Misunderstandings about Continuing Value  293
we compute gross cash flow by adding depreciation to NOPAT. Free cash 
flow equals gross cash flow minus gross investment. To compute the com-
pany’s gross investment, multiply NOPAT by the reinvestment rate, where 
the reinvestment rate equals the ratio of growth to ROIC (9 percent di-
vided by 16 percent), plus depreciation. To determine the present value 
of the company, sum the present value of the explicit forecast period cash 
flows plus the present value of continuing value. (Since the continuing 
value is measured as of year 5, the continuing value of $1,246.9 million is 
discounted by five years, not by six, a common mistake.) The total value 
equals $892.6 million.
Exhibit 14.5 details the calculations for a valuation model that uses an 
eight-year explicit forecast period and a continuing value that starts in year 9. 
The structure and forecast inputs of the model are identical to those of Exhibit 
14.4. In the first five years, growth is 9 percent, and ROIC equals 16 percent. 
After five years, growth drops to 6 percent, and ROIC drops to 14 percent. 
This leads to an explicit forecast value of $292.9 million, which is higher than 
under the shorter five-year window. Since NOPAT in the continuing value is 
higher, continuing value also is higher, but since it occurs three years later, its 
discounted value is lower.
You can see that the amounts under the two valuation methods are identi-
cal. Since the underlying value drivers are the same in both valuations, the 
results will be the same. The length of your forecast horizon should affect only 
the proportion of total value allocated between the explicit forecast period and 
continuing value, not the total value.
The choice of forecast horizon will indirectly affect value if it is associated 
with changes in the economic assumptions underlying the continuing-value 
estimate. You can unknowingly change the amount of value creation when 
you change your forecast horizon. Many forecasters assume the company will 
generate returns above the cost of capital during the explicit forecast period, 
and they set return on new capital equal to WACC in the continuing value. By 
extending the explicit forecast period, you increase the number of years the 
company is creating value. Extending the forecast period indirectly raises the 
value, even when that is not intended.
So how do you choose the appropriate length of the explicit forecast pe-
riod? The period should be long enough that the business will have reached 
a steady state by the end of it. Suppose you expect the company’s margins 
to decline as its customers consolidate. Margins are currently 14 percent, and 
you forecast they will fall to 9 percent over the next seven years. In this case, 
the explicit forecast period must be at least seven years, because continu-
ing-value approaches cannot account for the declining margin (at least not 
without complex computations). The business must be operating at an equi-
librium level for the continuing-value approaches to be useful. If the explicit 
forecast period is more than seven years, there will be no effect on the com-
pany’s total value.

294  Estimating Continuing Value 
Why Continuing Value Doesn’t Mark the End of Competitive Advantage
A related but subtle issue is the concept of the competitive-advantage period, 
or that period during which a company earns supernormal returns above the 
cost of capital. Although counterintuitive, setting RONIC equal to WACC in 
the continuing-value formula does not imply that the competitive-advantage 
period will conclude at the end of the explicit forecast period.
Remember, the key value driver formula is based on the return for new capital 
invested, not company-wide average ROIC. If you set RONIC in the continuing-
value period equal to the cost of capital, you are not assuming that the return on 
total capital (old and new) will equal the cost of capital. The original capital (prior to 
the continuing-value period) will continue to earn the returns projected in the last 
forecast period. In other words, the company’s competitive-advantage period has 
not come to an end once the continuing-value period is reached. Existing capital 
will continue to earn supernormal returns in perpetuity. For example, imagine a 
retailer that opens its initial stores in high-traffic, high-growth, extremely profitable 
areas. These stores earn a superior rate of return and fund ongoing expansion. 
But as the company grows, new locations become difficult to find, and the ROIC 
related to expansion starts to drop. Eventually, the ROIC on the newest store will 
approach the cost of capital. But does this imply that ROIC on early stores will 
drop to the cost of capital as well? Probably not. A great location is hard to beat.
Exhibit 14.6 shows the average ROIC, based on continuing-value growth of 5 
percent, the return on base capital is 18 percent, return on new capital is 10 per-
cent, and WACC is 10 percent. Note how the average return on aggregate capital 
declines only gradually. From its starting point at 18 percent, it declines to 14 per-
cent (the halfway point to RONIC) after 10 years in the continuing-value period. 
It reaches 12 percent after 21 years, and 11 percent after 37 years. How quickly this 
decay occurs from ROIC in the forecast period to RONIC in the continuing value 
depends on the growth rate in the continuing value. The higher the growth rate, 
the more capital there is to be deployed at lower returns, and the faster the drop.
EXHIBIT 14.6  Gradual Decline in Average ROIC According to Continuing-Value Formula
0
1
25
24
23
22
21
20
19
18
17
16
15
14
Year
ROIC on base capital
ROIC on total capital
RONIC
ROIC, %
13
12
11
10
9
8
7
6
5
4
3
2
4
8
12
16
20