Post on 26-Oct-2014
description
Estimating Continuing Value
2
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:
• The second term is the continuing
value: the value of the company’s
expected cash flow beyond the
explicit forecast period.
Present Value of Cash Flow
during Explicit Forecast Period
Present Value of Cash Flow
after Explicit Forecast Period
+Value =
Explicit Forecast Period
Continuing Value
Home Depot: Estimated Free Cash Flow$ millions
0
2,000
4,000
6,000
8,000
10,000
12,000
2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019
$ m
illi
on
s
3
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.
* Valuations use an eight-year explicit forecast period
4456
Tobacco
19
81
0
125
100
Sporting goods Skin care
High tech
-25
Continuing value
Explicit period cash flow
Continuing Value as a Percentage of Total Value
4
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!
5
The Key Value Driver Formula
• The continuing value is measured at time t, and thus will need to be discounted back t years to compute its present value.
• 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.
gWACC
RONIC
g1NOPLAT
Value Continuing1t
t
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
Expected long-term growth rate in revenues
& cash flows
The weighted average cost of capital, based on long-run target capital structure.
6
How Growth Affects Continuing Value
Continuing value is extremely
sensitive to long-run growth rates when RONIC is much greater than WACC
• 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.
7
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 operation
s =
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.
8
Continuing Value when Using Economic Profit
• The continuing value formula for economic profit models has two components:
gWACC
)ProfitPV(Economc
WACC
WACC-ROICICCV 2t1tt
t
WACC
WACC-RONICRONIC
gNOPLAT
)ProfitcPV(Economi1t
2t
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.
New Investment Economic Spread
Value using Perpetuity
• The present value of economic profit equals EVA / WACC (i.e. no growth)
9
Comparison of KVD and Economic Profit CV
• Consider a company with $500 in capital earning an ROIC of 20%. Its expected base-
year NOPLAT is therefore $100. If the company has a RONIC of 12%, a cost of capital
of 11%, and a growth rate of 6%, what is the company’s (continuing) value?
• Using the KVD formula:
000,1$%6%11
12%
6%1100$
Value Continuing t
• Using the Economic Profit-based KVD, we arrive at a partial value:
54.4$
11%
11%-12%12%
6%100
)ProfitcPV(Economi 2t
6%%11
54.4$
11%
11%-20%00$5CVt
Step 1
Step 2
0.5009.901.409CVt
10
Other Approaches to Continuing Value
Book value
Liquidation value
Price-to-earnings ratio
Market-to-book ratio
Replacement cost
Technique
Per accounting records
80 percent of working capital70 percent of net fixed assets
Industry average of 15.0x
Industry average of 1.4x
Book value adjusted for inflation
AssumptionsContinuing value
$ Million
268
186
624
375
275
• 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
You can not base
continuing value on
multiples from today’s
industry. Industry
economics will change
over time and so will
their multiples!
11
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.
Your estimate of enterprise value should not be affected by the length of the explicit
forecast period.
21
4054
6574
79
6046
3526
100% = $893 $893 $893 $893 $893
Continuing value
Value of explicit free cash flow
Horizon 5-year 10-year 15-year 20-year 25-year
Value of Operations
12
The Difference between RONIC and ROIC
ROIC on existing capital
ROIC on new capital(RONIC)
Company-wide ROIC
ROIC Percent
• 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.
13
An Example: Innovation, Inc.
DCF value at 11%
$1,235
1,050 (85%)
185 (15%)
Present value of continuing value
Value of years 1-9 free cash flow
Fre
e c
as
h f
low
Year
• 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.
14
An Example: Innovation, Inc.
Fre
e c
as
h f
low
Year
• 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.
Base business free cash flow
Free cash flow from new product line
DCF value at 11%
$1,235
358 (29%)
877 (71%)
New product line
Base business
15
• 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.
An Example: Innovation, Inc.
16
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-end working cap
Working capital/sales (percent)
300
30
330
30
362
31
347
30
Capital expenditures
Increase in working capital
Gross investment
Free cash flow
30
27
57
60
33
30
63
66
35
32
67
69
35
17
52
84
Sales
Operating expenses
EBIT
Cash taxes
NOPLAT
Depreciation
Gross cash flow
Year 9 Year 10 IncorrectCorrect
Year 11 (5% growth)
1,000
(850)
150
(60)
90
27
117
1,100
(935)
165
(66)
99
30
129
1,155
(982)
173
(69)
104
32
136
1,155
(982)
173
(69)
104
32
136
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!
17
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
18
Common Pitfalls: Distorting the Growing Perpetuity
• Simplifying the key value driver formula can result in distortions of continuing value.
Company-wide average ROIC
WACC
CV = NOPLAT
WACC-g
CV = NOPLAT
WACC
Forecast period
Continuing value period
Overly conservative?
Assumes RONIC equals
the weighted average
cost of capital
Overly aggressive?
Assumes RONIC
equals infinity!
19
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).