A model’s Base Year is the starting point of the model and often referred to as “time zero”. The choice of base year is important because many important assumptions use the base year, such as the fundamental income statement assumptions of revenue growth and margin expansion. Some key sources and uses assumptions, such as leverage multiple, and working capital assumptions may also use the base year as their calculation.
In many cases the base year is the last reported calendar year (e.g. 2021 Actual or 2021A). If the target uses a fiscal year convention (a fiscal year instead not ending on 12/31) that would be used instead. It’s surprisingly common, however, to use an estimated, projected, or last twelve months (LTM) value for the following reasons.
- End of the Year: If the model is being completed close to the end of the year (November or December for a calendar year target) or has completed the year but not yet reported results (January or February), it is likely the company has an accurate estimate for the full year results. In these cases it is usually preferable to use the estimate (e.g. 2021 Estimate or 2021E) rather than stale results that may be over a year old.
- Far Dated Closing: In some cases, the amount of time before closing may be very long. These could include a delay in approaching the target, the need to resolve litigation or environmental issues between sign and close, or an anticipated anti-trust process. In these cases it is usually preferable to use the estimate (next year) or even a projection (more than one year) to more accurately reflect the targets financials at time of close.
- Stub Period Model: In more advanced models, the LTM (e.g. LTM 06/30/21A) is used as the base year and driver for key income statement assumptions. The LTM is then paired with a stub period (e.g. 06/30/21 – 12/31/21) to bring the model back to the full accounting year convention. This is more likely to be used in the middle of the year when the previous year results may be too stale but the estimate for next year still has too much uncertainty. This also has the benefit of more closely aligning leverage metrics, which typically must be historical results, with the base year. While useful for these reasons, this method should not always be used because it brings additional complexity that may offset the potential advantages in accuracy. Stub periods also make it harder for model interpreters to understand growth rates and other ratios, as they may no longer represent a consistent amount of time. For example, the growth rate between LTM 06/30/21 and 2021A is not a full year and would need to be annualized, but the growth rate between 2021A and 2021E is a full year; this may not be obvious when comparing two rates side-by-side.
