292  Estimating Continuing Value 
To see how the value shift works, compare Exhibits 14.4 and 14.5. The former 
details the calculations for the valuation model using a five-year explicit fore-
cast period, whereas the latter repeats the analysis with an eight-year period.
In Exhibit 14.4, NOPAT starts at $100 million. During the first five years, 
NOPAT grows at 9 percent per year. Following year 5, NOPAT growth slows 
to 6 percent. Using the definition of free cash flow derived in Chapter 10, 
EXHIBIT 14.4  Valuation Using Five-Year Explicit Forecast Period
$ million
Year 1
Year 2
Year 3
Year 4
Year 5
Base 
for CV
NOPAT
100.0
109.0
118.8
129.5
141.2
149.6
Depreciation
20.0
21.8
23.8
25.9
28.2
Gross cash flow
120.0
130.8
142.6
155.4
169.4
Gross investment
(76.3)
(83.1)
(90.6)
(98.7)
(107.6)
Free cash flow (FCF)
43.8
47.7
52.0
56.7
61.8
× Discount factor
0.893
0.797
0.712
0.636
0.567
Present value of FCF
39.1
38.0
37.0
36.0
35.0
Present value of FCF1–5
185.1
Calculation of continuing value (CV)
Continuing value
707.5
CV
CV
WACC
0
5
5
5
1
1 12
707 5
=
+
=
=
(
)
( .
)
$
.
CV
NOPAT
g
RONIC
WACC
CV
5
1
1
=
−




−
=
−
g
1246 9
$ ,
.
(
)
=
$1,246.9
0.06
0.12
$149.6
0.12 – 0.06
Total value
892.6
EXHIBIT 14.5 Valuation Using Eight-Year Explicit Forecast Period
$ million
Year 1
Year 2
Year 3
Year 4
Year 5
Year 6
Year 7
Year 8
Base 
for CV
NOPAT
100.0
109.0
118.8
129.5
141.2
149.6
158.6
168.1
178.2
Depreciation
20.0
21.8
23.8
25.9
28.2
29.9
31.7
33.6
Gross cash flow
120.0
130.8
142.6
155.4
169.4
179.6
190.3
201.7
Gross investment
(76.3)
(83.1)
(90.6)
(98.7)
(107.6)
(104.7)
(111.0)
(117.7)
Free cash flow (FCF)
43.8
47.7
52.0
56.7
61.8
74.8
79.3
84.1
× Discount factor
0.893
0.797
0.712
0.636
0.567
0.507
0.452
0.404
Present value of FCF
39.1
38.0
37.0
36.0
35.0
37.9
35.9
34.0
Present value of FCF1–8
292.9
Calculation of continuing value (CV)
Continuing value
599.8
CV
NOPAT
g
RONIC
WACC
CV
8
1
=
−




−
=
g
CV
CV
WACC
0
8
8
8
1
1 12
=
+
=
=
(
)
( .
)
1 −
0.12 – 0.06
$1,485.1
(
)
=
$599.8
$1,485.1
0.06
0.12
$178.2
Total value
892.6

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.