HOLT Market Commentary

June 14, 2016

HOLT Wealth Creation Principles

Don’t Suffer from a Terminal Flaw, Add Fade to Your DCF
An improved method for valuing mature companies and estimating terminal value

Contacts: Key Points

David A. Holland • The addition of a profitability fade rate is an excellent enhancement to any DCF
HOLT, Senior Advisor model. It allows the forecaster to test the sensitivity of the terminal value to decay in
david.a.holland@credit-suisse.com profitability. The fade rate driver can be thought of as a profitability attenuator.

Bryant Matthews • Back-of-the-envelope valuations are possible for mature, ex-growth firms. 1 The
HOLT, Director Research drivers are forward economic profit (EP), invested capital growth rate, and the
312 345 6187 profitability fade rate. A fade rate of 0% is equivalent to a growing perpetuity and a
bryant.matthews@credit-suisse.com fade rate of 100% brings about an immediate profitability jump to the cost of capital
(EP = 0).

• We show how to perform a back-of-the-envelope valuation using Moet Hennessy

Louis Vuitton (LVMH). Intrinsic value for highly profitable firms is very sensitive to
changes in the fade rate.

• We show that the inverse of fade, 1/f, is equal to the expected competitive
advantage period (CAP) in years.

• A presentation pack is available illustrating how our improved approach can be

applied.

1
Back-of-the-envelope estimates of corporate value are best applied to mature and profitable firms. Early stage firms, growing stars, and turnarounds require
explicit forecasts to reflect their economic reality and provide a transition to steady-state.

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HOLT Market Commentary
June 14, 2016

Wealth Creation Principles

Don’t Suffer from a Terminal Flaw,
Add Fade to Your DCF

Contacts Introduction
David Holland Central to the HOLT framework is a competitive life-cycle where firms evolve through
HOLT, Senior Advisor different profitability and growth stages (see Madden references). This idea is a
david.a.holland@credit-suisse.com noteworthy feature of the HOLT valuation model which assumes that operating returns
Bryant Matthews are not perpetual and that they eventually fade to an opportunity cost of capital. This
HOLT, Director Research assertion is based on empirical research that shows that return on capital mean reverts
312 345 6187
(see for example “Modeling Persistence in Corporate Profits by Industry”). There is fade
bryant.matthews@credit-suisse.com
in profitability (CFROI) and asset growth (see “Prepared for Chance”).

Figure 1: The Competitive Life-cycle

Growth Fading Mature Turn-arounds
Question Marks Stars Cash Cows Dogs
BABA AAPL
JD
GOOG

BATS Required
CFROI rate of return
GROWTH
VW

BP

Stage 1 Stage 2 Stage 3 Stage 4

i ncrea s i ng CFROI a nd a bove-a vera ge but CFROI nea r cos t of bel ow-a vera ge
hi gh Rei nves tment fa di ng CFROI ca pi ta l , l ow growth CFROI

Corporate profitability is sticky, meaning it tends to persist. The degree of persistence

varies from industry to industry. Firms in the Household & Personal Products industry
exhibit strong persistence (slow fade) while Energy companies display weak
persistence (quick fade). Fade, f, is the complement of persistence (1-f). Growth
exhibits low persistence and tends to fade sharply. The assumption that strong growth
will persist warrants scrutiny. Less than 1-in-5 firms sustain growth above 20% for 5
years; less than 1-in-10 do it for 10 years (see “Prepared for Chance”).

Whether explicit or not, fade is a key driver in any discounted cash flow (DCF)
valuation. Most DCF models include a growing perpetuity that assumes zero fade in
profitability in the terminal period. Empirical evidence demonstrates that this assumption
is inaccurate. Fortunately, we provide a simple solution to this thorny and endemic
issue: the addition of a fade driver to the terminal value calculation.

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Company Valuation in a Nutshell

A simple DCF valuation model can be derived for a mature company with a constant return on invested capital ROIC,
invested capital growth rate g, and cost of capital r. Growth must be less than the cost of capital, and is usually set to
the long-term inflation rate or risk-free rate. The derivation is provided in Appendix A.

(1)
𝒈
𝑭𝑭𝑭𝑭𝟏 𝑵𝑵𝑵𝑵𝑵𝟏 �𝟏 − 𝑹𝑹𝑹𝑹∞ �
𝑽= =
(𝒓 − 𝒈) (𝒓 − 𝒈)

The enterprise value is V and NOPAT1 is next year’s net operating profit after tax. The return on invested capital
ROIC equals NOPAT divided by invested capital (IC) and is a popular measure of profitability.

The numerator represents the free cash flow to the firm’s capital providers (FCFF), which grows at a constant rate
into perpetuity. The numerator also represents the surplus cash flow that can be distributed to the firm’s capital
providers (the term g/ROIC∞ is the retention ratio). We have given ROIC the subscript infinity to remind ourselves that
this return on capital is forecast to last forever – it is not simply next year’s return on capital.

This equation is the ubiquitous favorite for calculating terminal values in DCF models. Please note that it embeds a
permanent stream of excess returns when the return on capital is greater than the cost of capital. You should think
carefully when applying it.

Equation (1) can be reformulated into an enterprise value-to-book ratio V/IC0 by substituting NOPAT1 = ROIC∞ x IC0
into equation (1) and then dividing both sides by IC0.

(2)
𝑽 (𝑹𝑹𝑹𝑹∞ − 𝒈)
=
𝑰𝑰𝟎 (𝒓 − 𝒈)

This equation estimates the intrinsic value of the enterprise relative to its invested capital. The basic principles of
shareholder value are evident upon inspection.

• When ROIC > r, value-to-book is greater than 1.0 and the intrinsic value is at a premium to book value. This
company would be a “value creator”.
• When ROIC < r, value-to-book is less than 1.0 and the intrinsic value is at a discount to book value. This company
would be a “value destroyer”.
• When ROIC = r, intrinsic value equals book value. Asset growth is irrelevant for this company and it should focus on
improving its return on capital before growing.
• All things being equal, an increase in the return on capital is always positive for value creation.
• Growth is not always value enhancing. All things being equal, asset growth is additive for value creators but
subtractive for value destroyers.

Factoring in Fade
The previous section assumed a perpetual return on capital, which is the default assertion of most DCF models. Let’s
relax this assumption and introduce an adjustable fade rate f. The fade driver controls the speed at which ROIC
converges toward the cost of capital. A fade rate of 100% brings about immediate convergence, and a fade rate of
0% specifies no fade and perpetual excess profitability. You can think of the fade driver as a profitability attenuator.
The fade parameter does not alter the invested capital growth rate, g, which is assumed to be constant.

Assuming that the spread of (ROIC – r) fades to zero means that economic profit EP dissipates and also decays to
zero. Economic profit is simply the spread multiplied by the beginning-of-year invested capital.

𝑬𝑬𝟏 = (𝑹𝑹𝑹𝑹𝟏 − 𝒓) × 𝑰𝑰𝟎

Economic profit quantifies the monetary amount of value creation. When the return on capital equals the cost of
capital, the economic profit is zero. Enterprise value can be expressed as a function of fade, invested capital growth

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and forward economic profit EP1. The derivation of equations (3) and (4) is shown in Appendix B. †

(3)
𝑬𝑬𝟏
𝑽 = 𝑰𝑰𝟎 +
[𝒓 − 𝒈 + 𝒇]

(4)

𝑬𝑬𝟏
𝑽 = 𝑰𝑰𝟎 +
[𝒓 − 𝒈 + 𝒇]

In equations (3) and (4), ROIC fades from a forward return of ROIC1 to the cost of capital r at an exponential rate of f
which is illustrated in Figure 2.

Figure 2: Fade in Profitability

20%

15%
Spread

10%

5%

0%
0 5 10 15 20 25 30 35 40 45 50
Year
0% 5% 10% 20% 50%

A forward spread of 15% is shown fading at different rates, e.g., ROIC1 = 25% and r = 10% for a forward spread of 15%. A fade rate of
0% results in a perpetual spread and a rate of 100% leads to an immediate jump to zero.

Companies that earn positive economic profits should trade at a premium to book while those that produce negative
economic profits should trade at a discount to book. The present value of future economic profits is equivalent to the
net present value (NPV) of the firm’s existing and future projects. Note that the enterprise value-to-book ratio V/IC0
equals one when ROIC equals the cost of capital. These results agree with common sense. Setting the fade rate to
zero leads to the growing perpetuity formulation of equations (1) and (2). We can add a few more points to the
principles of shareholder value by inspection of equation (4).

• All things being equal, if ROIC > r, then slower fade creates more value. Companies that can maintain high
operating returns are worth more than companies whose return on capital fades quickly. Sturdy competitive moats
are rewarded with larger price-to-book multiples. The relationship between moat strength and value can be assessed
by altering the fade rate.
• All things being equal, if ROIC < r, then faster fade creates more value. This result makes perfect sense. Value
destroyers that are able to rebound quickly to their cost of capital are worth more than those that cannot dig
themselves out of the grave. Asset growth only exacerbates value destruction when incremental investments are in
below cost of capital projects. The first law of holes is to stop digging when you’re in one.

Adding fade as a value driver enhances the soundness of a forecast. It also offers greater flexibility in estimating the
terminal value in a DCF valuation and testing its sensitivity to erosion in profitability over the long-term. It is simple to
add a fade rate to any DCF model and this avoids embedding a perpetual spread into the terminal value. The
sensitivity of value-to-book and fade is highlighted in Figure 3.

† 𝐸𝐸1 𝑉 (𝑅𝑅𝑅𝑅1 −𝑔+𝑓+𝑓𝑓)

The equation was simplified by dropping the cross-term f x g. The exact expressions are: 𝑉 = 𝐼𝐼0 + [𝑟−𝑔+𝑓+𝑓𝑓] and = (𝑟−𝑔+𝑓+𝑓𝑓)
𝐼𝐼0
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Figure 3: Sensitivity of Enterprise Value / Invested Capital to fade and growth rates
Fade
1.3 0% 5% 10% 50%
0% 2.5 2.0 1.8 1.3
Growth 2% 2.9 2.1 1.8 1.3
4% 3.5 2.3 1.9 1.3
6% 4.7 2.6 2.0 1.3
The sensitivity of the enterprise value-to-book ratio for different growth and fade rates when the cost of capital equals 10% and forward
ROIC equals 25% (forward spread of 15%). Faster fade leads to sharp deterioration in value. Growth has diminishing influence on value as
fade increases.

The Link between Fade and Competitive Advantage Period (CAP)

The introduction of a fade factor leads to greater flexibility in DCF valuation models and helps in rapidly testing the
sensitivity of value to the rate of excess spread decay. Thinking in terms of exponential fade rates is unfamiliar.
Instead of fading the excess spread at a constant rate, we will assume that in each year the profitability spread has a
probability p of shutting-off forever. The spread is binomial at (ROIC1 – r) or zero. The expected spread in year n is:

(𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 𝑠𝑠𝑠𝑠𝑠𝑠)𝑛 = (𝑅𝑅𝑅𝑅1 − 𝑟) × (𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝑂𝑂)𝑛 + 0 × (𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝑂𝑂𝑂)𝑛

(𝑅𝑅𝑅𝑅𝑛 − 𝑟) = (𝑅𝑅𝑅𝑅1 − 𝑟) × (1 − 𝑝)𝑛−1

Value as a function of failure probability p is shown in equation (5) and derived in Appendix C.
(5)
𝑉 (𝑅𝑅𝑅𝑅1 − 𝑔 + 𝑝)
=
𝐼𝐼0 (𝑟 − 𝑔 + 𝑝)

Equations (4) and (5) are identical and prove that p and f are equal. In other words, the fade rate and probability of
failure serve identical purposes. Exponential fade and a failure probability are mathematically indistinguishable. You
can think of excess spread and economic profit as fading or being switched-off like a light. Similar to a light bulb
failing forever once it burns out, economic profit is assumed to fall to zero once a company’s competitive advantage
has been extinguished. The expected competitive advantage period E[CAP] equals the expected life of the excess
spread. This may prove more intuitive than exponential decay.
∞
1
𝐸[𝐶𝐶𝐶] = �(1 − 𝑝)𝑛−1 =
𝑝
𝑛=1

An analytical solution for expected CAP in years equals 1/p. Thus p=0% is a perpetuity while p=10% is an expected
CAP of 10 years and p=50% is an expected CAP of 2 years. We have shown that the fade rate and probability of
spread failure are identical, and thus the inverse of the fade rate is the expected competitive advantage
period or CAP.

Figure 4: Fade and expected CAP

20%
CAP = 20 years
15% Fade = 5%
Spread

10%

5%

0%
0 5 10 15 20 25 30 35 40 45 50
Year
All things being equal, valuations will be equivalent whether it is assumed excess spread fades exponentially at a rate of f or shuts-off like a
light with an expected CAP of 1/f. A comparison of excess spread decay at a fade rate of 5% and expected CAP of 20 years, i.e., 1/f, is
diagrammed.

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To be perfectly clear, CAP is not represented by a single value but rather by a geometric distribution of on/off lives
with an expected value of 1/f. This distribution is also known as the waiting-time distribution since it describes the
length of time between catastrophic events, which is excess spread failure in our case. Figure 5 shows the
cumulative probability of the excess spread being on or off for an expected CAP of 10 years. There is a 66%
probability that the excess spread will be on in 5 years and a 34% probability it will have jumped to zero in 5 or fewer
years. The probability of shutting off in 10 or fewer years is 61%. The probability of the excess spread existing in 20
years is 14% and still 5% in 30 years despite the expected CAP only being 10 years. We demonstrate the valuation
equivalence in Appendix C.

Figure 5: Cumulative probability of spread switch from ON to OFF

100%
Cumulative Probability

80%

60% Cum Prob ON

Cum Prob OFF
40%

20%

0%
0 5 10 15 20 25 30 35 40 45 50
Year
The cumulative probability for the excess spread remaining on is graphed for an expected CAP of 10 years. Its complement is the
cumulative probability that the excess spread will have jumped to zero and turned off. The distribution of on/off lives is geometric, also
known as the waiting-time distribution.

The total expected CAP for a valuation employing a fade rate in the terminal period is simply the sum of the explicit
forecast period in years and 1/f for cases where the forecast ROIC exceeds the cost of capital. A ten-year forecast
followed by a 5% fade rate equates to a total expected CAP of 30 years (10 + 1/0.05 = 30 years). For situations
where the forward ROIC is less than the cost of capital, 1/f equals the expected recovery period.

Putting HOLT EP and Fade to Work

Enterprise value can be estimated using HOLT economic profit and inflation-adjusted economic net assets ENA0 as
the book value (see Appendix D).
(6)
𝐻𝐻𝐻𝐻 𝐸𝐸1
𝑉 ≅ 𝐸𝐸𝐸0 +
[𝑟 − 𝑔 + 𝑓]

Because the HOLT discount rate is real (not nominal), the formula requires a real growth rate in order to be
consistent.

Let’s perform a back-of-the-envelope valuation for a mature value creator and show how sensitive the valuation is to
fade and growth rates. The luxury goods company Moet Hennessey Louis Vuitton (LVMH) will be placed under the
microscope.

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Figure 6. The relative wealth chart and economic profit chart for LVMH on 30 March 2016 from HOLT Lens.

LVMH has been acquisitive in the past. We will value its organic possibilities and assume a base asset growth rate of
2.5% and a fade rate in profitability of 10%. LVMH’s HOLT operating economic profit was €3.645bn for the
December 2015 financial year. Economic net assets at the end of 2015 were approximately €37.7bn and the real
discount rate was 3.93%. The present value of economic profits is approximately €32.7bn under these assumptions.

𝐻𝐻𝐻𝐻 𝐸𝐸1 3.645 × 1.025

𝑃𝑃 𝑜𝑜 𝐸𝐸 ≅ = = €32.7𝑏𝑏
[𝑟 − 𝑔 + 𝑓] [0.039 − 0.025 + 0.10]

The other inputs necessary for valuing the share price were extracted from HOLT Lens. The share price on 30 March
2016 was €150.80. The intrinsic value based on our assumptions is only €77.00 (see Figure 7). Clearly, LVMH is
priced to have an expected CAP much greater than 10 years.

Valuation (Euro'mil)
IANA 37,744
PV of EP 32,687
Operating Enterprise Value 70,431
Investments 1,359
Debt (27,931)
Minority Interests (5,144)
Equity Value 38,715
Shares (mil) 502.8
Share Price (Euro) 77.00
Figure 7. The intrinsic share price of LVMH assuming a fade rate of 10%, real asset growth rate of 2.5%, and a real discount rate of
3.9%. The share price on 30 March 2016 was €150.80.

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If we set the fade rate to 4%, which equates to an expected CAP of 25 years, the intrinsic share price jumps to
€148.83 which is in line with the current share price (see Figure 8).

Valuation (Euro'mil)
IANA 37,744
PV of EP 68,805
Operating Enterprise Value 106,549
Investments 1,359
Debt (27,931)
Minority Interests (5,144)
Equity Value 74,833
Shares (mil) 502.8
Share Price (Euro) 148.83
Figure 8. The intrinsic share price of LVMH assuming a fade rate of 4%, real asset growth rate of 2.5%, and a real
discount rate of 3.9%. The share price on 30 March 2016 was €150.80.

As a rule of thumb, we wouldn’t recommend setting the HOLT discount rate to less than 4%, and would assume a
default discount rate of 6% for non-financials. The valuation is more prone to error as the fade rate approaches 0%.
Be cautious when dropping the fade rate to less than 5%. The asset growth rate is a long-term rate which must be
less than the discount rate. We would like to reiterate that this is a back-of-the-envelope estimate to save time and
play in the right ballpark.

Intrinsic value is very sensitive to the fade rate assumption for value creators. This sensitivity helps explain the risk
premium for quality stocks (see “The Measure of Quality”). The risk of owning quality stocks is that they lose their
luster, economic moat, and competitive advantage. An adjustable fade rate provides an excellent means to value the
effect of profitability attenuation in a DCF model.

References
Holland, D. and B. Matthews (2014). “Introducing HOLT Economic Profit”, Credit Suisse HOLT, September 2014.
Madden, B.J. (1999). CFROI Valuation: A Total System Approach to Valuing the Firm, Butterworth Heinemann.
Madden, B.J. (2016). Value Creation Thinking, LearningWhatWorks.
Matthews, B. and D. Holland (2013). “Modeling Persistence in Corporate Profits by Industry and Estimating a Company’s Fair Price”,
Credit Suisse HOLT, October 2013.
Matthews, B. and D. Holland (2014). “Star Performance: Are Growth Expectations Too High?”, Credit Suisse HOLT, November 2014.
Matthews, B. and D. Holland (2015). “Prepared for Chance: Forecasting Corporate Growth”, Credit Suisse HOLT, February 2015.
Matthews, B., D. Holland and R. Curry (2016). “The Measure of Quality”, Credit Suisse HOLT, February 2016.
McClave, J.T., P.G. Benson, and T. Sincich (2014). Statistics for Business and Economics, Pearson Education, 12th edition, page 254.

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Appendix
A. Enterprise Value as a Growing Perpetuity
The enterprise value V of a firm is the present value of its future free cash flows to the firm’s capital providers FCFF.
Free cash flows are discounted at the firm’s cost of capital r.
∞
𝐹𝐹𝐹𝐹𝑖
𝑉=�
(1 + 𝑟)𝑖
𝑖=1

Free cash flow equals net operating profit after tax NOPAT minus the change in invested capital ΔIC, which is the
change in invested capital from the beginning to the end of the period. Return on invested capital ROIC equals
NOPAT divided by the opening invested capital.

𝐹𝐹𝐹𝐹𝑖 = 𝑁𝑁𝑁𝑁𝑁𝑖 − ∆𝐼𝐼𝑖 = 𝑁𝑁𝑁𝑁𝑁𝑖 − 𝑔𝑖 × 𝐼𝐼𝑖−1

𝑁𝑁𝑁𝑁𝑁𝑖
𝑅𝑅𝑅𝑅𝑖 =
𝐼𝐼𝑖−1

The change in invested capital is simply invested capital growth g multiplied by the opening invested capital. We can
now write a general valuation equation in terms of the drivers ROIC and growth after some algebraic juggling.

∞ ∞ ∞ 𝑁𝑁𝑁𝑁𝑁 �1 − 𝑔𝑖
𝐹𝐹𝐹𝐹𝑖 𝑁𝑁𝑁𝑁𝑁𝑖 − 𝑔𝑖 × 𝐼𝐼𝑖−1 𝑖 �
𝑅𝑅𝑅𝑅𝑖
𝑉=� = � = �
(1 + 𝑟)𝑖 (1 + 𝑟)𝑖 (1 + 𝑟)𝑖
𝑖=1 𝑖=1 𝑖=1

If growth, ROIC and the cost of capital are assumed to remain constant, this expression simplifies to the growing
perpetuity equation, which is equation (1) in the report. ‡

𝑔 𝑔
∞
𝑁𝑁𝑁𝑁𝑁1 × (1 + 𝑔)𝑖−1 �1 − � 𝑁𝑁𝑁𝑁𝑁1 �1 − �
𝑅𝑅𝑅𝑅∞ 𝑅𝑅𝑅𝑅∞
𝑉=� =
(1 + 𝑟)𝑖 (𝑟 − 𝑔)
𝑖=1

This equation is very handy for terminal value calculations in a DCF model. Please note that it assumes a perpetual
return on capital, which embeds a permanent stream of excess returns when the return on capital is greater than the
cost of capital. You should think carefully when applying it.

When ROIC equals the cost of capital or growth equals zero, the equation simplifies further to a well-known
perpetuity.

𝑁𝑁𝑁𝑁𝑁1
𝑉=
𝑟

This equation generally represents a more conservative approach to valuing the terminal period.

B. Enterprise Value and Fade

We examined the valuation case where ROIC is constant. We will relax this condition and assume that while invested
capital grows at a constant rate of g, the spread of (ROIC – r) decays to zero, or mean-reverts at a fade rate f. The
ROIC in the first forecast year is ROIC1 and the initial economic profit EP1 is (ROIC1 – r) x IC0 where IC0 is the
opening enterprise book value. The economic profit decays to zero when the fade rate exceeds the growth rate,
eliminating the unrealistic assumption of perpetual excess returns.

(1+𝑔)𝑖−1 1
This growth series has a closed-form solution: ∑∞
‡
𝑖=1 (1+𝑟)𝑖
=
(𝑟−𝑔)
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𝑅𝑅𝑅𝑅𝑖 = (𝑅𝑅𝑅𝑅1 − 𝑟)(1 − 𝑓)𝑖−1 + 𝑟

𝐸𝐸𝑖 = (𝑅𝑅𝑅𝑅𝑖 − 𝑟) × 𝐼𝐼𝑖−1 = (𝑅𝑅𝑅𝑅1 − 𝑟) × (1 − 𝑓)𝑖−1 × (1 + 𝑔)𝑖−1 × 𝐼𝐼0
𝐸𝐸𝑖 = 𝐸𝐸1 × [(1 − 𝑓) × (1 + 𝑔)]𝑖−1
∞
𝐸𝐸𝑖
𝑉 = 𝐼𝐼0 + �
(1 + 𝑟)𝑖
𝑖=1
∞
𝐸𝐸1 × [(1 − 𝑓) × (1 + 𝑔)]𝑖−1
𝑉 = 𝐼𝐼0 + �
(1 + 𝑟)𝑖
𝑖=1

The last two equations state that a firm’s enterprise value is equal to its book value plus the present value of future
economic profit streams. This value is equivalent to the present value of future free cash flows to the firm’s capital
providers. When economic profits are zero, enterprise value should equal book value. Companies that earn positive
economic profits should trade at a premium to book while those that produce negative economic profits should trade
at a discount to book. The present value of future economic profits is equivalent to the net present value (NPV) of the
firm’s existing and future projects.

The enterprise value equation has the exact form of a growing perpetuity! Fade is essentially negative growth. The
analytical solution is simply:

𝐸𝐸1
𝑉 = 𝐼𝐼0 +
[𝑟 − (1 + 𝑔)(1 − 𝑓) + 1]

For our purposes, the term (1 + g)(1 – f) can be approximated by (1 + g – f) which simplifies the math for intrinsic
value. These are equations (3) and (4) in the report.

𝐸𝐸1
𝑉 ≅ 𝐼𝐼0 +
[𝑟 − 𝑔 + 𝑓]
(𝑅𝑅𝑅𝑅1 − 𝑔 + 𝑓)
𝑉 ≅ 𝐼𝐼0 ×
(𝑟 − 𝑔 + 𝑓)

The introduction of a fade driver makes these relationships far more realistic and useable. We can extend our
treatment to CFROI or other return metrics such as ROE.

C. The Equivalence of Fade and CAP in Valuation

Instead of fading the excess spread at a constant rate, we will assume that each year the profitability spread has a
probability p of being shut-off forever. The spread is binomial at (ROIC1 – r) or zero. The expected spread in years
two, three and n years is thus:

(𝑅𝑅𝑅𝑅2 − 𝑟) = (𝑅𝑅𝑅𝑅1 − 𝑟) × (1 − 𝑝) + 𝑝 × 0
(𝑅𝑅𝑅𝑅3 − 𝑟) = (𝑅𝑅𝑅𝑅2 − 𝑟) × (1 − 𝑝) + 𝑝 × 0 = (𝑅𝑅𝑅𝑅1 − 𝑟) × (1 − 𝑝)2
(𝑅𝑅𝑅𝑅𝑛 − 𝑟) = (𝑅𝑅𝑅𝑅1 − 𝑟) × (1 − 𝑝)𝑛−1

Eureka! This has the exact same form and solution as equation (4) and the fade equations derived in Appendix B.

We will show a worked example and focus on calculating the present value of future economic profits. Let’s assume
EP1 equals $1000, the fade rate is 50%, the invested capital growth rate is 4%, and the cost of capital is 10%.

𝐸𝐸1 $1000
𝑃𝑃 𝑜𝑜 𝐸𝐸 = = = $1724
[𝑟 − (1 + 𝑔)(1 − 𝑓) + 1] [0.10 − (1 + 0.04)(1 − 0.5) + 1]

Clarity is Confidence 10
This is market commentary and not a research document.
 HOLT

For the heck of it, we’ll check how close the exact result is to the approximation.

𝐸𝐸1 $1000
𝑃𝑃 𝑜𝑜 𝐸𝐸 ≅ = = $1786
[𝑟 − 𝑔 + 𝑓] [0.10 − 0.04 + 0.50]

The error in the present value approximation is 3.6% which is reasonable for most valuations considering the lack of
precision in estimating growth and fades rates. The error would be less for lower fade rates. A spreadsheet
calculation would agree with the exact equation if we calculated 500 years’ worth of present values (it would
converge much sooner than 500 years).

∞ 500
𝐸𝐸1 × [(1 − 𝑓) × (1 + 𝑔)]𝑖−1 [(1 − 0.50) × (1 + 0.04)]𝑖−1
𝑃𝑃 𝑜𝑜 𝐸𝐸 = � = $1000 × �
(1 + 𝑟)𝑖 (1 + 0.10)𝑖
𝑖=1 𝑖=1

(0.5 × 1.04)0 (0.5 × 1.04)1 (0.5 × 1.04)499

𝑃𝑃 𝑜𝑜 𝐸𝐸 = $1000 × � + ⋯+ � = $1724
(1.10)1 (1.10) 2 (1.10)500

Because the equations are the exact same, the numerical solutions would be the exact same if we assumed a
dichotomous response of spread on or permanently off, and a failure rate of 50%. Fade rate and failure rate are
mathematically equivalent.

Let’s work out the failure probabilities and the present value of economic profits at each failure life. If the spread
remains on, we’ll denote it by “S” for success. If the spread shuts off to zero (and thus EP drops to zero), we’ll
denote it by “F” for failure. In this example, the conditional probability of failure is always 50%, so the probability of
failing in year 3 p(SSF) is the probability of two years of success p(SS) multiplied by the conditional probability of
failure p(F|SS).

Shut off in year 1: p(S) = 100%; p(F) = 0%; PV(F) = 0

Shut off in year 2: p(SS) = (0.5)1 = 50%; p(SF) = 50%; PV(SF) = $909
Shut off in year 3: p(SSS) = (0.5)2 = 25%; p(SSF) = 25%; PV(SSF) = $1769
Shut off in year 4: p(SSSS) = (0.5)3 = 12.5%; p(SSSF) = 12.5%; PV(SSSF) = $2581

The expected value is the probability of failure in each year multiplied by the present of economic profits if failure
occurs in that year.

PV = p(F) x PV(F) + p(SF) x PV(SF) + p(SSF) x PV(SSF) …

PV = 0 x 0 + 0.50 x $909 + 0.25 x $1769 + 0.125 x $2581 + … = $1724

The present value for a failure rate of 50%, or expected CAP of 2 years, is $1724 which equals the value from the
fade valuation. Note that PV(SSF) which is the value for an exact CAP of 2 years is $1769. Expected CAP is a
geometric random variable and thus an average which equals 1/f. The valuations will not be equivalent for the same
expected CAP and singular CAP because of discounting and growth. Here is what the probability tree would look like
for the first six years. The truncated PV is $1705, so despite the short expected CAP of 2 years, there is the
possibility of survival beyond 6 years and additional value.

Clarity is Confidence 11
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 HOLT
50.0% 3.125%
ON in Year 6
4762.673348 4762.673348
50.0% Chance
ON in Year 5
0 4419.288925
50.0% 3.125%
OFF in Year 6
4075.904502 4075.904502
50.0% Chance
ON in Year 4
0 3884.401651
50.0% 6.25%
OFF in Year 5
3349.514377 3349.514377
50.0% Chance
ON in Year 3
0 3232.809391
50.0% 12.5%
OFF in Year 4
2581.21713 2581.21713
50.0% Chance
ON in Year 2
0 2500.702216
50.0% 25.0%
OFF in Year 3
1768.595041 1768.595041
100.0% Chance
ON in Year 1
0 1704.896563
50.0% 50.0%
OFF in Year 2
909.0909091 909.0909091
Chance
PV of EP Stream
1704.896563
0.0% 0.0%
OFF in Year 1
0 0

D. CFROI, Fade and Intrinsic Value

Enterprise value can be estimated using HOLT economic profit and inflation-adjusted economic net assets ENA0 as
the book value.

𝐻𝐻𝐻𝐻 𝐸𝐸1
𝑉 = 𝐸𝐸𝐸0 +
[𝑟 − (1 + 𝑔)(1 − 𝑓) + 1]
𝐻𝐻𝐻𝐻 𝐸𝐸1
𝑉 ≅ 𝐸𝐸𝐸0 +
[𝑟 − 𝑔 + 𝑓]

Because CFROI and HOLT EP are measured relative to inflation-adjusted gross investment (IAGI), the measure of
book-to-price is more complicated and requires adding back inflation-adjusted accumulated depreciation to enterprise
value. To be exact, the beginning of year CFROI should be calculated and include an economic depreciation based
on the cost of capital. The approximation below is crude but close enough for illustrative purposes.

𝐺𝐺𝐺𝐺𝐺 𝑒𝑒𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡 𝑣𝑣𝑣𝑣𝑣 = 𝐸𝐸𝐸0 + 𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼_𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎 𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎 𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑

𝐺𝐺𝐺𝐺𝐺 𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒 𝑣𝑣𝑣𝑣𝑣 (𝐶𝐶𝐶𝐶𝐶1 − 𝑔 + 𝑓)
≅
𝐼𝐼𝐼𝐼0 (𝑟 − 𝑔 + 𝑓)

The discount rate is real in HOLT, so the perpetual growth has to be real. For more on HOLT EP, see “Introducing
HOLT Economic Profit”.

Clarity is Confidence 12
This is market commentary and not a research document.
 HOLT

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Clarity is Confidence 13
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