Estimating Continuing Value
What is Continuing Value?
• To estimate a company’s value,
we separate a company’s
expected cash flow into two
periods and define the company’s
value as follows:
Home Depot: Estimated Free Cash Flow
$ millions
12,000
Present Value of Cash Flow
10,000
during Explicit Forecast Period
+
$ millions
Value =
8,000
6,000
Present Value of Cash Flow
4,000
after Explicit Forecast Period
2,000
0
• The second term is the continuing
value: the value of the company’s
expected cash flow beyond the
explicit forecast period.
2004 2005 2006 2007 2008 2009 2010 2011 2012 2013
Explicit Forecast
Period
2014 2015 2016 2017 2018 2019
Continuing
Value
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The Importance of Continuing Value
• A thoughtful estimate of continuing value is essential to any valuation because
continuing value often accounts for a large percentage of a company’s total value.
• Consider the continuing value as a percentage of total value for companies in four
industries. In these examples, continuing value accounts for 56% to 125% of total
value.
Continuing Value as a Percentage of Total Value
125
100
Explicit period
cash flow
81
56
Continuing
value
44
19
0
Tobacco
Sporting goods
High tech
Skin care
-25
* Valuations use an eight-year explicit forecast period
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Approaches to Continuing Value
Recommended Approaches:
Key value driver (KVD) formula
• The key value driver formula is superior to alternative methodologies because it is cash flow
based and links cash flow to growth and ROIC.
Economic profit model
• The economic profit leads to results consistent with the KVD formula, but explicitly highlights
expected value creation in the continuing value period.
Other Methods:
Liquidation Value and Replacement Cost
• Liquidation values and replacement costs are usually far different from the value of the
company as a going concern. In a growing, profitable industry, a company’s liquidation value
is probably well below the going-concern value.
Exit Multiples (such as P/E and EV/EBITA)
• Multiples approaches assume that a company will be worth some multiple of future earnings
or book value in the continuing period. But multiples from today’s industry can be
misleading. Industry economics will change over time and so will their multiples!
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The Key Value Driver Formula
• Although many continuing value models exist, we prefer the key value driver model.
• We believe the key value driver formula is superior to alternative methodologies
because it is cash flow based and links cash flow to growth and ROIC.
After-tax
operating profit in
the base-year
RONIC equals return on invested capital for
new investment. ROIC on existing
investment is captured by NOPLATt+1
g


NOPLATt 1 1 

RONIC


Continuing Value t 
WACC  g
The weighted average cost of
capital, based on long-run
target capital structure.
Expected long-term
growth rate in revenues
& cash flows
• The continuing value is measured at time t, and thus will need to be discounted back t
years to compute its present value.
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How Growth Affects Continuing Value
• Continuing value can be highly sensitive to changes in the continuing value parameters.
• Let’s examine how continuing value (calculated using the value driver formula) is
affected by various combinations of growth rate and rate of return on new investment.
Continuing value
is extremely
sensitive to longrun growth rates
when RONIC is
much greater than
WACC
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Continuing Value when Using Economic Profit
• When using the economic profit approach, do not use the traditional key value driver
formula, as the formula would double-count cash flows.
• Instead, a formula must be defined which is consistent with the economic profit-based
valuation method. The total value of a company is as follows:
Value of
operations
Invested
capital at
= beginning of +
forecast
Present value of
forecasted economic
profit during explicit
forecast period
+
Present value of
forecasted
economic profit
after the explicit
forecast period
Explicit Forecast Period
Continuing value only
represents long-run value
creation, not total value.
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Continuing Value when Using Economic Profit
• The continuing value formula for economic profit models has two components:
CVt 
IC t ROIC t 1 - WACC PV(Economc Profit t  2 )

WACC
WACC  g
Value created on current
capital, based on ROIC at end
of forecast period (using a no
growth perpetuity).
Value created (or destroyed) on
new capital using RONIC. New
capital grows at g, so a growing
perpetuity is used.
• The present value of economic profit equals EVA / WACC (i.e. no growth)
New Investment
Economic Spread
g 

NOPLATt 1 
 RONIC - WACC
RONIC 

PV(Economi c Profit t 2 ) 
WACC
Value using Perpetuity
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Comparison of KVD and Economic Profit CV
• Consider a company with $500 in capital earning an ROIC of 20%. Its expected baseyear NOPLAT is therefore $100. If the company has a RONIC of 12%, a cost of capital
of 11%, and a growth rate of 6%, what is the company’s (continuing) value?
• Using the KVD formula:
6% 

$100 1 

12% 

Continuing Value t 
 $1,000
11%  6%
• Using the Economic Profit-based KVD, we arrive at a partial value:
 6% 
100 
 12% - 11%
12% 

PV(Economi c Profit t  2 ) 
 $4.54
11%
CVt 
$50020% - 11% 
$4.54

11%
11%  6%
Step 1
Step 2
CVt  409.1  90.9  500.0
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Other Approaches to Continuing Value
• Several alternative approaches to continuing value are used in practice, often with
misleading results.
• A few approaches are acceptable if used carefully, but we prefer the methods
recommended earlier because they explicitly rely on the underlying economic
assumptions embodied in the company analysis
Continuing value
$ Million
Technique
Assumptions
Book value
Per accounting records
268
Liquidation value
80 percent of working capital
70 percent of net fixed assets
186
Price-to-earnings ratio
Industry average of 15.0x
624
Market-to-book ratio
Industry average of 1.4x
375
Replacement cost
Book value adjusted for
inflation
275
You can not base
continuing value on
multiples from today’s
industry. Industry
economics will change
over time and so will
their multiples!
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Length of Explicit Forecast
• While the length of the explicit forecast period you choose is important, it does not
affect the value of the company; it only affects the distribution of the company’s value
between the explicit forecast period and the years that follow.
• In the example below, the company value is $893, regardless of how long the forecast
period is. Short forecast periods lead to higher proportions of continuing value.
Value of Operations
100% =
Your estimate of
enterprise value should
not be affected by the
length of the explicit
forecast period.
$893
$893
$893
$893
35
$893
26
46
Continuing
value
60
79
65
Value of
explicit free
cash flow
Horizon
74
54
40
21
5-year
10-year
15-year
20-year
25-year
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The Difference between RONIC and ROIC
• Let’s say you decide to use an explicit forecast period of 10-years, followed by a
continuing value estimated with the KVD formula. In the formula, you assume
RONIC equals WACC. Does this mean the firm creates no value beyond year 10?
• No, RONIC equal to WACC implies new projects don’t create value. Existing projects
continue to perform at their base-year level.
ROIC Percent
ROIC on existing capital
Company-wide ROIC
ROIC on new capital
(RONIC)
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An Example: Innovation, Inc.
• Consider Innovation, Inc, a company with the following cash flow stream. Discounting
the company’s cash flows at 11% leads to a value of $1,235.
• Based on the cash flow pattern, it appears the company’s value is highly dependent
on estimates of continuing value…
Free Cash Flow at Innovation, Inc.
Free cash flow
$1,235
1,050
(85%)
185
(15%)
Year
Present value
of continuing
value
Value of years 1-9
free cash flow
DCF value
at 11%
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An Example: Innovation, Inc.
• But Innovation Inc consists of two projects: its base business (which is stable) and a
new product line (which requires tremendous investment).
• Valuing each part separately, it becomes apparent that 71 percent of the company’s
value comes from operations that are currently generating strong cash flow.
Free Cash Flow at Innovation, Inc.
$1,235
Free cash flow
Free cash flow from
new product line
358
(29%)
New
product
line
877
(71%)
Base
business
Base business
free cash flow
Year
DCF value
at 11%
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An Example: Innovation, Inc.
• By computing alternative approaches, we can generate insight into the timing of cash
flows, where value is created (across business units), or even how value is created
(derived from invested capital or future economic profits).
• Regardless of the method chosen, the resulting valuation should be the same.
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Common Pitfalls: Naïve Base Year Extrapolation
• A common error in forecasting the base level of FCF is to assume the re-investment
rate is constant, implying NOPLAT, investment, and FCF all grow at the same rate
Year 11 (5% growth)
Year 9
Year 10
1,000
1,100
1,155
(850)
(935)
(982)
(982)
EBIT
150
165
173
Cash taxes
(60)
(66)
(69)
173
(69)
NOPLAT
90
99
104
104
Depreciation
27
30
32
32
117
129
136
136
Capital expenditures
30
33
35
35
Increase in working capital
27
30
32
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Gross investment
57
63
67
52
Free cash flow
60
66
69
84
300
330
362
347
30
30
31
30
Sales
Operating expenses
Gross cash flow
Year-end working cap
Working capital/sales (percent)
Incorrect Correct
1,155
This level of investment
was predicated on a 10%
revenue growth rate
When the company’s
growth rate falls to 5%,
required investment should
fall as well!
With naïve base-year
extrapolation, FCF is
too small!
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Common Pitfalls: Overconservatism
Naïve Overconservatism
• The assumption that RONIC equals WACC is often faulty because strong brands,
plants and other human capital can generate economic profits for sustained
periods of time, as is the case for pharmaceutical companies, consumer products
companies and some software companies.
Purposeful Overconservatism
• Many analysts err on the side of caution when estimating continuing value
because of uncertainty, but to offer an unbiased estimate of value, use the best
estimate available. The risk of uncertainty will already be captured by the
weighted average cost of capital.
• An effective alternative to revising estimates downward is to model uncertainty
with scenarios and then examine their impact on valuation
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Common Pitfalls: Distorting the Growing Perpetuity
• Simplifying the key value driver formula can result in distortions of continuing value.
Company-wide average ROIC
NOPLAT
CV =
WACC-g
NOPLAT
CV =
WACC
Forecast
period
WACC
Overly aggressive?
Assumes RONIC
equals infinity!
Overly conservative?
Assumes RONIC equals
the weighted average
cost of capital
Continuing
value period
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Closing Thoughts
• Continuing value can drive a large portion of the enterprise value and should therefore
be evaluated carefully.
• Several estimation approaches are available, but recommended models (such as the key
value driver and economic profit models) explicitly consider:
• Profits at the end of the explicit forecast period - NOPLATt+1
• The rate of return for new investment projects - RONIC
• Expected long-run growth - g
• Cost of capital - WACC
• A large continuing value does not necessarily imply a noisy valuation. Other methods,
such as business components and economic profit can provide meaningful perspective
on how aggressive (or conservative) the continuing value is.
• Common pitfalls to avoid: naïve extrapolation to determine the base year cash flows,
purposeful overconservatism and naïve overconservatism (RONIC = WACC).
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