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 275 300  Estimating Continuing Value Assume that RONIC = WACC (that is, the return on incremental invested capital equals the cost of capital): CV NOPAT WACC WACC NOPAT WACC WACC WAC = −     − = −     + + t t g g g 1 1 1 C −g Canceling the term WACC – g leaves a simple formula: CV NOPAT WACC = + t 1 The fact that the growth term has disappeared from the equation does not mean that the nominal growth in NOPAT will be zero. The growth term drops out because new growth adds nothing to value, as the RONIC associated with growth equals the cost of capital. This formula is sometimes interpreted as implying zero growth (not even with inflation), but this is not an accurate interpretation. Misinterpretation of the convergence formula has led to another variant: the aggressive-growth formula. This formula assumes that earnings in the con- tinuing-value period will grow at some rate, most often the inflation rate. Some investment professionals then conclude that earnings should be discounted at the real WACC rather than at the nominal WACC. The resulting formula is: CV NOPAT WACC = − + t g 1 Here, g is the inflation rate. This formula can substantially overstate con- tinuing value, because it assumes that NOPAT can grow without any incre- mental capital investment. This is unlikely, or impossible, because any growth will probably require additional working capital and fixed assets. To see the critical assumption hidden in the preceding formula, we analyze the key value driver formula as RONIC approaches infinity: CV NOPAT RONIC WACC RONIC therefore RONIC C = −     − →∞ → + t g g g 1 1 0 ; , V NOPAT WACC NOPAT WACC = − ( ) − = − + + t t g g 1 1 1 0 Other Approaches to Continuing Value  301 Exhibit 14.12 compares the two variations of the key value driver formula, showing how the average return on invested capital (both existing and new investment) behaves under the two assumptions. In the aggressive-growth case, NOPAT grows without any new investment, so the return on invested capital eventually approaches infinity. In the convergence case, the average return on invested capital moves toward the weighted average cost of capital as new capital becomes a larger portion of the total capital base. Multiples Multiples, also known as comparables, assume that a company will be worth some multiple of future earnings or book value in the continuing period. But how do you estimate an appropriate future multiple? A common approach is to assume that the company will be worth a mul- tiple of earnings or book value based on the multiple for the company today. Suppose we choose today’s industry average enterprise-value-to-EBITDA ratio. This ratio reflects the economic prospects of the industry during the explicit forecast period as well as the continuing-value period. In maturing industries, however, prospects at the end of the explicit forecast period are likely to be very different from today’s. Therefore, a different EV-to-EBITDA is needed; one that reflects the company’s prospects at the end of the forecast period. What factors will determine that ratio? As discussed in Chapter 3, the primary determinants are the company’s expected growth, the rate of return on new capital, and the cost of capital. The same factors are in the key value driver formula. Unless you are comfortable using an arbitrary multiple, you are much better off with the value driver formula. EXHIBIT 14.12  Rates of Return Implied by Alternative Continuing-Value Formulas % Continuing-value period Explicit forecast period WACC Implied ROIC1 0 5 1 2 3 4 5 6 7 8 9 10 10 15 20 25 CV = NOPAT WACC – g CV = NOPAT WACC 1 Implied ROIC equals the return on both new and existing capital.