depreciation/last
year’s net PPE] and [retirements/last year’s net PPE]. Appendix 2 is a note on leasing.
The point is that payments associated with leases can be viewed as pertaining either to
the firm’s operations, or to its financing. If one is consistent, both views lead to the same
valuation result. A similar remark also applies to payments associated with pensions.
Model Overview
Essential features of the McKinsey model are the following:
1. The model uses published accounting data as input. Historical income statements
and balance sheets are used to derive certain critical financial ratios. Those historical
ratios are used as a starting point in making predictions for the same ratios in future
2. The object of the McKinsey model is to value the equity of a going concern. Even so,
the asset side of the balance sheet is initially valued. The value of the interest-bearing debt
is then subtracted to get the value of the equity. Interest-bearing debt does not include
deferred income taxes and trade credit (accounts payable and other current liabilities).
Credit in the form of accounts payable is paid for not in interest but in higher operating
expenses (i. e., higher purchase prices of raw materials) and is therefore part of operations
rather than financing. Deferred income taxes are viewed as part of equity; cf. Sections 9
and 10. It may seem like an indirect approach to value the assets and deduct interest-
bearing debt to arrive at the equity (i. e., it may seem more straight-forward to value
the equity directly, by discounting future expected dividends). However, this indirect
approach is the recommended one, since it leads to greater clarity and fewer errors in the
valuation process (cf. Copeland et al. 2000, pp. 150-152).
3. The value of the asset side is the value of operations plus excess marketable secu-
rities. The latter can usually be valued using book values or published market values.
Excess marketable securities include cash that is not necessary for operations. For valu-
ation purposes, the cash account may hence have to be divided into two parts, operating
cash (which is used for facilitating transactions relating to actual operations), and ex-
cess cash. (In the case of McKay, excess marketable securities have been netted against
interest-bearing debt at the date of valuation. Hence there are actually no excess mar-
ketable securities in the McKay valuation. This is one of the modelling choices that were
alluded to in the introduction.)
4. The operations of the firm, i. e., the total asset side minus excess marketable secu-

rities, are valued by the WACC method. In other words, free cash flow from operations
is discounted to a present value using the WACC. There is then a simultaneity problem
(actually quite trivial) concerning the WACC. More precisely, the debt and equity values
enter into the WACC weights. However, equity value is what the model aims to determine.
5. The asset side valuation is done in two parts: Free cash flow from operations is
forecasted for a number of individual years in the explicit forecast period. After that,
there is a continuing value derived from free cash flow in the first year of the post-horizon
period (and hence individual yearly forecasts must be made for each year in the explicit
forecast period and for one further year, the first one immediately following the explicit
forecast period). The explicit forecast period should consist of at least 7 - 10 years (cf.
Copeland et al. 2000, p. 234). The explicit forecast period can be thought of as a transient
phase during a turn-around or after a take-over. The post-horizon period, on the other
hand, is characterized by steady-state development. This means that the explicit forecast
period should as a minimal requirement be sufficiently long to capture transitory effects,
e. g., during a turn-around operation.
6. For any future year, free cash flow from operations is calculated from forecasted
income statements and balance sheets. This means that free cash flow is derived from a
consistent scenario, defined by forecasted financial statements. This is probably the main
strength of the McKinsey model, since it is difficult to make reasonable forecasts of free
cash flow in a direct fashion. Financial statements are forecasted in nominal terms (which
implies that nominal free cash flow is discounted using a nominal discount rate).
7. Continuing (post-horizon) value is computed through an infinite discounting for-
mula. In this tutorial, the Gordon formula is used (cf. Brealey and Myers 2002, pp. 38
and 64-65). In other words, free cash flow in the post-horizon period increases by some
constant percentage from year to year, hence satisfying a necessary condition for infinite
discounting. (The Gordon formula is another one of the modelling choices made in this
As can be inferred from this list of features, and as will be explained below, the
McKinsey model combines three rather different tasks: The first one is the production
of forecasted financial statements. This is not trivial. In particular, it involves issues
relating to capital expenditures that are fairly complex. (The abnormal earnings model
uses forecasted financial statements, just like the McKinsey model, so the first task is
actually the same for that model as well).
The second task is deriving free cash flow from operations from financial statements.
At least in principle, this is rather trivial. In fairness, it is not always easy to calculate free
cash flow from complicated historical income statements and balance sheets. However, all
financial statements in this tutorial are very simple (and there is, in any case, no reason
to forecast accounting complexities if the purpose is one of valuation). The third task is

discounting forecasted free cash flow to a present value. While not exactly trivial, this task
is nevertheless one that has been discussed extensively in the corporate finance literature,
so there is guidance available. This tutorial will explain the mechanics of discounting
in the McKinsey model. However, issues relating to how the relevant discount rates are
determined will largely be brushed aside. Instead, the reader is referred to standard text
books (for instance, Brealey and Myers 2002, chapters 9, 17, and 19).
Historical Financial Statements and the Calcula-
tion of Free Cash Flow
The valuation of McKay is as of Jan. 1 year 1. Historical input data are the income
statements and balance sheets for the years −6 to 0, Tables 1 and 2. Table 1 also includes
statements of retained earnings. It may be noted in Table 1 that operating expenses
do not include depreciation (i. e., operating expenses are cash costs). At the bottom of
Table 2, there are a couple of financial ratio calculations based on historical data for the
given years. Short-term debt in the balance sheets (Table 2) is that portion of last year’s
long-term debt which matures within a year. It is clear from Tables 1 and 2 that McKay’s
financial statements are very simple, and consequently the forecasted statements will also
have a simple structure. As already mentioned earlier, McKay has no excess marketable
securities in the last historical balance sheet, i. e., at the date of valuation.
From the data in Tables 1 and 2, historical free cash flow for the years −5 to 0
is computed in Table 3. Each annual free cash flow computation involves two balance
sheets, that of the present year and the previous one, so no free cash flow can be obtained
for year −6. Essentially the same operations are used to forecast free cash flow for
year 1 and later years (in Table 7). The free cash flow calculations assume that the
clean surplus relationship holds. This implies that the change in book equity (including
retained earnings) equals net income minus net dividends (the latter could be negative,
if there is an issue of common equity). The clean surplus relationship does not hold,
if PPE is written down (or up) directly against common equity (for instance). Such
accounting operations may complicate the calculation of free cash flow from historical
financial statements (and if so, that calculation may not be trivial). However, there is no
reason to forecast deviations from the clean surplus relationship in a valuation situation.
EBIT in Table 3 means Earnings Before Interest and Taxes. NOPLAT means Net Op-
erating Profits Less Adjusted Taxes. Taxes on EBIT consist of calculated taxes according
to the income statement (from Table 1) plus [this year’s tax rate]×(interest expense)
minus [this year’s tax rate]×(interest income). Interest income and interest expense are
taken from Table 1. The tax rate is given in Table 4. Calculated taxes according to the
income statement reflect depreciation of PPE over the economic life. Change in deferred

income taxes is this year’s deferred income taxes minus last year’s deferred income taxes.
In the McKay valuation example, it is assumed that deferred income taxes come about
for one reason only, timing differences in depreciation of PPE. That is, fiscal depreciation
takes place over a period shorter than the economic life.
Working capital is defined net. Hence, working capital consists of the following balance
sheet items: Operating cash plus trade receivables plus other receivables plus inventories
plus prepaid expenses minus accounts payable minus other current liabilities. Accounts
payable and other current liabilities are apparently considered to be part of the operations
of the firm, not part of the financing (they are not interest-bearing debt items). Change
in working capital in Table 3 is hence this year’s working capital minus last year’s working
capital. Capital expenditures are this year’s net PPE minus last year’s net PPE plus this
year’s depreciation. Depreciation is taken from Table 1, net PPE from Table 2. It should
be emphasized that depreciation in Table 1 (and forecasted depreciation in Table 5) is
according to plan, over the economic life of the PPE.
Free cash flow in Table 3 is hence cash generated by the operations of the firm, after
paying taxes on operations only, and after expenditures for additional working capital and
after capital expenditures. (“Additional working capital” could of course be negative. If
so, free cash flow is generated rather than absorbed by working capital.) Hence, free cash
flow represents cash that is available for distribution to the holders of debt and equity in
the firm, and for investment in additional excess marketable securities. Stated somewhat
differently, free cash flow is equal to financial cash flow, which is the utilization of free
cash flow for financial purposes. Table 3 also includes a break-down of financial cash flow.
By definition, free cash flow must be exactly equal to financial cash flow.
As suggested in the introduction (Section 1), certain payments may be classified as
pertaining either to free cash flow (from operations), or to financial cash flow. In other
words, those payments may be thought of as belonging either to the operations or the
financing of the firm. This holds, in particular, for payments associated with capital
leases. If one is consistent, the resulting valuation should of course not depend on that
classification. This issue is further discussed in Appendix 2.
We now return briefly to the financial ratios at the end of Table 2. Invested capi-
tal is equal to working capital plus net PPE. Debt at the end of Table 2 in the ratio
[debt/invested capital] is interest-bearing (short-term and long-term). The financial ratio
[NOPLAT/invested capital] is also referred to as ROIC (Return on Invested Capital). It
is a better analytical tool for understanding the company’s performance than other return
measures such as return on equity or return on assets, according to Copeland et al. (2000,
pp. 165-166). Invested capital in the ratio [NOPLAT/invested capital] is the average of
last year’s and this year’s. It is seen that McKay has on average provided a fairly modest
rate of return in recent years. It can also be seen from Table 3 that the free cash flow has

been negative, and that the company has handled this situation by increasing its debt.
It is also evident from the bottom of Table 2 that the ratio of interest-bearing debt to
invested capital has increased substantially from year −6 to year 0.
Table 4 contains a set of historical financial ratios. Those ratios are important, since
forecasts of the same ratios will be used to produce forecasted income statements and
balance sheets. Most of the items in Table 4 are self-explanatory, but a few observations
are called for. Net PPE (which is taken from Table 2) enters into four ratios. In two of
those cases, [depreciation/net PPE] and [retirements/net PPE], the net PPE in question
is last year’s. In the other two cases, [net PPE/revenues] and [timing differences/net
PPE], the net PPE in question is this year’s. Retirements are defined as depreciation
minus change in accumulated depreciation between this year and last year (accumulated
depreciation is taken from Table 2). This must hold, since last year’s accumulated de-
preciation plus this year’s depreciation minus this year’s retirements equals this year’s
accumulated depreciation.
The timing differences for a given year are measured between accumulated fiscal depre-
ciation of PPE and accumulated depreciation according to PPE economic life. For a given
piece of PPE that is about to be retired, accumulated fiscal depreciation and accumulated
depreciation according to economic life are both equal to the original acquisition value.
Consequently, non-zero timing differences are related to non-retired PPE only. The ratio
[timing differences/net PPE] in Table 4 has been calculated by first dividing the deferred
income taxes for a given year by the same year’s corporate tax rate (also given in Table
4). This gives that year’s timing differences. After that, there is a second division by that
year’s net PPE.
Forecast Assumptions Relating to Operations and
Working Capital
Having recorded the historical performance of McKay in Tables 1 - 4, we now turn
to the task of forecasting free cash flow for years 1 and later. Individual free cash flow
forecasts are produced for each year 1 to 12. The free cash flow amounts for years 1 to
11 are discounted individually to a present value. The free cash flow for year 12 and all
later years is discounted through the Gordon formula, with the free cash flow in year 12
as a starting value. Years 1 to 11 are therefore the explicit forecast period, and year 12
and all later years the post-horizon period.
Tables 5 - 8 have the same format as Tables 1 - 4. In fact, Table 5 may be seen as
a continuation of Table 1, Table 6 as a continuation of Table 2, and so on. We start
the forecasting job by setting up Table 8, the forecast assumptions. Using assumptions
(financial ratios and others) in that table, and using a couple of further direct forecasts

of individual items, we can set up the forecasted income statements, Table 5, and the
forecasted balance sheets, Table 6. From Tables 5 and 6, we can then in Table 7 derive
the forecasted free cash flow (just like we derived the historical free cash flow in Table 3,
using information in Tables 1 and 2).
Consider now the individual items in Table 8. It should be noted in Table 8 that all
items are the same for year 12, the first year of the post-horizon period, as for year 11,
the last year of the explicit forecast period. Since the first year in the post-horizon period
is representative of all subsequent post-horizon years, all items are the same for every
post-horizon year as for the last year of the explicit forecast period. This is actually an
important condition (cf. Levin and Olsson 1995, p. 38): If that condition holds, then free
cash flow increases by the same percentage (the nominal revenue growth rate for year
12 in Table 8, cell T137) between all successive years in the post-horizon period. This
means that a necessary condition for discounting by means of the Gordon formula in the
post-horizon period is satisfied.
The revenue growth in each future year is seen to be a combination of inflation and real
growth. Actually, in years 10 and 11 there is no real growth, and the same assumption
holds for all later years as well (in the application of the Gordon formula). The underlying
assumption in Table 8 is apparently that real operations will initially expand but will
eventually (in year 10) settle down to a steady state with no further real growth. Inflation,
on the other hand, is assumed to be 3% in all coming years (including after year 11). The
ratio of operating expenses to revenues is assumed to improve immediately, e. g., as a
consequence of a determined turn-around effort. Apparently, it is set to 90% year 1
and all later years. To avoid misunderstandings, this forecast assumption (and the other
ones displayed in Table 8) are not necessarily intended to be the most realistic ones that
can be imagined. The purpose is merely to demonstrate the mechanics of the McKinsey
model for one particular scenario. A table in Levin and Olsson 1995 (p. 124; based on
accounting data from Statistics Sweden) contains information about typical values of the
ratio between operating expenses and revenues in various Swedish industries (cf. also
Appendix 1 for a further discussion of the Statistics Sweden data base).
A number of items in the forecasted income statements and balance sheets are di-
rectly driven by revenues. That is, those items are forecasted as percentages of revenues.
In particular, this holds for the working capital items. It is thus assumed that as rev-
enues increase, the required amounts of working capital of different categories increase
correspondingly. It is not important whether revenues increase due to inflation or real
growth, or a combination of both. Working capital turns over very quickly, and therefore
it is a reasonable assumption that the working capital items are simply proportional to
revenues. The ratios between the different categories of working capital and revenues for
future years in Table 8 have been set equal to the average values of the corresponding

historical percentages in Table 4. Again, this is only for illustrative purposes. Another
table in Levin and Olsson 1995 (p. 125), again based on data from Statistics Sweden,
reports average values of the ratio between (aggregate) working capital and revenues in
different Swedish industries.
Forecast Assumptions Relating to Property, Plant,
and Equipment
The forecast assumptions relating to PPE will be considered next (this section and
the following two). The equations that determine capital expenditures may be stated as
follows (subscripts denote years):
(capital expenditures)t = (net PPE)t − (net PPE)t−1 + depreciationt,
(net PPE)t = revenuest × [this year’s net PPE/revenues],
depreciationt = (net PPE)t−1 × [depreciation/last year’s net PPE].
To this set of equations, we may add three more that are actually not necessary for the
retirementst = (net PPE)t−1 × [retirements/last year’s net PPE],
(accumulated depreciation)t
= (accumulated depreciation)t−1 + depreciationt − retirementst,
(gross PPE)t = (net PPE)t + (accumulated depreciation)t.
In particular, this second set of three equations is needed only if one wants to produce
forecasted balance sheets showing how net PPE is related to gross PPE minus accumulated
depreciation. It should be noted that such detail is not necessary, since the first set of
three equations suffices for determining net PPE, depreciation, and consequently also
capital expenditures.3
It is clear from the first three equations that forecasts have to be made for two partic-
ular ratios, [this year’s net PPE/revenues] and [depreciation/last year’s net PPE]. Setting
those ratios in a consistent fashion involves somewhat technical considerations. In this
section and the following one, one way of proceeding, consistent with the idea of the
company developing in a steady-state fashion in the post-horizon period, will be outlined.
To begin with, the idea of the company developing in a steady-state fashion has to
be made more precise. As indicated in Section 4, the forecast assumptions should be
3If the historical financial statements do not show gross PPE and accumulated depreciation, only net
PPE, then it seems pointless to try to include these items in the forecasted financial statements. If so,
the second set of three equations is deleted. In the McKay case, the historical statements do indicate
gross PPE and accumulated depreciation. For that (aesthetic) reason, those items will also be included
in the forecasted statements.