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<WACC WACC >WACC
• Growth rate. Few companies can be expected to grow faster than the economy for long periods. The best estimate is probably the expected long-term rate of consumption growth for the industry's products, plus inflation. We also suggest that sensitivity analyses be done to understand how the growth rate affects value estimates.
• WACC. The weighted average cost of capital should incorporate a sustainable capital structure and an underlying estimate of business risk consistent with expected industry conditions.
• Investment rate. The investment rate is not explicitly in the formula, but it equals ROIC divided by growth. Make sure that the investment rate can be explained in light of industry economics.
Exhibit 12.9 suggests where companies in different industries may lie relative to each other in terms of long-term growth and ROIC. This is merely a suggestion; each company will have unique characteristics.
Some of the mistakes made in estimating continuing values include naive base-year extrapolation and overconservatism:
Naive base-year extrapolation. Exhibit 12.10 illustrates a common error in forecasting the base level of free cash flow. From Year 9 to Year 10 (the
Exhibit 12.10 Right and Wrong Ways to Forecast the Base Free Cash Flow
Year 11 (5% growth)
Year 9 Year 10 Incorrect Correct
Sales 1,000 1,000 1,155 1,155
Operating expenses (850) (935) (982) (982)
EBIT 150 165 173 173
Cash taxes (60) (66) (69) (69)
NOPLAT 90 99 104 104
Depreciation 27 30 32 32
Gross cash flow 117 129 136 136
Capital expenditures 30 33 35 35
Increase in working capital 27 30 32 17
Gross investment 57 63 67 52
Free cash flow 60 66 69 84
Memo: Year-end working capital 300 330 362 347
Working capital/sales 30% 30% 31% 30%
Increase in working capital/sales 2.7% 2.7% 2.7% 1.5%
last forecast year), the company's earnings and cash flow grew by 10 percent. The forecast suggests that growth in the continuing value period will be 5 percent per year. A naive, and incorrect, forecast for Year 11 (the continuing value base year) simply increases every cash flow from Year 10 by 5 percent, as shown in the third column. This forecast is wrong because the increase in working capital is far too large for the increase in sales. Since sales are growing more slowly, the proportion of gross cash flow devoted to increasing working capital should decline significantly, as shown in the last column. In the last column, the increase in working capital is the amount necessary to maintain the year-end working capital at a constant percentage of sales. The naive approach results in a continual increase in working capital as a percentage of sales and will significantly understate the value of the company. Note that in the third column, free cash flow is 18 percent lower than it should be.
Naive overconservatism. Many analysts always assume the incremental return on capital in the continuing value period will equal the cost of capital. This also relieves them of having to forecast a growth rate, since growth in this case neither adds nor destroys value. For some businesses, this is obviously wrong. For example, both Coca-Cola's and PepsiCo's soft drink businesses earn high returns on invested capital, and their returns are unlikely to fall substantially as they continue to grow. Assuming that ROIC = WACC for these businesses would substantially understate their values. This applies equally to almost any business that sells something proprietary that is unlikely to
be duplicated, including many pharmaceutical companies, consumer products companies, and some software companies.
Purposeful overconservatism. Analysts sometimes are overly conservative because of the uncertainty and size of the continuing value. If continuing value is estimated properly, the uncertainty cuts both ways: The results are just as likely to be higher than the estimate as they are to be lower. So conservatism overcompensates for the uncertainty. This is not to say that you should not be concerned about the uncertainty. That is why careful development of scenarios is a critical element of any valuation.
Evaluating Other Approaches
A number of continuing value approaches are used in practice, often with misleading results. Some of these are acceptable if used carefully, but we prefer the approaches just recommended because they explicitly rely on the underlying economic assumptions embodied in the company analysis. The other approaches tend to hide the underlying economic assumptions. Exhibit 12.11 illustrates, for a sporting goods company, the wide dispersion of continuing value estimates arrived at by different techniques. This section explains why we prefer the recommended approaches. We classify the most common techniques into two categories: (1) other DCF approaches, and (2) non-cash flow approaches.