Misunderstandings about Continuing Value  295
Why Value Isn’t Just from Continuing Value
“All the value is in the continuing value” is a comment we’ve often heard 
from dismayed executives. Exhibit 14.7 illustrates the problem for a hypotheti-
cal company, Innovation Inc. Based on discounted free cash flow, it appears 
that 80 percent of Innovation’s value comes from the continuing value. But 
there are other interesting ways to interpret the source of value.
Exhibit 14.8 suggests an alternative: a business components approach. In-
novation Inc. has a base business that earns a steady 20 percent return on capi-
tal and is growing at 5 percent per year. It also has developed a new product 
line that will require several years of negative cash flow for development of 
a new sales channel, which management hopes will lead to organic growth. 
As shown in Exhibit 14.8, the base business has a value of $1,326 million, 
EXHIBIT 14.7  Innovation Inc.: Free Cash Flow Forecast and Valuation
$ million
–100
150
200
–50
50
100
250
10
9
8
7
6
5
4
3
2
1
Present value
of continuing value
Value of years 1–10
free cash flow
1,429
368
1,797
DCF value at 10% 
cost of capital
Free cash flow
Year
0
EXHIBIT 14.8  Innovation Inc.: Valuation by Components
$ million
–100
–50
50
0
100
150
200
250
10
9
8
7
6
5
4
3
2
1
New product
line
Base
business
472
1,325
1,797
DCF value at 10%
cost of capital
Free cash flow
Free cash flow from
new product line
Free cash flow from
new product line
Total free cash flow
Base business
free cash flow
Year

296  Estimating Continuing Value 
or 74 percent of Innovation’s total value. In other words, 74 percent of the 
company’s value comes from operations that are currently generating stable, 
predictable cash flow. Only 26 percent of total value can be attributed to the 
unpredictable growth business. When the situation is viewed this way, uncer-
tainty plays only a small role in the total value of the company.
It is possible to use the economic-profit model to generate another in-
terpretation of continuing value. Exhibit 14.9 compares the components of 
value for Innovation Inc., using the discounted-FCF approach, the business 
components approach, and an economic-profit model. Under the economic-
profit model, 35 percent of Innovation’s value is simply the book value of 
invested capital. The rest of the value, $1,172 million, is the present value of 
projected economic profit. Of that, only 34 percent of total value is generated 
during the continuing-value period—a much smaller share than under the 
discounted-FCF model.
Common Pitfalls
Estimating a company’s performance 10 to 15 years out is an imprecise exer-
cise. Common mistakes in continuing value estimation include erroneously 
extrapolating base-year cash flow, as well as making overly conservative as-
sumptions on capital returns, both naively and purposely.
EXHIBIT 14.9  Innovation Inc.: Comparison of Continuing-Value Approaches
$ million
Present value of
continuing value
Value of 
years 1–10
free cash flow
1,429
368
New product
line
Base
business
1,325
472
Economic-profit
continuing value
Invested capital
Present value of years 
1–10 economic profit
1,797
1,797
1,797
Free-cash-flow
approach
Business components
approach
Economic-profit
approach
625
566
606

Common Pitfalls  297
Erroneous Base-Year Extrapolation
Exhibit 14.10 illustrates a common error in forecasting the base level of free 
cash flow: assuming that the investment rate is constant, so that NOPAT, in-
vestment, and FCF all grow at the same rate. From year 9 to year 10 (the last 
forecast year), the company’s earnings and cash flow grow by 10 percent. It 
is believed that revenue growth in the continuing-value period will be 5 per-
cent per year. A common, yet incorrect, forecast for year 11 (the continuing-
value base year) simply increases every line item from year 10 by 5 percent, 
as shown in the third column. This forecast is wrong because the increase 
in working capital is far too large, given the smaller increase in sales. Since 
revenues are growing more slowly, the proportion of gross cash flow devoted 
to working capital requirements should decline significantly, as shown in the 
last column. In the final column, the increase in working capital should be 
the amount necessary to maintain the year-end working capital at a constant 
percentage of revenues.
The erroneous approach continually increases working capital as a per-
centage of revenues (5 percent) and will significantly understate the value of 
the company. Note that in the third column, free cash flow is 18 percent lower 
than it should be. The same problem applies to capital expenditures. To keep 
the example simple, we limited it to working capital.
To avoid making an error in estimating final-year cash flow, we highly 
recommend using the value driver formula instead of the cash flow perpetuity 
EXHIBIT 14.10  Correct and Incorrect Methods of Forecasting Base FCF
$ million
Year 11, 5% growth
Year 9
Year 10
Incorrect
Correct
Revenues
1,000
1,100
1,155
1,155
Operating expenses
(850)
(935)
(982)
(982)
EBITA
150
165
173
173
Operating taxes
(60)
(66)
(69)
(69)
NOPAT
90
99
104
104
Depreciation
27
30
32
32
Gross cash flow
117
129
136
136
Capital expenditures
(30)
(33)
(35)
(35)
Increase in working capital
(27)
(30)
(32)
(17)
Gross investment
(57)
(63)
(67)
(52)
Free cash flow
60
66
69
84
Supplemental calculations
Working capital, year-end
300
330
362
347
Working capital/revenues, %
30.0
30.0
31.3
30.0