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Value Driver Formulas for Continuing Value in the Discounted Cash Flow Model

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  • Jennergren, L. Peter

    (Department of Accounting)

Abstract

The influential valuation book by an author team from McKinsey recommends the so-called value driver formula rather than the Gordon formula for the continuing value in the post-horizon period in the discounted cash flow model for firm valuation. This recommendation has had considerable impact on valuation practice. This paper points out two weaknesses of the original value driver formula. The first weakness is that it is not a significant extension of the Gordon formula. The only case where it is applicable is where the requirement for working capital is not the same for the future growth projects (that are started in the successive years of the post-horizon period) as for the existing operations that are in place already at the end of the explicit forecast period, a fairly uninteresting case. In that case, the Gordon formula gives the same valuation result, implying that the original value driver formula is not necessary. The second weakness is that the split into existing operations and growth projects that underlies the original value driver formula implies that the existing operations are valued under the assumption of zero inflation, which is unreasonable if inflation is actually positive. This paper then derives a revised value driver formula that is a more significant alternative to the Gordon formula. In the revised formula, gross margins can differ between the existing operations and the growth projects. The valuation of the existing operations takes into account positive inflation. Continuing value is a sum of two separate value driver formulas, one for the existing operations and one for the growth projects. This means that most of the steady-state character of the post-horizon period is retained. A comparison with the original value driver formula in a representative setting indicates that the difference in resulting continuing values can be non-negligible.

Suggested Citation

  • Jennergren, L. Peter, 2011. "Value Driver Formulas for Continuing Value in the Discounted Cash Flow Model," SSE/EFI Working Paper Series in Business Administration 2011:5, Stockholm School of Economics, revised 30 May 2012.
    • Handle: RePEc:hhb:hastba:2011_005
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    References listed on IDEAS

    as
    1. Richard S Ruback, 2002. "Capital Cash Flows: A Simple Approach to Valuing Risky Cash Flows," Financial Management, Financial Management Association, vol. 31(2), Summer.
    2. Jennergren, L. Peter, 2004. "Continuing Value in Firm Valuation by the Discounted Cash Flow Model," SSE/EFI Working Paper Series in Business Administration 2004:15, Stockholm School of Economics.
    3. Christian Petersen & Thomas Plenborg, 2010. "How Do Firms Implement Impairment Tests of Goodwill?," Abacus, Accounting Foundation, University of Sydney, vol. 46(4), pages 419-446, December.
    4. L. Peter Jennergren & Kenth Skogsvik, 2011. "The Abnormal Earnings Growth Model, Two Exogenous Discount Rates, and Taxes," Journal of Business Finance & Accounting, Wiley Blackwell, vol. 38(5-6), pages 505-535, June.
    5. Jennergren, L. Peter, 2008. "Continuing value in firm valuation by the discounted cash flow model," European Journal of Operational Research, Elsevier, vol. 185(3), pages 1548-1563, March.
    6. Jennergren L. Peter, 2010. "On the Forecasting of Net Property, Plant and Equipment and Depreciation in Firm Valuation by the Discounted Cash Flow Model," Journal of Business Valuation and Economic Loss Analysis, De Gruyter, vol. 5(1), pages 1-28, November.
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    Keywords

    Valuation; free cash flow; discounting; continuing value; value driver formula; inflation;
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