302  Estimating Continuing Value 
When valuing an acquisition, companies sometimes fall into the circular 
reasoning that the multiple for the continuing value should equal the mul-
tiple paid for the acquisition. In other words, if I pay 15 times EBITDA today, 
I should be able to sell the business for 15 times EBITDA at the end of the 
explicit forecast period. In most cases, the reason a company is willing to pay 
a particular multiple for an acquisition is that it plans to improve the target’s 
profitability. So the effective EBITDA multiple it is paying on the improved 
level of EBITDA will be much less than 15. Once the improvements are in place 
and earnings are higher, buyers will not be willing to pay the same multiple 
unless they can make additional improvements beyond those already made. 
Chapter 18 describes other common mistakes made when using multiples.
Asset-Based Valuations
Unlike the previous methods, which rely on future cash flow or earnings, esti-
mating continuing value using replacement cost or liquidation value is known 
as an asset-based approach. Since these approaches ignore the future potential 
of the company, use them only in situations where ongoing operations are 
in jeopardy.
The liquidation value approach sets the continuing value equal to the esti-
mated proceeds from the sale of the assets, after paying off liabilities at the end 
of the explicit forecast period. Liquidation value is often far different from the 
value of the company as a going concern. In a growing, profitable industry, a 
company’s liquidation value is probably well below the going-concern value. 
In a dying industry, liquidation value may exceed going-concern value. Do not 
use this approach unless liquidation is likely at the end of the forecast period.
The replacement cost approach sets the continuing value equal to the ex-
pected cost to replace the company’s assets. This approach has at least two 
drawbacks. First, not all tangible assets are replaceable. The company’s orga-
nizational capital can be valued only on the basis of the cash flow the com-
pany generates. The replacement cost of just the company’s tangible assets 
may greatly understate the value of the company. Second, not all the com-
pany’s assets will ever be replaced. Consider a machine used by a particular 
company. As long as it generates a positive cash flow, the asset is valuable to 
the ongoing business of the company. But the replacement cost of the asset 
may be so high that replacing it is not economical. Here, the replacement cost 
may exceed the value of the business as an ongoing entity.
Closing Thoughts
The future is inherently unknowable, so it is understandable why many pro-
fessionals are skeptical about enterprise DCF models that rely on a continu-
ing-value formula. This skepticism may be warranted in some cases, but for 

Closing Thoughts  303
many valuations, disaggregating the continuing value into its economic com-
ponents can show why these concerns are overstated. Remember, the value of 
a company is merely its invested capital plus the economic profits it generates 
on that capital. If most of the value creation occurs during the explicit forecast 
period, then the continuing value plays a much smaller role than the free cash 
flow would lead you to believe.
When estimating continuing value, remember to follow a few simple 
guidelines for successful valuation. First, use the key value driver formula to 
estimate continuing value. Unlike the free-cash-flow model, the value driver 
formula implicitly models the correct investment required for growth. Second, 
carefully assess the value drivers at the time of continuing value. The value 
drivers should be consistent with the company’s potential in the future, rather 
than today’s performance or economic environment. We believe a thoughtful 
analysis will lead to insights not available with other models.

305
15
Estimating the Cost 
of Capital
To value a company using enterprise discounted cash flow (DCF), discount 
your forecast of free cash flow (FCF) at the weighted average cost of capital 
(WACC). The WACC represents the returns that all investors in a company—
equity and debt—expect to earn for investing their funds in one particular 
business instead of others with similar risk. The investment return they are 
forgoing is also referred to as their opportunity cost of capital. Since a compa-
ny’s investors will earn the cost of capital if the company meets expectations, 
the cost of capital is used interchangeably with expected return.
The WACC has three primary components: the cost of equity, the after-tax 
cost of debt, and the company’s target capital structure. Estimating WACC with 
precision is difficult because there is no way to directly measure an investor’s 
opportunity cost of capital, especially the cost of equity. Furthermore, many 
of the traditional approaches that worked for years have been complicated 
by recent monetary policies that have led to unusually low interest rates on 
government bonds. To estimate the cost of capital, we employ various models 
and approximations that are grounded in corporate-finance theory and build 
on empirical observations about the market value of companies. These models 
estimate the expected return on alternative investments with similar risk.
This chapter begins with a brief summary of the WACC calculation and 
then presents detailed sections on how to estimate its components: the cost of 
equity, the after-tax cost of debt, and the target capital structure, which is used 
to weight the first two components. The chapter concludes with a discussion 
of WACC estimation for companies whose capital structure is more complex 
than just traditional debt and common stock.