Wacc

where, Economic profitT+1 = The normalized economic profit in the first year after the explicit forecast period.

NOPLATt+1 = The normalized NOPLAT in the first year after the explicit forecast period.

g = The expected growth rate in NOPLAT in perpetuity. ROICj = The expected rate of return on net new investment. WACC = The weighted average cost of capital.

This formula says that the value of economic profit after the explicit forecast equals the present value of economic profit in the first year after the explicit forecast in perpetuity, plus any incremental economic profit after that year created by additional growth at returns exceeding the cost of capital. If expected ROIC: equals WACC, the second half of the equation equals zero and the continuing economic profit value is the value of the first year's economic profit in perpetuity.

The continuing value using a discounted cash flow approach will equal the sum of the economic profit continuing value plus the amount of invested capital in place at the end of the explicit forecast period.

Issues in the Interpretation of Continuing Value

In this section, we address three common misunderstandings about continuing value. First is the perception that the length of the forecast affects the value of a company. Second, there is often confusion about the ROIC assumption in the continuing value period. Third, some incorrectly infer that a large continuing value relative to the total value of a company means that all the company's value is created after the explicit forecast period. Does the Length of Forecast Affect the Value of a Company?

While the length of the explicit forecast period you choose is important, it does not affect the value of the company, only the distribution of value of the company between the explicit forecast period and the years that follow. In the examples in Exhibits 12.2 and 12.3, no matter what the length of the forecast period, the company value is $893. With a forecast horizon of five years, the present value of the continuing value accounts for 79 percent of total value, while with a 10-year horizon, the present value of continuing value accounts for only 60 percent of total value.

The choice of forecast horizon can have an indirect impact on value if it is associated with changes in the economic assumptions underlying the continuing value estimate. Analysts often unknowingly change their performance forecasts when they change their forecast horizon. Many forecasters assume that the rate of return on new invested capital equals the cost of capital in the continuing value period, but that the company will earn returns exceeding the cost of capital during the explicit forecast period. When they extend the explicit forecast period, they also extend the time period during which returns on new capital are expected to exceed the cost of capital. Therefore, extending the forecast period leads to an increase in value, attributable to the increase in the rate-of-return assumptions.

As we explained earlier in this chapter, the explicit forecast should be long enough so that the business will have reached a steady state of operations by the end of the period. Suppose you expect the company's margins to decline as its customers become more powerful. Margins are currently 12 percent and you forecast they will fall to 9 percent over the next seven years.

Exhibit 12.2 Comparison of Total Value Estimates Based on Different Forecast Horizons

Exhibit 12.3 Comparison of Total Value Calculations for Five-Year and Ten-Year Horizons

Î million

Overall assumptions

(percent)

Years 1-5

Return on investment (r) Growth rale (g) WACC

0 0

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