284  Forecasting Performance Exhibit 13.14 presents annualized growth in the U.S. consumer price index (CPI) versus expected ten-year inflation implied by traditional U.S. Treasury bonds and U.S. TIPS bonds. Since the ten-year TIPS bond is based on long- term inflation, the implied inflation rate is much more stable than the one-year change in CPI (in mid-2008, CPI grew at more than 5 percent when crude oil spiked, only to crater after the recession as companies cut prices to generate demand). Since 2000, actual and implied inflation have both hovered around 2 percent annually. Inflation can distort historical analysis, especially when it exceeds 5 per- cent annually. In these situations, historical financials should be adjusted to reflect operating performance independent of inflation. We discuss the impact of high inflation rates in Chapter 26. Concluding Thoughts In this chapter, we provided a detailed line-by-line process to create a set of financial forecasts. While it is important that the model reflect the complexities of the business you are analyzing, always keep a close eye on the bigger pic- ture. Make sure resulting value drivers, such as ROIC and growth, are consis- tent with the past performance of the business and the industry’s economics. When the model is complete, use the model to test the importance of various inputs. A sensitivity table can provide insight on not only the valuation but also on the actions management must undertake to capture it. EXHIBIT 13.14  Expected Inflation versus Growth in the Consumer Price Index % –3 –2 –1 0 1 2 3 4 5 6 2002 2004 2006 2008 2010 2012 2014 2016 2018 2000 Annualized growth in the consumer price index Implicit expected inflation as derived using 10-year U.S. TIPS bonds Source: Federal Reseve Bank of St. Louis. 285 14 Estimating Continuing Value A thoughtful estimate of continuing value is essential to any company valua- tion. It serves as a useful method for simplifying the valuation process while still incorporating solid economic principles. To estimate a company’s value, separate the forecast of expected cash flow into two periods and define the company’s value as follows: Value Present Value of Cash Flow during Explicit Forecast Period P = + resent 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 an explicit forecast period. By deliberately making some simple assumptions about the company’s performance during this second period—for example, assuming a constant rate of growth and return on capi- tal—you can estimate continuing value by using formulas instead of explicitly forecasting and discounting cash flows over an extended period. Continuing value often accounts for a large percentage of a company’s total value. Exhibit 14.1 shows continuing value as a percentage of total value for companies in four industries, given an eight-year explicit forecast. In these examples, continuing value accounts for 56 percent to 125 percent of total value. These large percentages do not necessarily mean that most of a com- pany’s value will be created in the continuing-value period. Often, continuing value is large because profits and other inflows in the early years are offset by outflows for capital spending and working-capital investment—investments that should generate higher cash flow in later years. We discuss the interpreta- tion of continuing value in more detail later in this chapter. The continuing-value formulas developed over the next few pages are consis- tent with the principles of value creation and discounted cash flow (DCF). This 286  Estimating Continuing Value is important, because many investment professionals ignore the economics that underpin their estimate of continuing value. For example, we have seen acquirers estimate the continuing value for a target company by applying the same mul- tiple of earnings five years in the future as the multiple they are currently paying for the acquisition target.1 By doing this, they are implicitly assuming that some- one would be willing to pay the same multiple five years from now, regardless of changes in prospects for growth and return on invested capital over that period. This type of circular reasoning leads to inaccurate valuations that are often overly optimistic. Instead, acquirers should estimate what the multiple will be at the end of the forecast period, given the company’s potential at that time. This chapter begins with the recommended continuing-value formulas for DCF and economic-profit valuation models. It then discusses concerns that arise out of common misinterpretations of continuing value, explaining how proper measurement addresses these concerns. Then we identify common pitfalls in estimation and offer best practices for avoiding these. Finally, we compare the recommended formulas with other common techniques, such as multiples and liquidation values. Recommended Formula for DCF Valuation If you are using the enterprise DCF model, you should estimate continuing value by using the value driver formula derived in Chapter 3: Continuing Value NOPAT RONIC WACC t t g g = −     − +1 1 1 Typical multiples include enterprise value-to-EBITA, where EBITA equals earnings before interest, taxes, and amortization, and enterprise value-to-EBITDA, where EBITDA equals earnings before inter- est, taxes, depreciation, and amortization. EXHIBIT 14.1  Continuing Value as a Percentage of Total Value 8-year forecast period, % 44 56 19 81 0 100 125 Forecast period cash flow Continuing value –25 Tobacco Sporting goods Skin care High tech