This document discusses methods for estimating continuing value in discounted cash flow valuations. It recommends using the key value driver formula or economic profit model to calculate continuing value. The key value driver formula links continuing value to growth, return on invested capital, and weighted average cost of capital. The economic profit model shows expected value creation in the continuing period. The document cautions against naive conservatism and discusses how continuing value assumptions like growth rates can significantly impact valuation but do not affect total company value. It also clarifies common misconceptions regarding issues like how forecast period length and "competitive advantage periods" relate to value.

1. Chapter 8: Estimating
Continuing Value

2. Topic: “Estimating continuing value”
 This topic will present interpretation of Continuing value by:
 Recommending formulas for discounted cash flows (DCF) and economic
profit valuation
 Discussing issues related to interpretation and will suggest some useful
practices as parameters of growth and return on invested capital

 Comparing recommended formulas with other continuing value techniques to
discuss advanced formulas'
Estimating continuing value

3. Table of contents
1. What is continuing value
2. Perspective of value
3. Continuing value as a percentage of total value
4. Recommended formula for discontinued cash flow valuation
5. NOPLAT
5.1 Normalized level of revenues
5.2 RONIC
5.3 Growth rate
5.4 WACC
6. Exhibit 9.2
7. Recommended Approaches for continuing value
7.1 Key value driver (KVD) formula
7.2 Economic profit model
7.3 other methods
Estimating continuing value

4. Table of contents
8. Sensitivity of value driver formula
9. Recommended formula for economic profit valuation
10. Economic profit formula
11. Subtleties of continuing value
12. Underlying process
13. Length of forecast affect the company’s value?
14. confusion about competitive advantage period
15. when value is created?
16. Naive over-conservatism
17. purposeful over-conservatism
18. Other approaches to continuing value
19. 2 Assumptions for Average Return
Estimating continuing value

5. What Is Continuing Value?
 To define continuing value, firstly, separate the
company’s expected cash flow into two periods
and define the its value as follows:
 Value = Present Value of Cash Flow during
Explicit Forecast Period + 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.
Estimating continuing value
Home Depot: Estimated Free Cash Flow
$ millions
0
2,000
4,000
6,000
8,000
10,000
12,000
2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019$millions

6. Perspective of value
Estimating continuing value

7. Continuing value as a percentage of total value
This value refers to horizon value of security
that is the present value at a future point in
time of all expected future cash flows along
with stable growth rate
Estimating continuing value

8. Recommended formula for discontinued cash
flow valuation
 This formula replicates the process of projecting cash flows and discounting them to their
present period.
Estimating continuing value

9. Example
 Data presented in below table demonstrates that same pattern continues after first 5 years presented
 Growth rate is 6 percent in NOPLAT and in free cash flow each period
 Rate of return on net new investment is 12 percent
 WACC assumed to be 11 percent
Estimating continuing value

10. By using different formulas
1) If discounted for longer period of 150 years then results revealed;
2) Next, by using the growing free cash flow perpetuity formula;
Estimating continuing value

11. By using different formulas
3) By using the value driver formula;
So, all three approaches yield the same result
Estimating continuing value

12. Estimating value drivers
 NOPLAT - Reflect a normalized level of earnings at the
midpoint of the business cycle
 FCF - Based on NOPLAT and level of capital expenditures
necessary to sustain growth
 ROIC - Consistent with competitive conditions, WACC and
growth
 WACC - Consistent with a sustainable capital structure
 Growth - Level of inflation? Consumption for industry?
Estimating continuing value

13. NOPLAT Proportion
 Proportion of NOPLAT is also likely to be less If,
“ the growth in the continuing value period is forecast to be less than the
growth in the explicit forecast period”
 In continuing value period, each dollar of NOPLAT becomes FCF (free
cash flow), this continuing value can be underestimated if dollar transition
is not explicitly taken into consideration for investors
Estimating continuing value

14. NOPLAT Level
The level of NOPLAT should be based on:
 Normalized level of revenues
 Sustainable margin
 ROIC
 Normalized level of revenues
It should reflect the midpoint of its business cycle and cycle average profit margins
Estimating continuing value

15. NOPLAT
RONIC (Rate of Return on New Invested Capital)
 The expected rate of return on new invested capital must be consistent
with desired outcomes or with respect to market competitive conditions
 RONIC must be set equal to WACC because economic theory suggests
that competition eliminates abnormal returns so RONIC and WACC
considered to be same.
Estimating continuing value

16. NOPLAT (Growth Rate and WACC)
Growth rate
 Few companies expect to grow faster than economy for longer periods
 Growth rate can be best determined by examining expected long term rate of
consumption growth for industry products + inflation
 Sensitivity analysis predicts growth rate effects on continuing value
estimations
WACC
 The weighted average cost of capital must incorporate sustainable capital
structure and estimation of business risk consistency along with industrial
conditions
Estimating continuing value

17. Exhibit 9.2 Impact of Continuing Value
Assumptions
Estimating continuing value

18. Recommended Approaches
for continuing value
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
Estimating continuing value

19. Sensitivity of value driver formula
 Value driver formula is highly sensitive to the formula
parameters as Exhibit 9.2 shows:
 At a 14 percent of expected rate of return on new capital, the
change in growth rate from 6 percent to 8 percent increased
the continuing value by 50 percent from about $1.4 billion to
$2.1 billion
Estimating continuing value

20. Recommended formula for economic profit
valuation
With economic profit approach, the continuing value does not
equal the explicit forecast period value
 Continuing value is incremental value over company’s
invested capital at the end of explicit forecast period
 The total value of the company is as follows:
Estimating continuing value

21. Economic Profit Formula
Estimating continuing value

22. Economic Profit Formula
 Incremental economic profit is created by additional growth at returns
exceeding the cost of capital
 If expected RONIC equals WACC, then second half part of this equation
becomes zero so such economic profit is defined as first year economic
profit value in perpetuity
 There is direct relationship between DCF based and economic profit
based continuing values but not identical
Estimating continuing value

23. Economic Profit Formula
Continuing value by using DCF = sum of economic
profit continuing value + amount of invested
capital at end of explicit forecast period
Continuing value only represents long-run value
creation, not total value.
Estimating continuing value

24. Subtleties of continuing value
Following are 3 misunderstandings about continuing value:
1. Length of the explicit forecast affects the company's value
2. There is confusion about relationship of continuing value to
the time frame a company forecasts to earn capital returns
more than its cost of capital
3. Some analysts incorrectly predict that value creation
occurs primarily after the explicit forecast period
Estimating continuing value

25. Underlying process
Estimating continuing value

26. Length Of Forecast Affect The Company’s
Value?
 No, it does not affect the company’s value, it only affects the
distribution of company’s value between explicit forecast
period and years that follows
 The choice of period length indirectly affects value if is
related changes in the economic assumptions
 Exhibit 9.3 shows that company’s value remained $893
regardless of how long the forecast period was
Estimating continuing value

27. Exhibit 9.3 Comparison of Total Value Estimates
Based on Different Forecast Horizons
Estimating continuing value

28. Length Of Forecast Affect The Company’s
Value?
 Extending the forecast period indirectly raises the value
 The explicit forecast should be long enough that business must reach its
steady state by the end of the period
Estimating continuing value

29. Confusion About Competitive Advantage
Period
 This notion that companies will earn return above invested cost of capital
followed by the decline to the cost of capital has confusion because it has
been discussed that there is no relationship between forecast horizon
and value of company
 Key value driver formula is based on incremental returns on capital, not
companywide average returns
 Companies advantage period will not come to end even once continuing
value period is reached
Estimating continuing value

30. When Value Is Created?
 This notion that companies will earn return above invested cost of capital
followed by decline to the cost of capital is somehow useful but not
identical
 Executives often assume that all the value is continuing value so 85
percent of innovation value comes from continuing value
Estimating continuing value

31. Naive Over-conservatism
 Financial analysts put assumptions that the incremental return on the
capital during continuing value period equals the cost of capital
 Growth rate neither adds nor destroys continuing value
 Some businesses consider this approach as too much conservatism
Estimating continuing value

32. Example…………
Coca-Cola and Pepsi’s businesses earns high returns
on invested capital and this return remains constant
because they continue to grow due to strength of
their brands
Estimating continuing value

33. Purposeful Over-conservatism
 Analysts sometimes are overly conservative because of uncertainty and
size of the continuing value
 Conservatism overcompensates for uncertainty
 There is significant role of uncertainty but it should be modeled by using
scenarios instead of conservatism
Estimating continuing value

34. Other Approaches To Continuing Value
 DCF cash flow approaches are modified with variations as one variation
is convergence formula
 Companies who assume return on new investment to cover the cost of
capital
 This assumption allows simpler version of the value driver formula as
follows
Estimating continuing value

35. Continued…………
The derivation begins with the value driver formula:
If RONIC= WACC then, formula is:
Estimating continuing value

36. Continued………..
 Misinterpretation of convergence formula has created another variation; the Aggressive
Growth Formula
This formula put assumption that :
 earnings in continuing value period will grow at some rate, often the inflation rate
 Earnings should be discounted at the real WACC rather than the nominal WACC. The
resulting Formula is:
Estimating continuing value

37. 2 Assumptions for Average Return
Estimating continuing value

38. 2 Assumptions for Average Return
In the aggressive growth case, NOPLAT grows without
any new investment, so return 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 the larger portion of the total capital base
Estimating continuing value

39. Questions?
Chapter 8. Forecasting Performance
39