298  Estimating Continuing Value model. The value driver model implicitly computes the required investment based on expectations of growth and ROIC. Naive Overconservatism Many investment professionals routinely assume that the incremental return on capital during the continuing-value period will equal the cost of capital. This practice relieves them of having to forecast a growth rate, since growth in this case neither adds nor destroys value. For some businesses, this assumption is too conservative. For example, both Coca-Cola’s and PepsiCo’s soft-drink businesses earn high returns on invested capital, and their returns are un- likely to fall substantially as they continue to grow, due to the strength of their brands, high barriers to entry, and limited competition.3 For these businesses, an assumption that RONIC equals WACC would understate their values.4 This problem applies equally to almost any business selling a product or service that is unlikely to be duplicated, including many pharmaceutical companies, numerous consumer products companies, and some software companies. However, even if RONIC remains high, growth will drop as the market matures. Therefore, any assumption that RONIC is greater than WACC should be coupled with an economically reasonable growth rate. Purposeful Overconservatism Some investment professionals are overly conservative because of the uncer- tainty and size of the continuing value. But if continuing value is to be esti- mated properly, the uncertainty should cut both ways: the results are just as likely to be higher than an unbiased estimate as they are to be lower. So con- servatism overcompensates for uncertainty. Uncertainty matters, but it should be modeled using scenarios, not through conservatism regarding ROIC or growth in the continuing-value formula. Other Approaches to Continuing Value Several alternative approaches to estimating continuing value are used in practice. A few approaches are acceptable if applied carefully, but in general, these alternatives often produce misleading results. We prefer the methods 3 Even the strongest brands face pressure from new technologies and changing customer preferences. For instance, Coca-Cola and PepsiCo have looked to new businesses as consumers have shifted away from soft drinks to bottled water and flavored teas. 4 In this example, RONIC equaling WACC is unlikely because of economic reasons. RONIC may also permanently exceed the cost of capital because capital is systematically understated. Under current accounting standards, only physical (or contractual) investment is capitalized on the balance sheet. Companies that have valuable brands, distribution, and intellectual property do not recognize their investment on the balance sheet unless acquired. For more on how to compute invested capital for companies with large intangible assets, see Chapter 24. Other Approaches to Continuing Value  299 explored earlier in this chapter, because they explicitly rely on the underlying economic assumptions embodied in the company analysis. Other approaches tend to obscure the underlying economic assumptions. Using the example of a sporting goods company, Exhibit 14.11 illustrates the wide dispersion of continuing-value estimates arrived at by different techniques. The most common techniques fall into three categories: other DCF ap- proaches, multiples, and asset-based valuations. This section describes tech- niques in these categories and explains why we prefer the approaches we recommended earlier. Other DCF Approaches The recommended DCF formulas can be modified to create additional con- tinuing-value formulas with more restrictive (and sometimes unreasonable) assumptions. One variation is the convergence formula. For companies in competitive industries, many expect that the return on net new investment will eventually converge to the cost of capital as all the excess profits are competed away. This assumption allows a simpler version of the value driver formula, as follows: CV NOPAT WACC = + t 1 The derivation begins with the value driver formula: CV NOPAT RONIC WACC = −     − + t g g 1 1 EXHIBIT 14.11  Continuing-Value Estimates for a Sporting Goods Company $ million Technique Assumptions Continuing value Other DCF approaches Perpetuity based on final year’s NOPAT Normalized NOPAT growing at inflation rate 582 Perpetuity based on final year’s cash flow Normalized FCF growing at inflation rate 428 Multiples (comparables) Price-to-earnings ratio Industry average of 15 times earnings 624 Market-to-book ratio Industry average of 1.4 times book 375 Asset-based valuations Liquidation value 80% of working capital 186 70% of net fixed assets Replacement cost Book value adjusted for inflation 275