840  Appendix H
of 4 percent to estimate the long-run growth rate. For a comprehensive discus-
sion of how to estimate continuing value, see Chapter 14.
Estimating the Weighted Average Cost of Capital
To value operations, discount cash flow at the weighted average cost of capital. 
The WACC incorporates the required return from all sources of capital into a 
single number.
Exhibit H.15: Weighted Average Cost of Capital. Net of excess cash, Costco 
uses less debt than any of its industry peers. With this in mind, we assume 
that Costco will disgorge excess cash and set their target debt-to-value ratio to 
their current debt-to-value as measured on a gross basis.
Likewise, when we estimate the cost of debt and cost of equity, we use 
the same debt-to-value ratio. For a comprehensive discussion of the cost of 
capital, see Chapter 15.
Valuing the Enterprise and Converting to Equity
To value Costco, we use both enterprise DCF and discounted economic profit. 
Free cash flow (FCF) models measure how cash flows in and out of the com-
pany, regardless of accounting. Economic profit links better to value creation. 
Implemented correctly, both models will lead to the same valuation result.
Exhibit H.16: Enterprise DCF Valuation. To arrive at the present value of 
cash flow, we sum each year’s discounted FCF with the discounted value of 
continuing value. Then we adjust the resulting value by half a year to estimate 
the value of operations, reflecting that cash flows are generated throughout 
the year. To the value of operations, we add any nonoperating assets that are 
excluded from free cash flow—in this case, excess cash and the value of tax 
loss carryforwards. For simplicity, we value tax loss carryforwards at book 
value less the valuation allowance.
Do not add other deferred-tax assets, such as those related to equity com-
pensation or deferred membership fees, to the value of operations. The value 
of these tax assets is already incorporated into NOPAT using cash-based taxes. 
Consequently, they are classified as an equity equivalent and ignored.
To estimate intrinsic equity value, subtract debt and debt equivalents 
from enterprise value. This includes all debt, capitalized operating leases, and 
noncontrolling interests. While we use the book values for ease of exposition, use 
the market value of each account when available. Dividing equity value by the 
number of shares leads to a value of almost $220 per share, which matches the 
share price in early 2019. For more on converting enterprise value into equity value 
by adding nonoperating assets and subtracting debt equivalents, see Chapter 16.

Appendix H  841
Exhibit H.17: ROIC and Economic Profit. A robust valuation will focus not 
only on the resulting share price, but also on the critical value drivers that 
result from the model. Exhibit H.17 presents ROIC and economic profit by 
year. When benchmarking across companies or over time, we usually calcu-
late ROIC using a two-year average of invested capital. In this situation, we 
calculate ROIC using invested capital from the beginning of the year, in order 
to create an economic-profit valuation that matches the results from enterprise 
DCF. In this exhibit, we present only a high-level analysis of performance. For 
more on how to disaggregate and assess ROIC in depth, see Chapter 12.
Exhibit H.18: Valuation Using Economic Profit. To determine the value of 
operations, add discounted economic profit to invested capital. As expected, 
an economic-profit-based valuation leads to the same value of operations as 
an enterprise DCF valuation.
Putting the Model to Work
While the valuation model is complete, a good financial analyst or investor will 
now put it to work. Ask yourself several questions: Which variables are the 
most critical to value? What is the value if performance remains unchanged? 
How does this value differ from one based on other forecasts? What is the 
value with proposed improvements? Are there scenarios that may provide 
additional insights on various strategies?
A model is more than its resulting valuation. As we discuss in Chapter 17, 
the most important insights are the ones you develop by testing alternatives 
and creating scenarios.