Reading: Valuation of Mature Companies

We have argued that it makes sense to model the firm's "exceptional" years with an explicit forecast period and then converge to a steady state once the firm is projected to reach more "normal" characteristics.

But what if a firm's "exceptional" years are already over? Put differently, what if we want to value a more mature company that operates in reasonably stable market environment? The above logic implies that, for such a firm, there is no need for an explicit forecast period. If the firm is already in the steady state, we should be able to obtain a reasonable first-pass valuation by proceeding directly to "continuing value."

It turns out that this procedure often works fairly well. This has important implications for the effort we have to put into our valuations. If the firm in question is really mature without many attractive new investment opportunities (ROIC ≤ WACC), we can often get an acceptable valuation with only 5 assumptions!

• Normalized sales
• Normalized EBIT margin
• Tax rate
• Long-term expected rate of inflation
• Cost of capital (WACC).

In contrast, if we believe that the firm is mature but still has valuable investment opportunities (ROIC > WACC), we need two additional pieces of information, namely:

• The return it earns on the new investments (ROIC)
• The fraction of NOPLAT it uses for new investments (p).

Let us illustrate this with a real-life example: Novartis in November 2016. At that time, the enterprise value of the firm (market value of equity plus debt outstanding) was approximately CHF 190 billion. To conduct a simplified valuation, we assume that the firm has no real growth opportunities (ROIC ≤ WACC) and therefore abstains from new investments going forward (p = 0). Consequently, we need 5 pieces of information to conduct a rough valuation:

• Normalized sales: CHF 47'513 million in 2015 (according to the annual report; assuming an exchange rate of 1 CHF/USD)
• Normalized EBIT margin (m): 18.2% (according to the annual report, assuming this is a normalized value)
• Tax rate (τ): 14% (according to the annual report, assuming this is a normalized value)
• Long-term expected rate of inflation (π): 1% (assumption)
• Cost of capital (WACC): 5% (assumption, based on market data)

With this information, we can derive the normalized free cash flow (last year):

Since there are no new investments (p = 0), the normalized growth rate g corresponds to the rate of inflation of 1%. Consequently, the assumptions imply a firm value of approximately CHF 190 billion:

  
Firm value = \( \frac{\text{Normalized FCF} \times (1+g)}{WACC - g} = \frac{7'437 \times 1.01}{0.05-0.01} \) ≈ 190'000.

This valuation corresponds to the actual market valuation of the firm in November 2016. Clearly, this simplified approach does not always work so perfectly. But in many instances, it will give us a good first idea of what a fair value of a mature firm could approximately be. It is therefore recommended to start the valuation of mature firms with this simplified procedure.

The Online Tool "Mature Firm Valuation" allows you to implement this simple valuation approach conveniently in your Webbrowser.