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

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