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Cash tax rate ill 31.4 31.6 31.6
ROIC (after tax, before goodwill) 14 8 17.6 17.4 17.3
WACC 9 0 6.7 6.7 6.7
Average economic profit 341.1 785.6 966.9 1,177.2
1 lor the historical period, revenue and bBIl A growth are only calculated lor the first lour years.
12— Estimating Continuing Value
Chapter 8 introduced the continuing value concept as a method for simplifying company valuations. This chapter explains how to estimate continuing values. As we stated earlier, a company's expected cash flow can be separated into two periods and the company's value defined as follows:
Present value of cash Present value of cash Viiluc — flow explicit + floiv after explicit
The second term is the continuing value. It is the value of the company's expected cash flow beyond the explicit forecast period. Using simplifying assumptions about the company's performance during this period—for example, assuming a constant rate of growth—permits us to estimate continuing value with one of several formulas. Using a continuing value formula eliminates the need to forecast in detail the company's cash flow over an extended period.
A high-quality estimate of continuing value is essential to any valuation, because continuing value often accounts for a large percentage of the total value of the company. Exhibit 12.1 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. Although these continuing values are large, this does not mean that most of a company's value will be realized in the continuing value period. It often just means that the cash inflow in the early years is offset by outflows for capital spending and working capital investment—investments that should generate higher cash flow in later years. The proper interpretation of continuing value will be discussed in more detail later in this chapter.
Exhibit 12.1 Continuing Value as a Percentage of Total Value
The continuing value approaches outlined in the following pages are consistent with the overall discounted cash flow and economic profit frameworks. This is important because we often see continuing value treated as though it is different from the DCF valuation of the explicit forecast period. Some acquirers estimate continuing value by applying a price-earnings multiple five years in the future equal to the multiple they are considering paying for the company. They are assuming that the target company is worth what they are willing to pay for it (adjusted for growth during the intervening five years), regardless of its economics, and that someone else would be willing to pay the same price. This type of circular reasoning leads to inaccurate valuations. Instead, they should try to estimate what the multiple should be at the end of the forecast period, given the industry conditions at that time.
The approaches we recommend not only provide consistency with the company's economic performance, they also offer insight into the underlying forces driving the value of the company.
We begin with recommended formulas for DCF and economic profit valuation. We discuss some of the issues commonly raised about interpreting continuing value and suggest some best practices in estimating continuing value parameters such as growth and return on invested capital. Finally, we compare the recommended formulas with other continuing value techniques and discuss more advanced formulas.
Recommended Continuing Value Formula for DCF Valuation
If you are using the enterprise DCF model, we recommend the value-driver formula for estimating continuing value.
where NOPLATT+1 The normalized level of NOPLAT in the first year after the = explicit forecast period.
g = The expected growth rate in NOPLAT in perpetuity.
ROIC, = The expected rate of return on net new investment.
WACC = The weighted average cost of capital.
We call this the value-driver formula because the input variables (growth, ROIC, and WACC) are the key drivers of value discussed throughout this book. The formula is derived by projecting cash flows into perpetuity and discounting them at WACC while making the following simplifying assumptions:
• The company earns constant margins, maintains a constant capital turnover, and thus earns a constant return on existing invested capital.
• The company's revenues and NOPLAT grow at a constant rate and the company invests the same proportion of its gross cash flow in its business each year.
• The company earns a constant return on all new investments.
We start with the simple formula for a cash flow perpetuity that grows at a constant rate:
Continuing Value = '—
where FCFT+1 = The normalized level of free cash flow in the first year after the explicit forecast period.