Recommended Formula for DCF Valuation  287
where NOPATt+1 = net operating profit after taxes in the first year after the 
explicit forecast period
g = expected growth rate in NOPAT in perpetuity
RONIC = expected rate of return on new invested capital
WACC = weighted average cost of capital
A simple example demonstrates that the value driver formula does, in fact, 
replicate the process of projecting the cash flows and discounting them to the 
present. Begin with the following cash flow projections:
 
Year 1
Year 2
Year 3
Year 4
Year 5
NOPAT
$10.0
$10.6
$11.2
$11.9
$12.6
Net investment
5.0
5.3
5.6
6.0
6.3
Free cash flow
$ 5.0
$ 5.3
$ 5.6
$ 6.0
$ 6.3
Beyond year 5, the company continues to reinvest half its after-tax operat-
ing profit at a 12 percent rate of return, driving continued growth at 6 percent. 
The weighted average cost of capital (WACC) is assumed to be 11 percent.
To compare the methods of computing continuing value, first discount a 
long forecast—say, 100 years:
CV =
+
+
+
+
$ .
.
$ .
( .
)
$ .
( .
)
...
$
( .
)
( .
)
5 0
1 11
5 3
1 11
5 6
1 11
50 1 06
1 11
2
3
99
100
CV = $99
Next, use the growth perpetuity formula:
CV =
−
$ .
.
.
5 0
0 11
0 06
CV = $100
Finally, use the value driver formula:
CV =
−




−
$
.
.
.
.
10 1
0 06
0 12
0 11
0 06
CV = $100
All three approaches yield virtually the same result. If we had carried out the dis-
counted cash flow beyond 150 years, the result would have been nearly identical.2
2 The sum of discounted cash flow will approach the perpetuity value as the forecast period is extended. 
In this example, a 75-year forecast period will capture 96.9 percent of the perpetuity value, whereas a 150-
year forecast period will capture 99.9 percent. This is only true, however, when growth is substantially 
less than the cost of capital. If the two variables are of near-equal value, an infinitely lived perpetuity will 
overstate the value of a company with a limited life. In these situations, either incorporate a probability of 
failure into your perpetuity, or approximate continuing value with a growth annuity.

288  Estimating Continuing Value 
Although the value driver formula and the cash-flow-based growth per-
petuity formula are technically equivalent, applying the growth perpetuity 
formula is tricky, and it is easy to make the common error of ignoring the in-
terdependence between free cash flow and growth. More specifically, if growth 
in the continuing-value period is forecast to be lower than the growth at the 
end of the explicit forecast period (as is normally the case), then required rein-
vestment is likely to be less, leading to higher free cash flow. If the perpetuity’s 
free cash flow is computed using cash flow from the higher-growth explicit 
forecast period, this cash flow will be too low, and the calculation will under-
estimate the continuing value. Later in this chapter, an example illustrates 
what can go wrong when using the cash flow perpetuity formula rather than 
the key value driver formula.
Because perpetuity-based formulas rely on parameters that never change, 
use a continuing-value formula only when the company has reached a steady 
state, with low revenue growth and stable operating margins. Chapters 8 and 
9 provide guidance for thinking about return on capital and long-term growth. 
In addition, when estimating the continuing-value parameters, keep in mind 
the following technical considerations:
• NOPAT. The level of NOPAT should be based on a normalized level of 
revenues, sustainable margin, and return on invested capital (ROIC). 
This is especially important in a cyclical business; revenues and oper-
ating margins should reflect the midpoint of the company’s business 
cycle, not its peak or trough.
• RONIC. The expected rate of return on new invested capital (RONIC) 
should be consistent with expected competitive conditions beyond the 
explicit forecast period. Economic theory suggests that competition will 
eventually eliminate abnormal returns, so for companies in competitive 
industries, set RONIC equal to WACC. However, for companies with 
sustainable competitive advantages, such as brands and patents, you 
might set RONIC equal to the return the company is forecast to earn 
during later years of the explicit forecast period. Chapter 8 contains data 
on the long-term returns on capital for companies in different industries.
• Growth rate. A company’s growth rate typically reverts to industry 
growth rates very quickly, and few companies can be expected to grow 
faster than the economy for long periods. The best estimate is probably 
the expected long-term rate of consumption growth for the industry’s 
products, plus inflation. Sensitivity analyses are useful for understand-
ing how the growth rate affects continuing-value estimates. Chapter 9 
provides empirical evidence on historical corporate growth rates.
• WACC. The weighted average cost of capital should incorporate a sus-
tainable capital structure and an underlying estimate of business risk 
consistent with expected industry conditions.