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Forecasting Performance:
Continuing Value
1
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
12,000
Present Value of Cash Flow
10,000
during Explicit Forecast Period
Value =
+
Present Value of Cash Flow
$ million
8,000
6,000
4,000
after Explicit Forecast Period
2,000
• The second term is the continuing
value: the value of the company’s
expected cash flow beyond the
explicit forecast period.
0
2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019
Explicit Forecast
Period
Continuing
Value
2
Session Overview
In this session, we will…
1. Introduce alternative approaches and specific formulas for estimating
continuing value.
• Although many continuing-value models exist, we prefer the key value
driver (KVD) model, which explicitly ties cash flow to ROIC and growth.
2. Examine the subtleties of continuing value.
• There are many misconceptions about continuing value. For instance, a
large continuing value does not necessarily imply aggressive assumptions
about long-run performance.
3. Discuss potential implementation pitfalls.
• The most common error associated with continuing value is naive
base-year extrapolation. Always check that the base-year cash flow is
estimated consistently with long-term projections about growth.
3
Approaches to Continuing Value
Recommended Approaches:
1.
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.
2.
Economic-profit model. The economic-profit model leads to results consistent with the KVD
formula, but explicitly highlights expected value creation in the continuing-value (CV) 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). A multiples approach assumes 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!
4
1. Key Value Driver Formula
• Although many continuing-value models exist, we prefer the key value driver (KVD)
model. 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
Weighted average cost of
capital, based on long-run target
capital structure
Expected long-term growth
rate in revenues and
cash flows
• The continuing value is measured at time t (not today), and thus will need to be
discounted back t years to compute its present value.
5
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 key value driver formula) is
affected by various combinations of growth rate and rate of return on new investment.
Impact of Continuing-Value Assumptions
WACC = 10%; NOPLAT = $100 million
Growth = 8%
Continuing value ($ million)
3,000
2,000
Growth = 6%
Growth = 4%
1,000
Continuing value is
extremely sensitive to
long-run growth rates
when RONIC is much
greater than WACC.
0
10
12
14
16
18
20
Return on new invested capital (percent)
6
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.
Gradual Decline in Average ROIC According to Continuing-Value Formula
20
ROIC on
base capital
ROIC (percent)
16
ROIC on
total capital
12
RONIC
8
4
0
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25
Year
7
2. Economic-Profit Model
• 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 that 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
Present value of
forecasted economic
forecasted economic
profit during explicit + profit after explicit
forecast period
forecast period
Explicit Forecast Period
Continuing value
represents only longrun value creation,
not total value.
8
2. Economic-Profit Model
• The continuing-value formula for economic-profit models has two components:
CVt 
ICt ROICt 1  WACC PV(Economi c 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 at t+2 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
9
Comparison of KVD and Economic-Profit CV
• Consider a company with $500 in capital earning an ROIC of 20 percent. Its expected
base-year NOPLAT is therefore $100. If the company has an RONIC of 12 percent, a cost
of capital of 11 percent, and a growth rate of 6 percent, 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 
Note how economic-profit CV
does not equal total value. To
arrive at total value, add
beginning value ($500).
$50020%  11% 
$4.54

11%
11%  6%
Step 1
Step 2
CVt  409.1  90.9  500.0
10
Session Overview
In this session, we will…
1. Introduce alternative approaches and specific formulas for estimating
continuing value.
• Although many continuing-value models exist, we prefer the key value
driver (KVD) model, which explicitly ties cash flow to ROIC and growth.
2. Examine the subtleties of continuing value.
• There are many misconceptions about continuing value. For instance, a
large continuing value does not necessarily imply aggressive assumptions
about long-run performance.
3. Discuss potential implementation pitfalls.
• The most common error associated with continuing value is naive baseyear extrapolation. Always check that the base-year cash flow is estimated
consistently with long-term projections about growth.
11
Length of Explicit Forecast Does Not Matter
• While the length of the explicit forecast period you choose is important, it does not affect the
value of the company; it affects only 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.
Comparison of Total-Value Estimates Using Different Forecast Horizons
percent
100% =
$893
Continuing value
79
Value of explicit
free cash flow
21
5
$893
$893
67
60
33
40
8
10
$893
46
54
15
$893
Modeling assumptions
35
Growth
65
RONIC
WACC
Spread
Years 1–5 Years 6+
9
6
16
(12)
4
12
(12)
0
20
Length of explicit forecast period (years)
12
Length of Explicit Forecast Does Not Matter
•
To determine the present value of the company, sum the present value of the explicit
forecast period cash flows plus the present value of continuing value. The total value
equals $892.6 million.
Valuation Using Five-Year Explicit Forecast Period
13
Length of Explicit Forecast Does Not Matter
•
The valuation model below uses an eight-year explicit forecast period and a
continuing value that starts in year 9. The structure and forecast inputs of the model
are identical to those on the previous page.
Valuation Using Eight-Year Explicit Forecast Period
14
Alternative Views of CV: Innovation, Inc.
• Consider Innovation, Inc., a company with the following cash flow stream. Discounting
the company’s cash flows at 11 percent leads to a value of $1,235 million. Based on the
cash flow pattern, it appears the company’s value is highly dependent on estimates of
continuing value…
Innovation, Inc.: Free Cash Flow Forecast and Valuation
15
Alternative Views of CV: 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, stable cash flow.
Innovation, Inc.: Valuation by Components
16
Alternative Views of CV: 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.
Innovation, Inc.: Comparison of Continuing-Value Approaches
$ million
1,235
1,235
358
1050
New product
line
364
Base business
Economic-profit
continuing
value
104
Present value
of years 1-9
economic profit
767
Invested
capital
Present value
of continuing
value
877
185
1,235
Value of years 1-9
free cash flow
Free cash flow approach
Business components
approach
Economic-profit approach
17
Session Overview
In this session, we will…
1. Introduce alternative approaches and specific formulas for estimating
continuing value.
• Although many continuing-value models exist, we prefer the key value
driver (KVD) model, which explicitly ties cash flow to ROIC and growth.
2. Examine the subtleties of continuing value.
• There are many misconceptions about continuing value. For instance, a
large continuing value does not necessarily imply aggressive assumptions
about long-run performance.
3. Discuss potential implementation pitfalls.
• The most common error associated with continuing value is naive baseyear extrapolation. Always check that the base-year cash flow is estimated
consistently with long-term projections about growth.
18
Common Pitfalls: Naive Base-Year Extrapolation
• A common error in forecasting the base level of free cash flow (FCF) is to assume that
the reinvestment rate is constant, implying NOPLAT, investment, and FCF all grow at the
same rate.
Correct and Incorrect Methods of Forecasting Base FCF
The $30 million of
investment was predicated
on a 10 percent revenue
growth rate.
$ million
Year 11 (5% growth)
Revenues
Operating expenses
EBITA
Operating taxes
NOPLAT
Year 9
1,000
(850)
150
(60)
90
Year 10
1,100
(935)
165
(66)
99
Incorrect
1,155
(982)
173
(69)
104
Correct
1,155
(982)
173
(69)
104
Depreciation
Gross cash flow
27
117
30
129
32
136
32
136
Capital expenditures
Increase in working capital
Gross investment
(30)
(27)
(57)
(33)
(30)
(63)
(35)
(32)
(67)
(35)
(17)
(52)
60
66
69
84
Free cash flow
Supplemental calculations
Working capital, year-end
Working capital/revenues (percent)
300
30.0
330
30.0
362
31.3
347
30.0
A 5 percent growth rate
requires much smaller
investments in working
capital.
By growing working capital
investment at
5 percent, free cash flow is
dramatically understated.
19
Common Pitfalls: Distorting the KVD Formula
• Simplifying the key value driver formula can result in distortions of continuing value.
Rates of Return Implied by Alternative Continuing-Value Formulas
percent
25
CV 
NOPLAT
WACC  g
20
Overly aggressive?
Assumes RONIC
equals infinity!
Implied ROIC
15
CV 
10
WACC
5
NOPLAT
WACC
Overly conservative?
Assumes RONIC equals
the weighted average
cost of capital.
0
1
2
3
4
Explicit forecast period
5
6
7
8
9
10
Continuing-value period
20
Common Pitfalls: Overconservatism
Naive Overconservatism
• The assumption that RONIC equals WACC can be 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 its size and 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.
21
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 four
components:
1.
Profits at the end of the explicit forecast period—NOPLATt+1
2.
The rate of return for new investment projects—RONIC
3.
Expected long-run growth—g
4.
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 your continuing-value forecasts.
22