Estimating Continuing Value

Finance 622

Valuation Chapter 12

Agenda• Estimating Continuing Value

• Continuing Value Formula for DCF Valuation

• Continuing Value Formula for Economic Profit Valuation

• Interpretation of Continuing Value

• Parameters for Continuing Value Variables

• Common Pitfalls

• Evaluating Other Approaches

Value =

PV of CF during the + PV of CF after theExplicit Forecast Period Explicit Forecast Period

Continuing Value =

PV of the Expected CF after the Explicit Forecast Period

Continuing Value Formula for DCF

ValuationDFC 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

CV = FCFT+1

WACC-g

FCFT+1 = The normalized level of free cash flow in the first

year after the explicit forecast period.

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

 which is =  

IR = g ROICI

Build with the Free Cash Flow Definition

FCF = NOPLAT x 1 - g

ROICI

 

Also Know AsValue-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%

Year1 2 3 4 5

NOPLAT 100 106 112 120 126Net Investment 50 53 56 60 63Free Cash Flow 50 53 56 60 63

CV= 50/1.11+53/(1.11)2+56/(1.11)3+…50(1.06)149/(1.11)150=999

Long Range Forecast of 150 years

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

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

CV formula for Economic Profit Valuation

CV = Economic profitT+1 + (NOPLATT+1)(g/ROICI)(ROICI – WACC)

WACC WACC (WACC – g)

Economic ProfitT+1= The normalized economic profit in the first year after the explicit forecast period.

NOPLAT = The normalized NOPLAT in the first year after the explicit forecast period.

g = The expected growth rate in NOPLAT in perpetuity.

ROICI = The expected rate of return on new new investments.

WACC = The weighted average cost of capital.

Issues in the Interpretation of Continuing Value

The length of the forecast doe not affect the Value of the Company.

I’m so Confused about ROIC.

When is Value Created?

Total Value Calculations 5 yearsOverall Assumptions (%) Year 1-5 6+

Return on Investment 16% 12%

Growth rate 9% 6%

WACC 12% 12%

Base

5 yr. Horizon 1 2 3 4 5 for CV

NOPLAT 100.0 109.0 118.8 129.5 141.2 149.63

Depreciation 20.0 21.8 23.8 25.9 28.2

Gross Cash Flow 120.0 130.8 142.6 155.4 169.4

Gross Investment 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

Present Value of cash flow 39.0 38.0 37.0 36.0 35.0

Present value of CV

NOPLAT(1-g/ROIC) (1/1+WACC)^5 =

WACC -g

149.6(6%/12%) (0.5674) = 707.5

12% - 6%

Present Value of FCF 1 - 5 184.9

Continuing Value 707.5

Total Value 892.4

Total Value Calculations 10 yearsOverall Assumptions (%) Yr 1-5 6+

Return on Investment 16% 12%Growth rate 9% 6%WACC 12% 12%

Base10 yr. Horizon 1 2 3 4 5 6 7 8 9 10 for CVNOPLAT 100.0 109.0 118.8 129.5 141.2 149.6 158.6 168.1 178.2 188.9 200.2Depreciation 20.0 21.8 23.8 25.9 28.2 29.9 31.7 33.6 35.6 37.8Gross Cash Flow 120.0 130.8 142.6 155.4 169.4 179.6 190.3 201.7 213.9 226.7Gross Investment 76.3 83.2 90.7 98.8 107.7 104.7 111.0 117.6 124.7 132.2FCF 43.70 47.63 51.92 56.59 61.69 74.85 79.37 84.13 89.18 94.53

Discount Factor 0.893 0.797 0.712 0.636 0.567 0.507 0.452 0.404 0.361 0.322Present 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%) 0.322 537.3 12% - 6%

Present Value of FCF 1 - 5355.4Continuing Value 537.3Total 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 ApproachLooks at the negative cash flow when invested in a new business line and its appearance of long range value.

Economic Profit ModelValuation is the same from all three methods.

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

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 ApproachesConvergence 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 formulaCV= 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.

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.

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