1. Introduction

When valuing firms or investment projects, you forecast the relevant future cash flows and capitalize them with a risk-adjusted discount rate. The problem is, these computations are based on economic and business assumptions that should be carefully scrutinized.In valuing a firm, for instance, we might have overestimated the market potential. Or we might have ignored the reaction of existing competitors, the possibility of entry by new competitors, or we might have assumed unrealistic profit margins. It is therefore important that, after computing our value estimate, we sit back and review the assumptions we made.

In spite of all the care we put into the correct analysis, however, finding the value of a firm involves a lot of guesswork. Even if our assumptions are economically correct, mean future net cash flows and discount rates cannot be computed exactly. We should therefore always think critically about the many assumptions and simplifications we made.The estimated value of a firm is what the word says, an estimate as opposed to a precise measure.We should consequently not say that a given firm is worth, say, USD 100 million, but rather that it is worth approximately USD 100 million. Approximately means that the value could be somewhat larger or smaller than USD 100 million.

If we go through the set of assumptions we made throughout our analysis, it is easy to see that many of them could be measured imprecisely:


Discount rate

Average net cash flows

Cost of debt

Average revenues

Cost of equity

Average costs

Average future investment outlays

Long-term EBIT-margin

Long-term growth rate


This section briefly describes how we can proceed: we assess the degree of approximation made in estimating the various determinants of project value and derive the range of project value these approximations imply. Every valuation exercise should address these issues.

Ultimately, the analysis of potential measurement errors should provide answers to the following three questions:

  • Which are the main drivers of firm value?
  • What can happen if our assumptions are wrong?
  • How likely are the various outcomes?


For our analysis, it is important to understand the difference between measurement error and uncertainty. The following example illustrates that difference.