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 Recommended Formula for DCF Valuation  287 where NOPATt+1 = net operating profit after taxes in the first year after the explicit forecast period g = expected growth rate in NOPAT in perpetuity RONIC = expected rate of return on new invested capital WACC = weighted average cost of capital A simple example demonstrates that the value driver formula does, in fact, replicate the process of projecting the cash flows and discounting them to the present. Begin with the following cash flow projections:   Year 1 Year 2 Year 3 Year 4 Year 5 NOPAT $10.0 $10.6 $11.2 $11.9 $12.6 Net investment 5.0 5.3 5.6 6.0 6.3 Free cash flow $ 5.0 $ 5.3 $ 5.6 $ 6.0 $ 6.3 Beyond year 5, the company continues to reinvest half its after-tax operat- ing profit at a 12 percent rate of return, driving continued growth at 6 percent. The weighted average cost of capital (WACC) is assumed to be 11 percent. To compare the methods of computing continuing value, first discount a long forecast—say, 100 years: CV = + + + + $ . . $ . ( . ) $ . ( . ) ... $ ( . ) ( . ) 5 0 1 11 5 3 1 11 5 6 1 11 50 1 06 1 11 2 3 99 100 CV = $99 Next, use the growth perpetuity formula: CV = − $ . . . 5 0 0 11 0 06 CV = $100 Finally, use the value driver formula: CV = −     − $ . . . . 10 1 0 06 0 12 0 11 0 06 CV = $100 All three approaches yield virtually the same result. If we had carried out the dis- counted cash flow beyond 150 years, the result would have been nearly identical.2 2 The sum of discounted cash flow will approach the perpetuity value as the forecast period is extended. In this example, a 75-year forecast period will capture 96.9 percent of the perpetuity value, whereas a 150- year forecast period will capture 99.9 percent. This is only true, however, when growth is substantially less than the cost of capital. If the two variables are of near-equal value, an infinitely lived perpetuity will overstate the value of a company with a limited life. In these situations, either incorporate a probability of failure into your perpetuity, or approximate continuing value with a growth annuity.