Chapter 10 Forecasting Performance: Continuing Value Instructors: Please do not post raw PowerPoint files on public website. Thank you! 1

2 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 0 2,000 4,000 6,000 8,000 10,000 12, $ million

3 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.

4 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!

5 1. Key Value Driver Formula 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. 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 NOPLAT t+1 Expected long-term growth rate in revenues and cash flows 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 key value driver formula) is affected by various combinations of growth rate and rate of return on new investment. Impact of Continuing-Value Assumptions

7 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

8 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 forecasted economic profit during explicit forecast period + Present value of forecasted economic profit after explicit forecast period Explicit Forecast Period Continuing value represents only long- run value creation, not total value.

9 2. Economic-Profit Model The continuing-value formula for economic-profit models has two components: 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 at t+2 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 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: Using the economic-profit-based KVD, we arrive at a partial value: Step 1 Step 2 Note how economic-profit CV does not equal total value. To arrive at total value, add beginning value ($500).

11 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.

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. 12 Comparison of Total-Value Estimates Using Different Forecast Horizons

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. 13 Valuation Using Five-Year Explicit Forecast Period

Length of Explicit Forecast Does Not Matter 14 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

15 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

16 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

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. Alternative Views of CV: Innovation, Inc. Innovation, Inc.: Comparison of Continuing-Value Approaches

18 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.

Common Pitfalls: Naive Base-Year Extrapolation 19 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. 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.

20 Common Pitfalls: Distorting the KVD Formula Simplifying the key value driver formula can result in distortions of continuing value. Overly conservative? Assumes RONIC equals the weighted average cost of capital. Overly aggressive? Assumes RONIC equals infinity! Rates of Return Implied by Alternative Continuing-Value Formulas

21 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.

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 four components: 1.Profits at the end of the explicit forecast period—NOPLAT t+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.