0. Estimating Continuing Value

1. 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

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 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

3. Presentation Overview
LAN-ZWB ZWB
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.

4. 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!

5. 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.
After-tax operating profit in the base-year
RONIC equals return on invested capital for new investment. ROIC on existing investment is captured by NOPLATt+1
The weighted average cost of capital, based on long-run target capital structure.
Expected long-term growth rate in revenues & cash flows
The continuing value is measured at time t, and thus will need to be discounted back t years to compute its present value.

6. 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

7. 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.

8. Continuing Value when Using Economic Profit
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.
The present value of economic profit equals EVA / WACC (i.e. no growth)
New Investment
Economic Spread
Value using Perpetuity

9. 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:
Step 1
Step 2

10. 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
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
You can not base continuing value on multiples from today’s industry. Industry economics will change over time and so will their multiples!

11. Presentation Overview
LAN-ZWB ZWB
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.

12. 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.
Your estimate of enterprise value should not be affected by the length of the explicit forecast period.
Value of Operations
100% =
$893
Continuing value
Value of explicit free cash flow
Horizon
5-year
10-year
15-year
20-year
25-year

13. 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.
ROIC on existing capital
ROIC on new capital
(RONIC)
Company-wide ROIC
ROIC Percent

14. 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
Free cash flow
Year
Present value of continuing value
1,050 (85%)
Value of years 1-9 free cash flow
185 (15%)
DCF value at 11%

15. 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.
DCF value at 11%
$1,235
358 (29%)
877 (71%)
New product line
Base business
Free Cash Flow at Innovation, Inc.
Free cash flow
Year
Free cash flow from new product line
Base business free cash flow

16. 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.

17. Presentation Overview
LAN-ZWB ZWB
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.

18. 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
Capital expenditures
Increase in working capital
Gross investment
Free cash flow 30 27 57 60 33 63 66 35 32 67 69 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
117
1,100
(935)
165
(66) 99
129
1,155
(982)
173
(69)
104
136
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

19. 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

20. 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
WACC
CV =
WACC
Forecast period
Continuing value period

21. 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).