Company Valuation Under IFRS : Interpreting and Forecasting ...

Chapter Five – Valuing a company
generated after 5 years if no additional investments were undertaken, and the
value that we are putting on the investment programme after the forecast period.
In our discussion of the DCF valuation, we did not concentrate on the
assumptions made to derive the terminal value, so let us do so here, as we are
now in possession of far more insight into what they mean. The growth figure is
generally uncontentious. If a company grows faster than nominal GDP for ever
then it will end up taking over the world, which has yet to happen. In reality,
mature companies grow less fast than nominal GDP, so the growth rate used in
terminal values should be around 3-4 per cent as a maximum.
What about the return on incremental investment? In theory, this should drop into
line with the cost of capital with the result that economic profit erodes away and
there is no need to put a value on incremental investments. In practice, as we shall
discuss later, balance sheets for many companies do not fully reflect the
investments made to establish the brand, develop the drug, and so on. We then
have two choices: we can rebuild the balance sheet as if large amounts of
operating cost had been capitalised, or we can just accept that it is unrealistic to
assume that incremental returns, as shown in the published accounts, will not be
higher than the WACC. In the latter case we are explicitly assuming a positive
investment spread to correct for the inadequacy of published accounts to meet
our requirements.
This is why it is common for valuations to assume that incremental returns will be
lower than that achieved at the end of the forecast period, but higher than the WACC.
One of the advantages of the economic profit approach is that it makes explicit in
the print-out of the valuation how much value is dependent on this assumption.
3.6 Sensitivities
What we have discounted is cash flows and economic profits derived from a base
case assumption. True, we have used a discount rate that has some risk premium
built into it, but so long as we remain within the CAPM framework this merely
reflects market risk, and ignores specific risk. What this means is that the onus is on
the modeller, when a base case has been generated, to put high and low cases round
it, typically by flexing the assumptions for growth rates, margins and capital
requirements during the forecast period, and for growth and return on incremental
capital after the forecast period. Experimenting with this will quickly establish
where the really important assumptions lie, and also how sensitive the resulting
valuation is to each of the individual variables. It will also establish the extent to
which valuations are skewed, as upward or downward changes in assumed margins,
for example, will probably not have symmetrical effects on the derived valuation.
If it is possible to ascribe probabilities to the different input assumptions, then the
resulting values can be probability weighted, to produce a possibly more
meaningful number than the base case value. Pushing this analysis to its logical
conclusion results in so-called Monte-Carlo analysis, which requires as inputs
211