Don’t (only) use multiples for your continuing value

By Werner Rehm and Vartika Gupta, CFA with Alok Bothra and Rodrigo Assun??o

Estimating the continuing value (CV) in a discounted cash flows (DCF) model is vital. The cash flows beyond the explicit forecast period often represent a substantial portion of value.

It is common to use current, average, or somehow estimated multiples as a proxy in CV estimates, or the classic perpetuity free cash flow (FCF) approach (FCF/(WACC-g)). Both the multiples approach and the FCF perpetuity method have advantages and shortcomings.

• The multiples approach uses some implicit assumptions about future growth and ROIC. In particular, this method assumes that the long-term performance is equal to today’s performance. To address this challenge, we can estimate an implied multiple based on the company’s expected performance for the long term. For this example, as illustrated in Exhibit 1, a multiple of about 8 would imply a ROIC of 8 percent (below the cost of capital), which might be too conservative. On the other hand, a multiple of about 14 ?would imply a 14 percent ROIC and a 6 percent long-term growth rate, which could be too optimistic. The point here is that multiples are a shortcut and hide implicit long-term economic assumptions.
• The FCF perpetuity method in most cases assumes a lower growth rate for the continuing value than for the explicit forecast period while using the prior year’s FCF. Business schools often spend quite some time on estimating “adjusted CF” for this purpose—a pro-forma FCF that is consistent with lower required reinvestment for lower growth, which leads to higher cash flows than using the last year’s FCF estimate. But how do you adjust capital expenditure and working capital needs for this lower perpetuity growth? In practice, nobody does. Everybody just uses the prior year’s FCF, even when it was based on higher growth assumptions.

Linking CV mathematically to long-term economics

There is an easier and more accurate method available that directly links explicit return and growth assumptions to value (Exhibit 2).

Often this is referred to as “estimating” value, but in fact, it is a version of the FCF approach that links cash flow mathematically to return on capital and growth (exhibit 3).

By using this CV linking method, you can have a great discussion on the potential long-term sustainable growth and returns in an industry. For example, while a business might see higher ROIC in the medium term, competitive advantages might be competed away in the long term. This is especially important in these times when so many companies in so many industries are investing in the transition to renewable energy—will long term ROICs be the same as historical?

Here are a few principles to consider when using this formula to link CV more accurately to long-term economics:

1. Net operating profit after tax (NOPAT) includes the year after the explicit forecast period based on a sustainable level of profitability.
2. Return on new investment capital (RONIC) links to a story or scenario, and to expectations of future competitive conditions. When competitive advantages are sustainable, RONIC can be close to the estimate at the end of the explicit forecast period. For example, global consumer packaged goods companies tend to have a sustainable advantage from their brand, having built and/or acquired their way to global scale, and a sustainable ROIC as well. Some of these companies had ROIC above 40 percent 50 years ago based on their brands and there is no reason to believe that they wouldn’t have that 50 years from now.?In other cases, competitive advantages erode with time, reducing returns, and RONIC may equal the cost of capital. This does not mean that all cash flows from that point on will have a net present value of zero, because the cash flows from existing capital will carry into the continuing value period. Instead, total ROIC will not immediately approach WACC, but rather will arrive there gradually (Exhibit 4).

3. Growth rates need to be consistent with the inflation used to calculate WACC. If you assume a higher-than-normal inflation for your WACC estimate (in a foreign currency, for example), you need to carry this through into the CV growth, or use a different WACC for the CV.

In our work, when we see multiples used for CV estimates, we translate them into implied ROIC and perpetuity growth so we can foster a discussion around what’s reasonable. You can similarly challenge your team by creating a simple table with growth, return on capital, and implied multiple for the CV.

What is your experience? What methods do you usually use for CV and why? What mistakes have you encountered? What alternative approaches have you seen?