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. NOPLAT (1 - g/r) r„ rM , „,„„.,10 $200.21 (1 - 6% ! 12%) ,„ „_,_,.

Present value of continuing value = — '—— [11 (1 + WACC)] = --—i-——--(0.322)

Continuingvaiue 537,2

Total value 392 6

The explicit forecast period in this case must be at least seven years, because continuing value approaches cannot account for the declining margin (at least not without much computational complexity). The business must be operating at an equilibrium level for the continuing value approaches to be useful. If the explicit forecast is more than seven years, there will be no effect on the total value of the company. Confusion about ROIC

A related issue is the concept of competitive advantage period or the period of super-normal returns. This is the notion that companies will earn returns above the cost of capital for a period of time, followed by a decline to the cost of capital. While this is clearly a useful concept, it is dangerous to link it to the length of the forecast. One reason is simply that, as we just showed, there is no necessary connection between the length of the forecast and the value of the company.

More important is that we have seen the concept of competitive advantage period inappropriately linked to the continuing value formula. Remember, the value-driver formula is based on incremental returns on capital, not companywide average returns. If you assume that incremental returns in the continuing value period will just equal the cost of capital, you are not assuming that the return on total capital (old and new) will equal the cost of capital. The return on the old capital will continue to earn the returns it is projected to earn in the last forecast period. In other words, the company's competitive advantage period has not come to an end once you reach the continuing value period. Exhibit 12.4 shows the implied average ROIC assuming that projected continuing value growth is 4.5 percent, the return on base capital is 18 percent, the return on incremental capital is 10 percent, and the WACC is 10 percent. The average return on all capital declines gradually. From its starting point at 18 percent, it declines to 14 percent (the halfway point to the incremental ROIC) after 11 years. It reaches 12 percent after 23 years and 11 percent after 37 years.

When Is Value Created?

Managers are sometimes uncomfortable that ''all the value is in the continuing value." Exhibit 12.5 illustrates the problem for Innovation Inc. It appears that 85 percent of Innovation's value comes from the continuing value. Exhibit 12.6 suggests an alternative interpretation of where value is coming

Exhibit 12.4 Average ROIC Declines Gradually Using CV Formula

Exhibit 12.5 Innovation Inc., Free Cash Flow Forecast and Valuation

from—a business components approach. Innovation Inc. has a base business that earns a steady 12 percent return on capital and is growing at 4 percent per year. It also has developed a new product line that will require several years of negative cash flow because of construction of a new plant. Exhibit 12.6 shows that the base business has a value of $877, or 71 percent of Innovation's total value. So 71 percent of the company's value comes from operations that are currently generating strong cash flow. But the company has decided to reinvest this cash flow in a profitable new product line. This does not mean that 85 percent of the value is more than eight years out. It just means that the cash flow pattern mechanically results in the appearance that most of the value is a long way off.

Exhibit 12.6 Innovation Inc., Valuation by Components

Exhibit 12.7 Innovation Inc., Comparison of Continuing Values

We can also use the economic profit model for another interpretation on continuing value. Exhibit 12.7 compares the components of value for Innovation Inc. using the two interpretations discussed earlier as well as the economic profit model. Under the economic profit model 62 percent of Innovation's value is simply its invested capital. The rest of the value is the present value of projected economic profit (8 percent for economic profit before 2007 and 30 percent for economic profit after 2007).

Estimating Parameters for Continuing Value Variables

The parameters that must be defined to estimate continuing value are net operating profits less adjusted taxes (NOPLAT), free cash flow (FCF), rate of return on new investment (ROIC), rate of growth in NOPLAT (g ), and weighted average cost of capital (WACC). Careful estimation of these parameters is critical because continuing value is sensitive to their value, particularly the growth assumption. Exhibit 12.8 shows how continuing value (calculated using the value driver formula) is affected by various combinations of growth rate and rate of return on new investment. The example assumes a $100 base level of NOPLAT and a 10 percent WACC. Notice that at a 14 percent expected rate of return on new capital, changing the growth rate from 6 percent to 8 percent increases the continuing value by 50 percent, from about $1,400 to about $2,100.

Estimating the continuing value parameters should be an integral part of the forecasting process. The continuing value parameters should reflect a coherent forecast for the long-term economic situation of the company and its industry. Specifically, the continuing value parameters should be based on the expected steady state condition to which the company will migrate in the scenario you are valuing.

Exhibit 12.8 Impact of Continuing-Value Assumptions

Exhibit 12.8 Impact of Continuing-Value Assumptions

10 12 14 16 18 20

Return on net new invested capital (percent)

Some suggestions follow regarding continuing value parameters for the value-driver and the free cash flow perpetuity formulas:

• NOPLAT. The base level of NOPLAT should reflect a normalized level of earnings for the company at the midpoint of its business cycle. Revenues should generally reflect the continuation of the trends in the last forecast year adjusted to the midpoint of the business cycle. Operating costs should be based on sustainable margin levels, and taxes should be based on long-term expected rates.

• Free cash flow. First, estimate the base level of NOPLAT as described above. Although NOPLAT is usually based on the last forecast year's results, the prior year's level of investment is probably not a good indicator of the sustainable amount of investment needed for growth in the continuing value period. Carefully estimate how much investment will be required to sustain the forecasted growth rate. Often the forecasted growth in the continuing value period is lower than in the explicit forecast period, so the amount of investment should be a proportionately smaller amount of NOPLAT.

• Incremental ROIC. The expected rate of return on new investment should be consistent with expected competitive conditions. Economic theory suggests that competition will eventually eliminate abnormal returns, so for many companies, set ROIC = WACC. If you expect that the company will be able to continue its growth and to maintain its competitive advantage, then you might consider setting ROIC equal to the return the company is forecasted to earn during the explicit forecast period.

Exhibit 12.9 Potential Positioning on Continuing Value Parameters inflation

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