Estimating Continuing Value

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Estimating Continuing Value
Chapter 12

• Presented by
• Supatcharee Hengboriboonpong
• Kittanai Pongsak

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Outline

• 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

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Value

• PV of CF during PV of CF after
• Explicit forecast explicit forecast
• period period

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Continuing Value

• The value of the companys expected cash flow
  beyond the explicit forecast period.

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Continuing Value Formula for DCF Valuation

• Continuing Value

NOPLATt1(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.
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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 companys 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.

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Simple Formula for a Cash Flow Perpetuity that
grows at a constant Rate

• Continuing value FCFT1
• WACC-g

FCFT1 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.
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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.
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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

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Also Known AsValue-Driver Formula

• Because the input variables of
• Growth, ROIC and WACC
• are the key drives of
• Value

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Growth rate in NOPLAT Free Cash
Flow 6 ROICi 12
and WACC 11
Long Range Forecast of 150 years
CV 50/1.1153/(1.11)256/(1.11)350(1.06)149/(1.
11)150999
Growing Free Cash Flow Perpetuity Formula
CV 50/11 - 6 1000
Value-Driver Formula
CV 100(1-6/12) / 11-61000
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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
  companys invested capital at the end of the
  explicit forecast period

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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
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CV Economic profitT1 (NOPLATT1)(g/ROICI)(ROI
CI WACC) WACC
WACC (WACC g)
Continuing value formula for economic profit

• Economic ProfitT1 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.

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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 companys value is created after the
  explicit forecast period

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Total Value Calculations 5 years
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Total Value Calculations 10 years
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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 companys competitive advantage period
has not come to an end once you reach the
continuing value period.
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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.
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When is Value Created? Below, it appears the 85
of the companys value come form the Continuing
Value.
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A Business Components ApproachLooks at the
negative cash flow when invested in a new
business line and its appearance of long range
value.
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Economic Profit ModelValuation is the same from
all three methods.
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Impact of Continuing-Value Assumptions
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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 years
  results, the prior years 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.

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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 ROICWACC. 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 industrys products, plus inflation. We also
  suggest that sensitivity analyses be done to
  understand how the growth rate affects value
  estimates.

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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

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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)

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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.

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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
• CVNOPLATT1(1-g/ROICI)/WACC-g
• Assume ROICIWACC
• (incremental invested capital the cost of
  capital)
• CVNOPLATT1(1-g/WACC)/WACC-g
• CV NOPLATT1 (WACC-g)/(WACC) /WACC-g
• Canceling the term WACC-g leaves a simple
  formula
• CV NOPLATT1/WACC

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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 NOPLATT1(1-g/ROICI) /WACC-g
• ROIC 8 therefore g/ROICI 0
• CV NOPLATT1(1-0)/WACC-g
• CV NOPLATT1/WACC-g

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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
  companys 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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Any Questions?
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Thank you for your attention!