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expected values. In my view, five years is generally long enough.

Imagine telling a decision-maker that you have included a TV only at the end of a ten-year plan

10

period. This sounds as though you know a lot about the future prospects of the company. If, how-

ever, all you have is a one-year plan and you have then assumed that everything stays constant in real

terms then the remaining nine years of your ten-year plan are contributing nothing different to the

valuation than using a TV after year 1.

357 The third pillar: What sets the share price?

I should point out at this stage that this suggestion of the adoption of

a relatively short period of specific cash flow forecasts is at odds with the

approach recommended by the standard valuation texts. As I have already

pointed out, these stress the accuracy of valuation and as a result they do

suggest use of longer plan periods such as 10â€“15 years. My view is that this

encourages a misplaced belief in the accuracy of numbers. There are times

when a long plan period should be used but my suggestion is that this should

be the exception rather than the rule.

Step 2: Calculating the present value of the terminal value

This step involves calculating the TV and then discounting it to the present

so that it can subsequently be added into the overall share price valuation.

Up to now we have simply assumed that the TV is set through the growth to

perpetuity approach. In this part I will consider various variants of the per-

petuity approach and then give several other methods as well. The full list of

methods which I will cover is:

1. Funds flow to perpetuity

2. Growth adjusted profit

3. Overview adjusted profit

4. Sustainable return on capital

5. Two-stage growth to perpetuity

6. Specified company life

7. Life of asset

8. Trading multiple

9. Book value

10. Liquidation

Clearly the list is very long. The skill is to pick an appropriate method for the

circumstances. I have used all of these methods at one time or another in the

past and there is no â€˜right answerâ€™. I will review each method and try to point

towards their strengths and weaknesses. Readers who are not likely imme-

diately to become involved in calculating a TV might want to skim read this

section in order to become aware of the range of techniques that are avail-

able. They could then return at some later date and consider them thoroughly

if/when they need to apply them themselves.

The traditional funds flow to perpetuity formula is as follows:

Funds Flow Ã— (1 + Growth )

TV =

(Cost of Capital âˆ’ Growth )

358 The three pillars of financial analysis

This would give the value as at the end of the plan period where the final year

funds flow is expected to grow at a fixed rate of growth to perpetuity. The cal-

culation assumes that the first funds flow in the post-plan period occurs one

year after the end of the plan. If the plan has assumed mid-year cash flows the

value will be as at the middle of the final year. In either case the discount fac-

tor to apply to the TV in order to calculate its present value is the same as the

discount rate which is applied to the funds flow in the final year of the plan.

This formula was used in the initial valuation of the YMCC plan shown

earlier. The growth assumption was zero and so the TV factor was one divided

by the 9% CoC or 11.1. With a final year funds flow of $15.5m the TV was

$172.1m and the present value of this was $116.8m. Had the growth assump-

tion been changed to a steady decline of 1% pa the TV would have fallen to

$155.0m. If we had decided for some reason that 4% growth was achievable,

the TV would have risen to $310.0m.

What we must all be aware of is that the TV formula is right only if the

assumptions are reasonable. The key, in my view, is to confirm that the

assumptions are indeed acceptable and to adjust as necessary.

My greatest concern with this approach is the way that it appears that

the growth assumption can be changed independently from the funds flow

assumption. This is exactly what I did in the simple illustrations above. To

do this, however, would be to defy what I refer to as â€˜financial gravityâ€™. This is

illustrated in the following example.

If we consider the final year of the YMCC plan we can see that capital

investment is expected to be $4.6m whereas amortisation is $7.8m. The result

is that the book value of fixed assets declines from $82.7m to $79.5m. Quite

clearly this cannot go on for ever, yet a simple perpetuity assumption of

zero growth in the post-plan period would assume that it did. I have a bet-

ter method to offer and this will allow for the investment in fixed assets and

working capital that is necessary to facilitate the assumed rate of growth.

I call my method the growth adjusted profit method. It depends on the

relationship that:

Funds Flow = Profit âˆ’ Growth Ã— Capital Employed

So, rather than take the final yearâ€™s funds flow from the plan, we can take the

final yearâ€™s profit and subtract from it growth times capital employed. This

will then automatically adjust funds flow for different rates of growth. So,

in the YMCC case the approach used in the earlier chapters had calculated

the TV from the final yearâ€™s funds flow of $15.5m times the TV factor which,

thanks to the assumed rate of growth being 0% and the CoC 9%, was 11.1.

359 The third pillar: What sets the share price?

So we had a TV of $172.1m. The adjusted profit method would take the final

yearâ€™s profit of $13.3m, subtract nothing for growth11 and then multiply by

the TV factor of 11.1. The TV would have fallen to $147.5m.

An equation such as the growth adjusted profit method can easily be pro-

grammed into a spreadsheet model and this is, I believe, better than using

the traditional funds flow growth to perpetuity method.

What this method is doing is to allow for the investments in fixed assets

and working capital that are necessary in order to facilitate growth. It can

also allow for the reductions in fixed assets and working capital that follow

from a steady shrinkage in size. This will go a good part of the way towards

meeting the concern that I have with the traditional growth to perpetuity

method that appears to allow growth rates to be set independently from

funds flow.

A related method that I call the overview adjusted profit method requires

the analyst to make a specific estimate of two further items in order to arrive

at an even better estimate of the funds flow figure which is consistent with

the assumed rate of growth. The first stage of this requires use of an estimated

steady-state capital employed figure to be used in the calculation rather than

simply using the capital employed as at the end of the plan period. It is pos-

sible, for example, that the final year of a plan has a particularly high capital

employed figure and using this as the basis for setting value may be inappro-

priate. In the YMCC example the final-year capital employed was $101.3m.

This is still high owing to the heavy capital investment in the early years of

the plan. We might want to decide that the steady-state capital employed fig-

ure to use in calculating the adjustment to profit was, say, $90m. If we were

to do this the valuation with 1% growth would involve deducting $0.9m from

the final-year profit to arrive at the sustainable funds flow of $12.4m.12

The second adjustment to profit makes an allowance for any fixed costs

which are necessary in order to facilitate the assumed rate of growth. These

fixed costs would need to cover, for example, the cost of any project develop-

ment teams or brand development or R&D effort, all of which will contribute

towards growth. I should stress that the adjustment may well serve to increase

the steady-state funds flow to above the final yearâ€™s profit figure. This is because

plans often allow for high growth rates and so have built into them the costs

Because the growth assumption was for zero growth. If we had wanted to assume, say, 1% growth

11

we would have subtracted 1% of the $101.3m capital employed from profit, i.e. $1m. The sustainable

funds flow would have fallen to $12.3m and the implied TV would be $155.3m.

We would complete the calculation by multiplying this by 1.01 and dividing by 0.08. The TV would

12

be $156.5m.

360 The three pillars of financial analysis

of the various development activities. If the TV assumption is that growth is

reduced to only nominal levels then it can be reasonable to strip quite signifi-

cant costs out of the planâ€™s final year as we seek to establish a good estimate of

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