Chapter 12
Estimating Continuing
Value
Presented by
Supatcharee Hengboriboonpong
Kittanai Pongsak
Outline
•
Estimating Continuing Value
•
Continuing Value Formula for DCF Valuation
•
Continuing Value Formula for Economic Profit
•
Interpretation of Continuing Value
•
Parameters for Continuing Value Variables
•
Common Pitfalls
•
Evaluating Other Approaches
Valuation
Value =
PV of CF during
Explicit forecast
period
+
PV of CF after
explicit forecast
period
Continuing Value =
The value of the company’s
expected cash flow beyond the
explicit forecast period.
Continuing Value Formula for
DCF Valuation
Continuing Value=
NOPLATt+1(1-g/ROICI)
WACC-g
NOPLAT = The normalized level of NOPLAT in the first year after the
explicit forecast period.
g
= The expected growth rate in NOPLAT in perpetuity.
ROIC
= The expected rate of return on net new investment.
WACC
= The weighted aver cost of capital.
Assumptions for the Continuing
Value Formula for DCG Valuation
 The company earns constant margins, maintains a constant
capital turnover, and thus earns a constant return on existing
invested capital.
 The company’s revenues and NOPLAT grow at a constant rate
and the company invests the same proportion of its gross cash
flow in its business each year.
 The company earns a constant return on all new investments.
Simple Formula for a Cash Flow Perpetuity
that grows at a constant Rate
Continuing value =
FCFT+1
WACC-g
FCFT+1 = The normalized level of free cash flow in the first
year after the explicit forecast period.
This formula is well established in the finance and
mathematic literature.
Free Cash Flow in terms of NOPLAT and
Investment Rate
Free Cash Flow= NOPLAT x (1-IR)
IR = The investment rate, or the percentage of
NOPLAT reinvested in the business each year.
Relationship between
IR, g and ROICI
g = ROICI x IR
IR =
g/ ROICI
Now build this into the free cash flow (FCF) definition
FCF = NOPLAT
x
1-
g
ROICI
Substituting for FCF gives the value driver formula
Continuing value = NOPLAT (1-g/ROIC)
WACC-g
Also Known As
Value-Driver Formula
Because the input variables of
Growth, ROIC and WACC
are the key drives of
Value
Growth rate in NOPLAT & Free Cash Flow = 6%
ROICi = 12% and WACC = 11%
1
NOPLAT
Net Investment
Free Cash Flow
Year
3
2
100
50
50
106
53
53
4
112
56
56
5
120
60
60
126
63
63
Long Range Forecast of 150 years
CV= 50/1.11+53/(1.11)2+56/(1.11)3+…50(1.06)149/(1.11)150=999
Growing Free Cash Flow Perpetuity Formula
CV= 50/11% - 6% = 1000
Value-Driver Formula
CV= 100(1-6%/12%) / 11%-6%=1000
Recommended Continuing Value
Formula for Economic Profit
Valuation
With the economic profit approach, the
continuing value does not represent
the value of the company after the
explicit forecast period.
Instead, it is the incremental value
over the company’s invested capital at
the end of the explicit forecast period
CV formula for Economic Profit Valuation
Value =
Invested capital at the beginning of the period
+
Present value of forecasted economic profit
during explicit forecast period
+
Present value of forecasted economic profit
after the explicit forecast period
Continuing value formula for economic profit
CV = Economic profitT+1 + (NOPLATT+1)(g/ROICI)(ROICI – WACC)
WACC
WACC (WACC – g)
Economic ProfitT+1=
NOPLAT
=
g
=
ROICI
=
WACC
=
The normalized economic profit in the first
year after the explicit forecast period.
The normalized NOPLAT in the first year
after the explicit forecast period.
The expected growth rate in NOPLAT in
perpetuity.
The expected rate of return on new new
investments.
The weighted average cost of capital.
Issues in the Interpretation of
Continuing Value
Three common misunderstandings about
continuing value:
 The perception that the length of the forecast affects
the value of the company
 The confusion about the ROIC assumption in the
continuing value period
 All the company’s value is created after the explicit
forecast period
Total Value Calculations 5 years
Overall Assumptions (%)
Year 1-5
Return on Investment
Grow th rate
WACC
6+
16%
12%
9%
6%
12%
12%
Base
5 yr. Horizon
1
2
3
4
5
100.0
109.0
118.8
129.5
141.2
20.0
21.8
23.8
25.9
28.2
120.0
130.8
142.6
155.4
169.4
76.3
83.2
90.7
98.8
107.7
FCF
43.70
47.63
51.92
56.59
61.69
Discount Factor
0.893
0.797
0.712
0.636
0.567
39.0
38.0
37.0
36.0
35.0
NOPLAT
Depreciation
Gross Cash Flow
Gross Investment
Present Value of cash flow
Present value of CV
NOPLAT(1-g/ROIC)
(1/1+WACC)^5 =
WACC -g
149.6(6%/12%)
(0.5674) =
12% - 6%
Present Value of FCF 1 - 5
184.9
Continuing Value
707.5
Total Value
892.4
707.5
for CV
149.63
Total Value Calculations 10 years
Overall Assumptions (%) Yr 1-5
6+
Return on Investment
Growth rate
WACC
12%
6%
12%
10 yr. Horizon
NOPLAT
Depreciation
Gross Cash Flow
Gross Investment
FCF
16%
9%
12%
1
2
3
4
100.0 109.0 118.8 129.5
20.0 21.8 23.8 25.9
120.0 130.8 142.6 155.4
76.3 83.2 90.7 98.8
43.70 47.63 51.92 56.59
5
141.2
28.2
169.4
107.7
61.69
6
149.6
29.9
179.6
104.7
74.85
7
158.6
31.7
190.3
111.0
79.37
8
168.1
33.6
201.7
117.6
84.13
9
178.2
35.6
213.9
124.7
89.18
Base
10 for CV
188.9 200.2
37.8
226.7
132.2
94.53
Discount Factor
0.893 0.797 0.712 0.636 0.567 0.507 0.452 0.404 0.361 0.322
Present Value of cash flow 39.0 38.0 37.0 36.0 35.0 38.0 35.9 34.0 32.2 30.4
Present value of CV
NOPLAT(1-g/ROIC) (1/1+WACC)^5 =
WACC -g
149.6(6%/12%)
12% - 6%
0.322 537.3
Present Value of FCF 1 - 5355.4
Continuing Value
537.3
Total Value
892.6
Confusion about ROIC
Confusion can occur with the concept of competitive advantage period
when companies will earn returns above the cost of capital for a period of
time, followed by a decline in the cost of capital. It is dangerous to link it to
the length of the forecast. As it has been shown that there is no connection
between the length of the forecast and the value of the company.
Remember, the value-driver formula is based on incremental returns on
capital, not company wide average returns. If you assume that incremental
returns in the CV period will just equal the cost of capital, you are not
assuming that the return on total capital (old and new) will equal the cost of
capital.
The return on the old capital will continue to earn the returns it is projected
to earn in the last forecast period.
In other words, the company’s competitive advantage period has not come
to an end once you reach the continuing value period.
Exhibit 12.4 shows the implied average ROIC assuming that projected CV
growth is 4.5%, the return on base capital is 18%, the return on
incremental capital is 10%, and the WACC is 10%. The average return on
all capital declines gradually. From its starting point of 18% , it declines to
14% (the halfway point to the incremental ROIC) after 11 years. It
reaches 12% after 23 years and 11% after 37 years.
When is Value Created? Below, it appears the 85% of the
company’s value come form the Continuing Value.
A Business Components Approach
Looks at the negative cash flow when invested in a new business line
and its appearance of long range value.
Economic Profit Model
Valuation is the same from all three methods.
Impact of Continuing-Value Assumptions
Estimating Parameters for Continuing Value
Variables
NOPLAT The base level of NOPLAT should reflect a normalized
level of earnings for the company at the midpoint of its business
cycle. Revenues should generally reflect the continuation of the
trends in the last forecast year adjusted to the midpoint of the
business cycle. Operating costs should be based on sustainable
margin levels, and taxes should be based on long-term expected
rates.
Free Cash Flow First, estimate the base level of NOPLAT as
described above. Although NOPLAT is usually based on the last
forecast year’s results, the prior year’s level of investment is
probably not a good indicator of the sustainable amount of
investment needed for growth in the continuing value period.
Carefully estimate how much investment will be required to
sustain the forecasted growth rate. Often the forecasted
growth in the CV Period is lower so the amount of investment
should be proportionately smaller amount of NOPLAT.
Estimating Parameters for Continuing Value
Variables
Incremental ROIC The ROIC should be consistent with expected
competitive conditions. Economic theory suggests that competition
will eventually eliminate abnormal return, so for many companies,
set ROIC=WACC. If you expect the company will be able to
continue its growth and to maintain its competitive advantage, then
you might consider setting ROIC equal to the return the company is
forecasted to earn during the explicit forecast period.
Growth rate The best estimate is probably the expected long-term
rate of consumption growth for the industry’s products, plus
inflation. We also suggest that sensitivity analyses be done to
understand how the growth rate affects value estimates.
Estimating Parameters for Continuing
Value Variables
WACC The weighted average cost of capital should incorporate a
sustainable capital structure and an underlying estimate of
business risk consistent with expected industry conditions.
Investment Rate The investment rate is not explicitly in the
formula, but it equals ROIC divided by growth. Make sure that
the investment rate can be explained in light of industry
economics
Common Pitfalls
Naïve Base-Year Extrapolation A continual increase in working
capital as a percentage of sales and therefore significantly
understating the value of the company (increase in working
capital is too large for the increase in sales)
Common Pitfalls
Naïve Over-conservatism Do not assume that the incremental
return on capital in the continuing value period will equal the
cost of capital. In doing so, one is apt not to forecast growth
rate since growth nether adds nor destroys value. Case in point
are companies with proprietary products who can command
high returns on invested capital.
Purposeful Over-conservatism The size and uncertainty of
Continuing Value leads to over-conservatism. But uncertainty is
a two edged sword, it can cut both ways. Careful development
of scenarios (Venture SimsTM) are critical elements of any
valuation.
Other DCF Approaches
Convergence Formula implies zero growth. This is
not the case. It means that growth will add nothing
to value, because the return associated with growth
just equals the cost of capital.
Start with Value-driver Formula
CV=NOPLATT+1(1-g/ROICI)/WACC-g
Assume ROICI=WACC
(incremental invested capital = the cost of capital)
CV=NOPLATT+1(1-g/WACC)/WACC-g =
CV= NOPLATT+1 (WACC-g)/(WACC) /WACC-g
Canceling the term WACC-g leaves a simple formula
CV= NOPLATT+1/WACC
Other DCF Approaches
Aggressive Formula Assumes that earnings in the
Continuing Value period will grow at some rate, most
often the inflation rate. The conclusion is then drawn
that earnings should be discounted at the real WACC
rather than the nominal WACC. Here, g is the
inflation rate. This formula can substantially over
states Continuing Value because it assumes that
NOPLAT can grow without any incremental capital
investment: any growth will probably require
additional working capital and fixed assets.
Assume that ROIC approaches infinity:
CV= NOPLATT+1(1-g/ROICI) /WACC-g
ROIC ∞ therefore g/ROICI
0
CV= NOPLATT+1(1-0)/WACC-g =
CV= NOPLATT+1/WACC-g
Non-Cash Flow Approaches
Liquidation-Value Approach sets the continuing value equal to
an estimate of the proceeds from the sale of the assets of the
business, after paying off liabilities at the end of the explicit
forecast period.
Replacement-Cost Approach sets the continuing value equal to
the expected cost to replace the company’s assets.
Price-To-Earnings Ratio Approach assumes the company will
be worth some multiple of its future earnings in the continuing
period.
Market-To-Book Ratio Approach assumes the company will be
worth some multiple of its book value, often the same as its
current multiple or the multiple of comparable companies.
Any Questions?
Thank you for your
attention!