Estimating Continuing Value

1. 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: Present Value of Cash Flow during Explicit Forecast Period + Value = Present Value of Cash Flow after Explicit Forecast Period • The second term is the continuing value: the value of the company’s expected cash flow beyond the explicit forecast period. Explicit Forecast Period Continuing Value

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. Continuing Value as a Percentage of Total Value • 125 • 100 • Explicit period cash flow • Continuing value • High tech • Tobacco • Sporting goods • Skin care • -25 * Valuations use an eight-year explicit forecast period

4. Presentation Overview In this presentation, we will… • 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. • 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. • 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 • 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. RONIC equals return on invested capital for new investment. ROIC on existing investment is captured by NOPLATt+1 After-tax operating profit in the base-year Expected long-term growth rate in revenues & cash flows The weighted average cost of capital, based on long-run target capital structure. • The continuing value is measured at time t, and thus will need to be discounted back t years to compute its present value.

7. How Growth Affects Continuing Value • 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. • Continuing value is extremely sensitive to long-run growth rates when RONIC is much greater than WACC

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: 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: Value created (or destroyed) on new capital using RONIC. New capital grows at g, so a growing perpetuity is used. Value created on current capital, based on ROIC at end of forecast period (using a no growth perpetuity). • The present value of economic profit equals EVA / WACC (i.e. no growth) Economic Spread New Investment Value using Perpetuity

10. Step 1 Step 2 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: • Using the Economic Profit-based KVD, we arrive at a partial value:

11. Assumptions • 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 • Continuing value • $ Million • Technique • 268 • 186 • 624 • 375 • 275 • Book value • Liquidation value • Price-to-earnings ratio • Market-to-book ratio • Replacement cost Other Approaches to Continuing Value • 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… • 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. • 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. • 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. 100% = • $893 • $893 • $893 • $893 • $893 • Continuing value Your estimate of enterprise value should not be affected by the length of the explicit forecast period. • Value of explicit free cash flow • Horizon • 5-year • 10-year • 15-year • 20-year • 25-year 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. Value of Operations

14. ROIC Percent ROIC on existing capital Company-wide ROIC ROIC on new capital (RONIC) 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.

15. Free cash flow • Year An Example: Innovation, Inc. • 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. • $1,235 • Present value of continuing value • 1,050 (85%) • Value of years 1-9 free cash flow • 185 (15%) • DCF value at 11%

16. $1,235 • New product line • 358 (29%) • Free cash flow • Base business • 877 (71%) • Year • DCF value at 11% An Example: 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 cash flow. Free Cash Flow at Innovation, Inc. • Free cash flow from new product line • Base business free cash flow

17. An Example: Innovation, Inc. • 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.

18. Presentation Overview In this presentation, we will… • 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. • 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. • 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.

19. Year 11 (5% growth) • Year 9 • Year 10 • Incorrect • Correct • Sales • Operating expenses • EBIT • Cash taxes • NOPLAT • Depreciation • Gross cash flow 1,000 1,100 1,155 1,155 (850) (935) (982) (982) 150 165 173 173 (60) (66) (69) (69) 90 99 104 104 27 30 32 32 136 129 136 117 • 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 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 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! • Year-end working cap • Working capital/sales (percent) • 300 • 30 • 330 • 30 • 362 • 31 • 347 • 30

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 Overly aggressive? Assumes RONIC equals infinity! • NOPLAT • CV = • WACC-g Overly conservative? Assumes RONIC equals the weighted average cost of capital • NOPLAT • CV = • WACC • WACC • Continuing value period • Forecast period

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).