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

298  Estimating Continuing Value 
model. The value driver model implicitly computes the required investment 
based on expectations of growth and ROIC.
Naive Overconservatism
Many investment professionals routinely assume that the incremental return 
on capital during the continuing-value period will equal the cost of capital. 
This practice relieves them of having to forecast a growth rate, since growth in 
this case neither adds nor destroys value. For some businesses, this assumption 
is too conservative. For example, both Coca-Cola’s and PepsiCo’s soft-drink 
businesses earn high returns on invested capital, and their returns are un-
likely to fall substantially as they continue to grow, due to the strength of their 
brands, high barriers to entry, and limited competition.3 For these businesses, 
an assumption that RONIC equals WACC would understate their values.4 This 
problem applies equally to almost any business selling a product or service 
that is unlikely to be duplicated, including many pharmaceutical companies, 
numerous consumer products companies, and some software companies.
However, even if RONIC remains high, growth will drop as the market 
matures. Therefore, any assumption that RONIC is greater than WACC should 
be coupled with an economically reasonable growth rate.
Purposeful Overconservatism
Some investment professionals are overly conservative because of the uncer-
tainty and size of the continuing value. But if continuing value is to be esti-
mated properly, the uncertainty should cut both ways: the results are just as 
likely to be higher than an unbiased estimate as they are to be lower. So con-
servatism overcompensates for uncertainty. Uncertainty matters, but it should 
be modeled using scenarios, not through conservatism regarding ROIC or 
growth in the continuing-value formula.
Other Approaches to Continuing Value
Several alternative approaches to estimating continuing value are used in 
practice. A few approaches are acceptable if applied carefully, but in general, 
these alternatives often produce misleading results. We prefer the methods 
3 Even the strongest brands face pressure from new technologies and changing customer preferences. 
For instance, Coca-Cola and PepsiCo have looked to new businesses as consumers have shifted away 
from soft drinks to bottled water and flavored teas.
4 In this example, RONIC equaling WACC is unlikely because of economic reasons. RONIC may also 
permanently exceed the cost of capital because capital is systematically understated. Under current 
accounting standards, only physical (or contractual) investment is capitalized on the balance sheet. 
Companies that have valuable brands, distribution, and intellectual property do not recognize their 
investment on the balance sheet unless acquired. For more on how to compute invested capital for 
companies with large intangible assets, see Chapter 24.