Estimating Continuing Value Presented by Supatcharee Hengboriboonpong Kittanai Pongsak Chapter 12

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

Value = PV of CF during + PV of CF after Explicit forecastexplicit forecast periodperiod

Continuing Value = The value of the company’s expected cash flow beyond the explicit forecast period.

Continuing Value Formula for DCF Valuation Continuing Value= Continuing Value= NOPLAT t+1 (1-g/ROIC I ) 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 Continuing value = FCF T+1 WACC-g WACC-g FCF T+1 = 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.

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 ROIC I g = ROIC I x IR IR = g/ ROIC I Now build this into the free cash flow (FCF) definition FCF = NOPLAT x 1 - g ROIC I ROIC I Substituting for FCF gives the value driver formula Substituting for FCF gives the value driver formula Continuing value = NOPLAT (1-g/ROIC) WACC-g

Also Known As Value-Driver Formula Because the input variables of Growth, ROIC and WACC Growth, ROIC and WACC are the key drives of Value

Growth rate in NOPLAT & Free Cash Flow = 6% ROIC i = 12% and WACC = 11% Growth rate in NOPLAT & Free Cash Flow = 6% ROIC i = 12% and WACC = 11% CV= 50/ /(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 profit T+1 + (NOPLAT T+1 )(g/ROIC I )(ROIC I – WACC) WACC WACC (WACC – g) Economic Profit T+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. ROIC I =The expected rate of return on new new investments. WACC =The weighted average cost of capital. Continuing value formula for economic profit

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 company’s value is created after the explicit forecast period

Total Value Calculations 5 years

Total Value Calculations 10 years

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 Approach Looks at the negative cash flow when invested in a new business line and its appearance of long range value.

Economic Profit Model Valuation is the same from all three methods.

Impact of Continuing-Value Assumptions

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 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 ROIC=WACC. 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 industry’s products, plus inflation. We also suggest that sensitivity analyses be done to understand how the growth rate affects value estimates.

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 Sims TM ) are critical elements of any valuation.

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 CV=NOPLAT T+1 (1-g/ROIC I )/WACC-g Assume ROIC I =WACC (incremental invested capital = the cost of capital) CV=NOPLAT T+1 (1-g/WACC)/WACC-g = CV= NOPLAT T+1 (WACC-g)/(WACC) /WACC-g Canceling the term WACC-g leaves a simple formula CV= NOPLAT T+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= NOPLAT T+1 (1-g/ROIC I ) /WACC-g ROIC ∞ therefore g/ROIC I 0 CV= NOPLAT T+1 (1-0)/WACC-g = CV= NOPLAT T+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.

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