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 Valut1 = flow dltriHg explicit + floiv (i/fcrexplicit

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

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.

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