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

Presentation Overview

In this presentation, 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 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 naïve base-

year extrapolation. Always check that the base-year cash flow is

estimated consistently with long-term projections about growth.

5

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!

6

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.

7

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.

8

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.

9

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)

10

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

11

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!

12

Presentation Overview

In this presentation, 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 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 naïve base-

year extrapolation. Always check that the base-year cash flow is

estimated consistently with long-term projections about growth.

13

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

14

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.

15

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.

16

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

17

• 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.

18

Presentation Overview

1. Introduce alternative approaches and specific formulas for estimating

continuing value.

• Although many continuing value models exist, we prefer the key value

driver 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 naïve

base-year extrapolation. Always check that the base-year cash flow

is estimated consistently with long-term projections about growth.

In this presentation, we

will…

19

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!

20

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

21

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!

22

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).