Estimating Continuing Value

1
What is Continuing Value?
To estimate a companys value,
we separate a companys
expected cash flow into two
periods and define the companys
value as follows:
The second term is the continuing
value: the value of the companys
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
i
l
l
i
o
n
s
2
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 companys 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
44
56
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
3
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 companys 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 todays industry can be
misleading. Industry economics will change over time and so will their multiples!
4
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.
g WACC
RONIC
g
1 NOPLAT
Value Continuing
1 t
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 NOPLAT
t+1
Expected long-term
growth rate in revenues
& cash flows
The weighted average cost of
capital, based on long-run
target capital structure.
5
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.
Lets 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.
6
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
operations


=

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.
7
Continuing Value when Using Economic Profit
The continuing value formula for economic profit models has two components:
( )
g WACC
) Profit PV(Economc
WACC
WACC - ROIC IC
CV
2 t 1 t t
t

+ =
+ +
( )
WACC
WACC - RONIC
RONIC
g
NOPLAT
) Profit c PV(Economi
1 t
2 t
|
.
|

\
|
=
+
+
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)
8
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 companys (continuing) value?
Using the KVD formula:
000 , 1 $
% 6 % 1 1
12%
6%
1 100 $
Value Continuing
t
=

|
.
|

\
|

=
Using the Economic Profit-based KVD, we arrive at a partial value:
( )
54 . 4 $
11%
11% - 12%
12%
6%
100
) Profit c PV(Economi
2 t
=
|
.
|

\
|
=
+
( )
6% % 1 1
54 . 4 $
11%
11% - 20% 00 $5
CV
t

+ =
Step 1
Step 2
0 . 500 9 . 90 1 . 409 CV
t
= + =
9
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 capital
70 percent of net fixed assets

Industry average of 15.0x

Industry average of 1.4x

Book value adjusted for
inflation
Assumptions
Continuing 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 todays
industry. Industry
economics will change
over time and so will
their multiples!
10
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 companys 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
40
54
65
74
79
60
46
35
26
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
11
The Difference between RONIC and ROIC
ROIC on existing capital
ROIC on new capital
(RONIC)
Company-wide ROIC
ROIC Percent
Lets 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 dont create value. Existing projects
continue to perform at their base-year level.
12
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
F
r
e
e

c
a
s
h

f
l
o
w

Year
Consider Innovation, Inc, a company with the following cash flow stream. Discounting
the companys cash flows at 11% leads to a value of $1,235.
Based on the cash flow pattern, it appears the companys value is highly dependent
on estimates of continuing value
Free Cash Flow at Innovation, Inc.
13
An Example: Innovation, Inc.
F
r
e
e

c
a
s
h

f
l
o
w

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 companys
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
14
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.
15
Common Pitfalls: Nave 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 Incorrect Correct
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 companys
growth rate falls to 5%,
required investment should
fall as well!
With nave base-year
extrapolation, FCF is
too small!
16
Common Pitfalls: Overconservatism
Nave 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
17
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!
18
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 - NOPLAT
t+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: nave extrapolation to determine the base year cash flows,
purposeful overconservatism and nave overconservatism (RONIC = WACC).