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Daniela Venanzi - Financial performance measures and value creation: a review

working paper december 27, 2010

1

Financial performance measures and value creation: a reviewdi

Daniela Venanzi

Full Professor of Corporate FinanceDepartment of Business & Law Roma Tre University

December 27, 2010

Contents

1.

Introduction2. Criticisms of the accounting-based measures of performance3.

Competing financial performance measures3.1.

Trends in performance measurement3.2.

Economic value measures Economic value added (EVA)

Cash flow return on investment (CFROI)

Shareholder value added (SVA)4.

The metrics war4.1.

The association between economic value measures and stock returns4.2. The association between economic value measures and DCF approach4.3. Managerial implications of economic value measures

5. A comparison: strengths and weaknesses of the economic value measures

References

Abstract

Corporate financial performance measured in terms of accounting-based ratios has been viewed asinadequate as firms began focusing on shareholder value as the primary long-term objective of theorganization. Corporate managers have been facing a period where a new economic framework thatbetter reflects economic value and profitability had to be implemented in their companies. Theincreased efficiency at the capital markets requires that capital allocation within companiesbecome more efficient: a value based management framework that better reflects opportunitiesand pitfalls, is therefore necessary. Subsequently, value metrics were devised that explicitlyacknowledged that both equity and debt have costs, and thus there was a need to incorporatefinancing risk-return into performance calculations. The focus of this article is a review of the mainvalue-based measures: the economic value added (EVA), the cash flow return on investment(CFROI) and the shareholder value added (SVA). The objective is contributing to the developing

dialogue on the appropriateness of different financial performance measures by reviewing theirdifferences as well as their similarities in terms of measurement, association with market financialperformance and DCF approach, implications on managerial incentives, and by highlighting theirrespective strengths and weaknesses.

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1.

INTRODUCTION

Periodic measurement of firm performance is conducted for several reasons: it helps investors to

formulate their expectations concerning the future earning potential of firms; it supplies a plausible

feedbackon

how

well

the

company

has

achieved

its

goals;

itfurnishes

the

basis

of

an

adequate

bonus

plan

thatgivesincentivestoachievethefirmsgoalsandrewardstheresultsofproperdecisions.

Corporate financial performancemeasured in terms of accountingbasedmetrics has been viewed as

inadequate as firms began focusing on shareholder value as the primary longterm objective of the

organization: they fail to take into account the factors that drive shareholder value. Subsequently,

financialbased valuemeasures and valuemetricswere devised that explicitly acknowledged that both

equity and debt have costs, and thus there was a need to incorporate financing riskreturn into

performance calculations. The focus of this article is a review of themain valuebasedmeasures: the

economic value added (EVA) described by Stewart (1991), the cash flow return on investment (CFROI)

approachoftheBostonConsultingGroupand theshareholdervalueapproach(SVA)describedbyAlfred

Rappaport

(1986).

Information

and

empirical

results

about

the

efficacy

of

the

different

approaches

are

limitedandcontradictoryandseemtobeprimarilyprovidedbyauthorswithstrongcommercialinterestin

theoutcomeofanyreasearchintotheeffectivenessofthemethodologies.Thispaperaimsatcontributing

to the developing dialogue on the appropriateness of different financial performancemeasures, with

respect to their association with stock returns or DCF approach and their implications onmanagerial

incentivesandcompensation.Itwouldbeamistaketobelievethatanysinglemeasureisperfectlysuitedto

alltypesoffinancialdecisionsupport,meanwhileitcouldbeveryusefultocomparethedifferentmeasures

by highlighting their respective strengths and weaknesses as well as their similarities. This paper is

organized as follows. First, we summarize the shortcomings of the accountingbased measures of

performance;therefore, weillustratetheeconomicmeasures,highlightingtheirdifferencesincalculation.

Subsequently, we compare the economic measures effectiveness by reviewing firstly the empirical

evidenceontheirassociationwithmarketmeasuresofreturn;secondly, their linkagewithDCFapproach

and finallytheir impactonmanagementbehaviourwhenused incompensationsystem.A finalreviewof

thestrengthsandweaknessesofeachvaluebasedmetricswillconcludetheanalysis.

2.

CRITICISMSOFTHEACCOUNTINGBASED MEASURESOFPERFORMANCE

Valueisafunctionof1)investments2)cashflow3)economiclifeand4)capitalcost.Themechanismthatis

usedonthemarkettoestablishvalueusingthesefourfactors iswhatwecall theDiscountedCashFlow

(DCF)approach.This is thereasonwhyweuseDCFmethodswhenwecalculateon investmentsthatwe

plantomakeinacompany.Theobjectivefordoingthisistobeabletoestablishandexecutestrategiesand

investments that increase shareholder value. But in practice something peculiar seems to occur

(Weissenrieder,1997). Aftertheinvestmenthasbeenmadecompanies,analystsandmediaabandonthis

thinking and enter theworldofP/Eratios,profitpershare,ROI,balancesheets,P&Lstatements,book

equity, goodwill, depreciation methods We try to follow up the value creation and profitability of

investmentsthatwehavemadebyusingaccountingdata.Rappaport(2005)callthisdiseasetheshortterm

earningsobsession.

Accountingdoesnothandleanyoffourfactorsthewayafinancialframeworkshouldhandle them.What

kind of information does the organization need for strategic decision making and for managing the

company'scurrentoperations?Choosingsomethingfortheonlyreasonthatitlooksmuchlikewhatwesee

todayfromourcurrentframework(accounting)wouldbeamistake.

Compellingevidenceindicatesthatmanagersareobsessedwithearnings.Arecentsurveyof400financial

executivesshowsthatthevastmajorityviewearningsasthemost importantperformancemeasurethey

reporttooutsiders(Grahametal., 2005).Thetwokeyearningsbenchmarksarequarterlyearningsforthe

samequarterlastyearandtheanalystconsensusestimateforthecurrentquarter. Executivesbelievethat

meetingearningsexpectationshelpsmaintainorincreasethestockprice,providesassurancetocustomers

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andsuppliers,andbooststhereputationofthemanagementteam.Failuretomeetearningstargetsisseen

asasignofmanagerialweaknessand,ifrepeated,canleadtoacareerthreateningdismissal.

Managing for shortterm earnings compromises shareholder value. In the following section some

fundamental shortcomings of the traditional accountingbased metrics both as value measure and

performancemeasure aresummarized.

a)

inaccuracyandsubjectivityoftheaccountingnumbers

The accounting principles provide companieswith room tomanipulate the accounting figures. Earnings

numbermay be computed using alternative and equally acceptable accountingmethods: a change in

accountingmethodforfinancialreportingpurposescanmaterially impactearningsbutdoesnotalterthe

companys cash flows and therefore should not affect its economic value. This could produce two

implications:

comparisonsamongdifferentfirmsaswellasdifferentyearsofthesamecompany arenotreliable

managerscanassumemoralhazardbehaviours thatcan inducevariousmanipulationsofaccounting

data. A 2005 survey of 400USA financial executives (Graham et al., 2005) reveals that companies

manage

earnings

with

more

than

just

accounting

gimmicks:

a

startling

80%

of

respondents

said

they

woulddecreasevaluecreatingspendingonresearchanddevelopment,advertising,maintenance,and

hiringinordertomeetearningsbenchmarks.Morethanhalftheexecutiveswoulddelayanewproject

evenifitentailedsacrificingvalue.Managerspushrevenuesintothecurrentperiodanddeferexpenses

to futureperiods: theyborrow from the future tosatisfy todayearningsexpectations. Jensen (2004)

citedWorldCom,EnronCorporation,NortelNetworks,andeToysascompanies thatpushedearnings

managementbeyondacceptable limits tomeetexpectations andendedupdestroyingpartor allof

theirvalue.AswellasJensen,wecouldcite CirioandParmalatassimilarexamples.

Moreover, accounting numbers can be distorted by inflation: in determining traditional accounting

measuresofreturn,bothnumeratoranddenominatoroftheaccountingratiosaddupnothomogeneous

numbers,i.e.numbersnotexpressedin thesamemonetaryunit.Forexample, inflationcanincreaseROI

by increasingcapitalturnover (salesare incurrentnumbers,meanwhile investedcapital isnot). Onthe

contrary,measures basedonDCF calculations are not affected by inflation: in determining valuebased

measuresofperformance it isenoughtousehomogeneousnumbers (realornominal)ofcash flowsand

discountrates.Therefore ROIcoulddependontheaverageage ofthefixedassetsofthefirm.

Despite, International Financial Reporting Standards (IFRS) attempting to reduce the possibility of such

manipulations, valuationmethodologiessuchasmarktomarkettendtoexacerbatetheproblem.

b)

nonalignmentwiththeorganizationalgoalofmaximizingshareholderwealth

Accountingbasedmeasuresofreturnomit toconsiderthecostofinvestedcapital,bothin termsofrisk

free rate and risk premium. Therefore, maximizing earnings or return does no imply to maximize

shareholdervalue.

Maximizingearningsomittoaccountfortheamountofcapitalinvestedtoproduceearnings.Itcouldresult

convenientanyinvestmentthatproduceearnings,nomatterwhatreturnitearnsorwhatriskitbears. This

casebeing true,acompanyalwaysprefers to retainand reinvest itsearnings,never topay themout to

investors. Instead, it couldbedemonstrate that cutting the firmsdividends to increase investmentwill

raisethestockpriceif,andonlyif,thenewinvestmentearnsarateofreturnonnewinvestmentsgreater

than itscostofcapital, i.e.therate investorscanexpecttoearnby investing inalternative,equallyrisky,

securities.

WhenweuseaccountingratesofreturnlikeROIorROA,werisktoincurinthesameproblem.Toillustrate,

amanagerthatusesROIinitsinvestmentdecisionswillbeencouragedonlytoselectprojectsthatequalor

exceedhis/her SBUsordivisionscurrentROIregardless ofthevaluecreationofthat investment inthe

longerterm:projectsof thesameSBUordivisioncandifferinriskandcostofcapitalfromtheaveragerisk

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andcostofcapitalofthemixofassetsinplace.Obviouslythesemeasuresencouragemanagersmuchmore

toact inwaysthatareincongruentwiththecorporateobjectiveof maximizingshareholderwealthwhen

managers aremeasuredandrewardedonmaximizingthem.

Inmarketingterms,itisimperativeforbusinessestoallocatecapitaltoendeavoursthatwouldbeclassified

asstars

in

the

Boston

Consulting

Group

(BCG)

matrix,

and

put

to

sleep

those

that

would

be

classified

as

dogs.Traditionalaccountingperformancemeasuresmaynotenablemanagement to identifybetween

theseandinfactmayencouragedogstobefedmore.

Inordertoavoidthesemisleadingbehaviors,hurdleratesorminimumacceptableratesforROIareoften

basedonanestimateofthebusinessunits(ordivisions)costofcapital.Theessentialproblemwiththis

approach is thatROI isanaccrualaccounting returnand isbeingcompared toacostofcapitalmeasure

whichisaneconomicreturndemandedbyinvestors.

Wecan demonstratethataccountingreturnofinvestmentdiffersfromeconomicreturnofinvestmentas

wellasapplesdifferfromoranges(thecaseofasingleprojectcanbeextendedeasilytomanyprojects):

ACCOUNTING ONEYEAR RETURN: (cashflow depreciation other non cash charges + capital

expenditures+ incremental investments inworking capital)/average (over theyear)netbookvalue

(i.e.bookvalueminusaccumulateddepreciation);

ECONOMICONEYEARRETURN= (cashflow+change inpresentvalue)/ investmentpresentvalueat

beginning of year. We can define the change of the present value over the year as economic

depreciation.Theeconomicreturn(r)canbederivedasfollows(CFt andVAt are cashflowandpresent

valueinyeart,respectively):

1

1

1

Notethatunlikeeconomicincomethatdependsstrictlyoncashflows,bookincome(thenumeratorofthe

accountingreturn)departsfromcashflowsinceitdoesnotincorporate currentyearsinvestmentoutlays

forworking capitalor fixed capital. In addition,non cash items such asdepreciation and provisions for

deferredcostsorlossesaredeductedtoarriveatbookincome. Furthermore,depreciationrepresentsthe

allocationofcostover theexpectedeconomic lifeofanasset.Accountantsdonotattemptnordo they

claim toestimate changes inpresentvalue. Ifdepreciationand the change inpresentvaluediffer, then

bookincomewillnotbeanaccuratemeasureofeconomicincome.

Therefore, ROI isnotanaccurateor reliableestimateof theDCF return.Solomon (1967)demonstrates

thattheextenttowhichROIoverstatestheeconomicorDCFreturnisacomplexfunctionofthefollowing

factors(inparenthesesthesignoftheeffectontheoverstatement):

lengthofprojectlife(+)

capitalizationpolicy()

thespeedofdepreciationpolicy(+)

thetimelagbetweenoutlaysandtherecoupmentoftheseoutlaysfromcashinflows(+)

the growth rateofnew investments (): if a company grows rapidly, itsmixwill bemoreheavily

weighted with new investments for which ROIs will be relatively low. Thus, the ROI of a growth

companywill be lower than that a steadystate one, investments economic returns being equal.

Whengrowthrateandeconomicrateofreturnareequal,ROIisequaltoo.ROIdiffers fromeconomic

returnwhenthegrowthrateis greaterorsmallerthantheeconomicreturn.

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Hefoundalsothatthereisnosystematicpatternintheerrorthatallowsacorrectiontobemade.

Thefollowingexample(Tables 1and2),referringtoaninvestmentinanewrestaurant,showsthatwhile

therestaurantinvestmentisexpectedtoyieldaneconomicreturnof15%,theROIresultsaresubstantially

different. ROI progresses from a negative figure in the first year to 200% in the fifth year when the

restaurantfacilities

are

almost

fully

depreciated.

Thus,

ROI

understates

the

economic

rate

of

return

in

the

first two years and significantly overstates it for the last three years. The fiveyear average ROI is

approximately 23%, almosttwicethe15%DCFrateofreturn.Astheaboveexampleillustrates,accounting

ROI typicallyunderstates ratesof returnduring theearly stageofan investmentandoverstates rates in

laterstagesastheassetbasecontinuestodecrease.Somemightopposethattheseerrorsoffsetoneother

overtimeasthefirmmovestowardabalancedmixofoldandnewinvestments.Unfortunately,theerrors

arenotoffsetting.Table3 illustrates thisproblem.One restaurant (identical to the investmentdiscusses

earlier)peryearisopenedduringthefirstfiveyears.Thus,beginninginthefifthyearthefirmwillfinditself

inasteadystatesituation. Thesteadystate ROIis 23%,whichsignificantlyoverstatesthe15%economic

rateofreturn.

In

addition

to

theoretical

arguments,

also

empirical

evidence

shows

that

the

accounting

information

does

not by itself adequately explain market valuations nor provide comparability between firms, thus

accountingdataareinadequateinreliablycapturingafirmstrueeconomicperformance.

Empiricaldatafrommanycountriesdemonstratesthefollowingevidence:

nonapparentrelationshipbetween EPSgrowthandtotalshareholderreturns

weakcorrelationbetween EPSgrowthandprice/earningsratio(P/Es)

robustcorrelation betweenmarketvalue andpresentvalueofexpectedcashflows

statistically significant abnormal returns are observed when firms change accounting approach to

valuinginventoriesandcomputingcostofsales:positiveinshiftfromFIFOtoLIFOandnegativeinthe

opposite shift. Therefore, if the inflation rate isnon null,market returns result to be influenced by

change

in

expected

cash

flows

while

do

not

react

to

change

in

accounting

methods:

the

shift

from

FIFOtoLIFO,infact,ifinflationrateispositive,lessentheaccountingincomeand,allbeingequal,cash

flowsincreasebymeansof smallertaxpayments

greater correlationwith market value added (market value of a companyminus book value of its

equityanddebt) of DCFperformancemeasuresthanaccountingmeasures

greater correlation with market value added of residual income measures of performance, i.e.

measuresthataccountforthecostofcapitalinvested.

Table1Theeconomicreturnofinvesting in anewrestaurant

source:Rappaport(1986)

YEARS (data in000)

1

2

3

4

5

Cashflows 176,23 250

350

400

400

Present value(15%)

(atbeginningofyear)(1)

1000

973,76

869,8

650,28347,84

Presentvalue (15%)

(atendofyear)

973,76 869,8

650,28347,84

0

Changein valueduringyear

(economicdepreciation)

26,24

103,95

219,52

302,44

347,84

Economicincome

150 146

130,5

97,6

52,2

Economicrateofreturn (%)(2)

15 15 15

15

15

(1)Thepresentvalueatthebeginningoftheyeariscalculatedbydiscountingthe

remainingcashflowsat15% (2)EconomicrateofreturncorrespondstoIRR

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Table2TheROIofinvestinginanewrestaurant

source:Rappaport(1986)

Table3ROIinthesteadystate

c)

shorttermismofmanagerialdecisionmaking

Accounting measures of performance can orientate management to a mistaken concern about

maximizingcurrentperformancemeasures.Forexampleamanagerthat ismeasuredonmaximizingROI

willbeencouragedonlytoselectprojectsthatequalorexceedtheircurrentROIregardlessofthepotential

valueofinvestmentsinthelongerterm.Thus,theobjectiveofmaximizingROImayresultinprojectsthat

willcreatewealthforshareholdernottobeapproved.Managerscanmaximizecurrentprofits byreducing

discretionaryexpenses thatmayadverselyaffect futureprofitability,by lessening future revenues (for

exampleR&Dexpensesorother similarexpenses like training anddevelopment costs,brandmarketing

expenses, advertising, etc.) or increasing future costs (for example plant andmachinerymaintenance

costs). Theseinvestments arecharacterizedbytakingalongtimetotranslateinitialoutflowsintofinancial

results, andas isstated inmoststrategytextbooks, longtermsurvivalofafirm isdependent indeedon

thiskindofinvestments.

In addition, ROI does not account for the postplanning period residual value of the business unit or

company.Normally,onlyasmall portionofafirms marketvaluedependsonprofitsgeneratedinafive

yearspan; conversely, thelargerportiondependsoncashflowsgeneratedbeyondthatpoint. Abusiness

1

2

3

4

5(steadystate)

)

Accountingincome (perrestaurant)

1

23,77 +50

+150

+200

+200

2

23,77

+50

+150

+200

+200

3

23,77

+50

+150

+200

4

23,77

+50

+150

5

23,77

+50

6

23,77

Accountingincome (total) 23,77 26,23 176,23 376,23 576,23 576,23Netbookvalue(perrestaurant)

1

900

700

500

300

100

2

900

700

500

300

1003

900

700

500

300

4

900

700

500

5

900

700

6

900

Netbook value (total) 900 1600

21002400

2500

2500

ROIforallrestaurants (%) 2,6

1,6

8,4

15,7

23,0

23,0

YEARS (datain000)

1 2

3

4

5

Cashflows 176,23

250

350

400

400

Depreciation

(strightline)

200

200

200

200

200

Accountingincome 23,77 50 150 200 200

Netbookvalue

(atbeginningofyear)

1000

800

600

400

200

Netbookvalue

(atendofyear)

800

600

400

200

0

Averagebookvalue

ROI(%)

900

2,6

700

7,1

500

30

300

66,7

100

200

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attempting to increase itsmarket share and competitive position will likely increase its new product

developmentandmarketingspending,priceaggressively,andinvest inexpandedproductioncapacityand

working capital (Rappaport 1986). While these activities will strengthen the organization long term

strategicpositionandincreasemarketvalue,ROIislikelydeclineoverthenextseveralyears. Conversely,a

harvestingstrategy allowserosioninmarketshareandwillgeneratebetterplanningperiodROIs,butthe

residualvalue

islikely

to

be

very

small.

3. COMPETINGFINANCIALPERFORMANCEMEASURES

3.1

Trendsinperformancemeasurement

The choice of performance measures is one of the most critical challenges facing organizations.

Performance measurement systems play a key role in developing strategic plans, evaluating the

achievementoforganizationalobjectivesandcompensatingmanagers.

Manymanagers feel that traditionalaccountingbasedmeasurement systemsno longeradequately fulfil

thesefunctions.

A

1996

survey

by

the

Institute

of

Management

Accounting

(IMA)

found

that

only

15

percent

of

the

respondents' measurement systems supported top management's business objectives well, while 43

percentwerelessthanadequateorpoor.

In response, firms increasingly are implementing new performancemeasurement systems toovercome

these limitations.Sixtypercentof the IMA respondents, forexample, reported theywereundertakinga

majoroverhaulorplanningtoreplacetheirperformancemeasurementsystems.

The perceived inadequacies in traditional accountingbased performance measures have motivated a

variety of performance measurement innovations ranging from "improved" financial metrics such as

"economic value"measures to "balanced scorecards"of integrated financial and nonfinancialmeasures

(IttnerandLarcker,1998).Mosteconomictheoriesanalyzingthechoiceofperformancemeasuresindicate

that performance measurement and reward systems should incorporate any financial or nonfinancial

measurethatprovidesincrementalinformationonmanagerialeffort(subjecttoitscost).

Despite thesemodels, firms traditionally have relied almost exclusively on financialmeasures such as

budgets, profits, accounting returns and stock returns formeasuring performance (Ittner and Larcker,

1998).

Table4 Uses,qualityandperceived importanceoffinancialandnonfinancialperformancemeasures

(LingleandSchiemann,1996)

source:IttnerandLarcker(1998)

Schiemann

and

Associates

surveyed

203

executives

in

1996

on

the

quality,

uses

and

perceived

importance

ofvariousfinancialandnonfinancialperformancemeasures(LingleandSchiemann,1996).Theirresultsare

presented inTable4.While82percentoftherespondentsvaluedfinancialinformationhighly,morethan

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90percentclearlydefinedfinancialmeasuresineachperformancearea,includedthesemeasuresinregular

management reviews,and linked compensation to financialperformance. Incontrast,85percentvalued

customer satisfaction information highly, but only 76 percent included satisfaction measures in

managementreviews,just48percentclearlydefinedcustomersatisfactionforeachperformanceareaor

used these measures for driving organizational change, and only 37 percent linked compensation to

customersatisfaction.

Similar

disparities

exist

for

measures

of

operating

efficiency,

employee

performance,

communityandenvironment,andinnovationandchange.

More importantly,mostexecutiveshad little confidence inanyof theirmeasures,withonly61percent

willingtobettheirjobsonthequalityoftheirfinancialperformance informationandonly41percenton

thequalityofoperatingefficiency indicators, thehighestratednonfinancialmeasure (IttnerandLarcker,

1998).

Perceived inadequacies in traditional performance measurement systems as well as the managers

confidenceinfinancialperformancehaveledmanyorganizationstoplacegreateremphasison"improved"

financial measures that are claimed to overcome some of the limitations of traditional financial

performance.Wereviewthistrendinthefollowingsection.

3.2

Economicvaluemeasures

Whiletraditionalaccountingmeasuressuchasearningspershareandreturnon investmentarethemost

commonperformancemeasures, they havebeen criticized fornot taking into consideration the costof

capitalandforbeingundulyinfluencedbyexternalreportingrules.

Meanwhilethetraditionaldiscountedcashflow (DCF)modelprovidesforathoroughanalysisofallofthe

different ways in which a firm can increase value, it can become complex, as the number of inputs

increases. It is also very difficult to tiemanagement compensation systems to a discounted cash flow

model, sincemanyoftheinputsneedtobeestimatedandcanbemanipulatedtoyieldtheresultsthatone

wants.

InsteadofexplicitDCFmodelasimplifiedformulabasedDCFapproachcanbeusedbymakingsimplifying

assumptions about a business and its cash flow stream (for example, constant revenue growth and

margins)sothattheentireDCFcanbecaptured inaconciseformula(Copelandetal., 1990).TheMiller

Modigliani(MM)formula(Table5),whilesimple,isanexamplethat isparticularlyusefulfordemonstrating

thesourcesofacompanysvalue. TheMMformulavaluesacompanyasthesumofthevalueofthecash

flowofitsassetscurrentlyinplaceplusthevalueofitsgrowthopportunities; becausetheformulaisbased

onsoundeconomicanalysis, itcanbeused to illustrate thekey factors thatwillaffect thevalueof the

company and therefore to show how the two components of value performance can be measured

separately,althoughitislikelytobetoosimpleforrealproblemsolving, unfortunately.

Inaddition, itwasstated thatNPVconcept isuselessunlesswecandiscount the investmentscomplete

cashflowoveritscompletedeconomiclife:inotherwords,itisonlywhenitisconsideredoverthelifeof

thebusiness,andnotinanygivenyear, thatcashflowapproachbecomessignificant. Thus, itcouldbea

measureofperformanceonly if itcouldbeperiodized intoyears,quarters,monthsorthetimeperiodof

theuserschoice.Moreover,this iswhatsomeneweconomicmeasures(whichwillbeanalyzedbelow)

trytodo.

Ifweassumethatmarketsareefficient,wecanreplacetheunobservablevaluefromthediscountedcash

flowmodelwiththeobservedmarketprice,andrewardorpunishmanagersbasedupontheperformance

ofthestock.Thus,afirmwhosestockpricehasgoneupisviewedashavingcreatedvalue,whileonewhose

stockpricegoesdownhasdestroyedvalue.Compensationsystemsbaseduponthestockprice, including

stock grants and warrants, have become a standard component of most management compensation

packages.Whilemarketpriceshavetheadvantageofbeingupdatedandobservable,theyarealsonoisy.

Evenifmarketsareefficient,stockpricestendtofluctuatearoundthetruevalue,andmarketssometimes

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domakebigmistakes.Further,afirmsstockperformanceseemstobemuchmorereliablewhenevaluated

overseveralyears.Thus,afirmmayseeitsstockpricegoup,anditstopmanagementrewarded,evenasit

destroysvalue.Conversely,themanagersofafirmmaybepenalizedasitsstockpricedrops,eventhough

the managers may have taken actions that increase firm value. In addition, market measures of

performancereflectfactorsbeyondmanagerscontrol(suchasdeclininginflationandlowerinterestrates,

forexample)

as

well

as

tend

to

aggregate

relevant

information

inefficiently

for

compensation

purposes

(theirforwardlookingcharactermayresultincompensatingforpromisesandnotforactualachievements);

finally, they cannot be disaggregated beyond the firm level. Thus, they cannot be used to analyze the

managersofindividualdivisionsofafirm,andtheirrelativeperformance.

Consultingfirmspromoted avarietyof"economicvalue"measurestoovercomelimitationsofaccounting

basedandmarketmeasures.Weillustrateinthissectionthemostknownmetrics.

Table5TheMillerModiglianiDCFformula(MillerModigliani,1961)

valueofentity=valueofassetsinplace+valueofgrowth

valueofassetsinplace=

valueofgrowth=

where:

E(NOPAT)=expectednetoperatingprofitaftertaxes

(assumedasproxyofexpectedcashflowsaftertaxes)WACC=weightedaveragecostofcapitalaftertaxes

K=investmentrate(percentageofcashflowsinvestedinnewprojects)

r=rateofreturnoninvestedcapital

N=intervalofcompetitiveadvantage

The foundation for all these "new" performance measures is the concept of residual income (RI),

developedmany yearsago indeed(Worthingtonetal.,2001).Inthe1920seminalcontribution,Marshall

concluded,thegrossearningsofmanagementwhichamanisgettingcanonlybefoundaftermakingupa

careful account of the true profits of his business, and deducting interest on his capital. Later, the

desirability of quantifying economic profit as a measure of wealth creation was operationalized bySolomons(1965)asthedifferencebetweentwoquantities,netearningsandthecostofcapital. Asearly

asthe1920sGeneralMotorsappliedthisconceptand inthe1950sGeneralElectric labelled itresidual

income andapplieditasaperformancemeasuretotheirdecentralizeddivisions.Itisdefinedintermsof

aftertaxoperatingprofitslessachargeforinvestedcapital,whichreflectsthefirmsweightedaveragecost

of capital. Close parallels are thereby found in the related (nontrademarked) concepts of abnormal

earnings,excessearnings,excessincome,excessrealisableprofits and superprofits(Biddleetal.,1997).

Economicprofit(EP)isavariantofRIbutasareturnofequity.It isthebookprofitlesstheequitysbook

value(atthebeginningoftheconsideredperiod)multipliedbytherequiredreturntoequity.AsROEisthe

ratio of profit after taxes to book value of equity,we can also express the economic profit as ,whereisthebeginningbookvalueofequityandisthecostofequity. Itisobviousthatfortheequitymarketvaluetobehigherthanitsbookvalue,ROEmustbegreaterthan,ifROEand areconstant(Fernandez, 2003).

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Economicvalueadded(EVA)

SternStewart&Co.'s(hereafterSternStewart)trademarked"EconomicValueAdded"(EVA) isthefirm's

proprietary adaptation of residual income. EVA is a modified version of residual income where the

modifications consistof accountingadjustmentsdesigned to convertaccounting income and accounting

capitalto

economic

income

and

economic

capital.

Thus,

the

significance

of

the

difference

between

EVA

and

residualincomeisdependentupontheimpactoftheseaccountingadjustments.

EVA isdetermined asadjustedoperating incomeminusacapitalcharge,andassumes thatamanager's

actionsonlyaddeconomicvaluewhentheresultingprofitsexceedthecostofcapital.

EconomicValueAdded=NOPATcostofcapitalxcapitalinvested

=(ROCcostofcapital)x(capitalinvested)

where

NOPAT=netoperatingprofitaftertaxes

ROC=NOPAT/capital invested=returnoncapital(invested).

There

are

three

basic

inputs

that

we

need

for

EVA

computation:

the

return

on

capital

earned

on

an

investment,thecostofcapitalforthatinvestmentandthecapitalinvestedinit.

Thereare twowaysofestimating NOPAT (Damodaran,2000).One is touse the reportedEBITon the

income statement and to adjust this number for taxes:NOPAT = EBIT (1 tax rate).Whenwe use this

computation,weignorethetaxbenefitofinterestexpensessinceitisalreadyincorporatedintothecostof

capital(byanaftertaxcostofdebt). Alternatively,wecanarriveatNOPATbystartingwithnetincomeas

follows:NOPAT=netincome+interestexpenses(1 taxrate)nonoperatingincome(1taxrate).Adding

backtheaftertaxportionofinterestexpensesensuresthatthetaxbenefitfromdebtdoesnotgetdouble

counted.

It

is

more

difficult

to

estimate

the

capital

invested

at

the

level

of

the

firm

than

of

a

single

project,

because

inafirm projectstendtobeaggregatedandexpensesareallocatedacrossthem.Oneobvioussolutionmay

betousethemarketvalueofthefirm,butmarketvalueincludescapitalinvestednotjustinassetsinplace

butinexpectedfuturegrowth.Ifwewanttoevaluatethequalityofassetsinplace,weneedameasureof

themarketvalueofjust theseassets.Given thedifficultyofestimatingmarketvalueofassets inplace,

manyanalyststurntothebookvalueofcapitalasaproxyforthemarketvalueofcapitalinvestedinassets

inplace(Damodaran,2000).

Wecanuseadoubleapproachtomeasureinvestedcapital.Thecapitalbasedapproachconsidersthebook

values of equity and interest bearing debt (netted against cash balances). The assetbased approach

couldarriveatasimilarresultusingthebookvaluesoftheassetsofthefirmasfollows:

invested capital=net fixedasset+currentasset current liabilities cash =net fixedasset+noncash

workingcapital.

Thetwoapproachescouldgivenonequivalentresultswhenthefirmhas longterm liabilitiesthatarenot

interestbearingdebt(forexampleprovisionsandsimilar):theywillbeexcludedfromtheinvestedcapital

computationwhenweusethecapitalapproach.

Thereasonwenetoutcashisconsistentwiththeuseofoperatingincomeasourmeasureofearnings.The

interest incomefromcashorcashequivalents isnotpartofoperating income.Obviously,forcompanies

with significant cash balances, exclusion of cash from invested capital and of its interest income from

NOPATcoulddiscouragesmanagerstousecashbalancesefficiently.

Thebookvalue,however, isanumber that reflectsnotjust theaccountingchoicesmade in thecurrent

period,butalsoaccountingdecisionsmadeover timeonhow todepreciateassets,value inventoryand

dealwithacquisitions(Damodaran,2000).Itisalsoinfluencedbytheaccountingclassificationofexpenses

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intooperatingandcapitalexpenditures,withonlythelattershowingupaspartofcapital.Thelimitationsof

book value as ameasureof capital invested has led analystswhouse EVA to adjust thebook valueof

capitaltogetabettermeasureofcapitalinvested.

SimilarproblemsarisewhenweneedtoestimateNOPATand ROC.Theoperatingincomethatwewould

like toestimatewouldbe theoperating incomemadebyassets inplace.Theoperating income,usually

measuredas

earnings

before

interest

and

taxes

in

an

income

statement,

may

not

be

agood

measure

of

this

figure,forthesamereasonsthathasledtoadjustthebookvalueofcapitalinvested.

The practitionerswho use EVA claim tomakemany adjustments to the accountingmeasures of both

operatingincomeandinvestedcapital.SternStewartmakesasmanyas164adjustmentstoarriveatEVA.

Table 6 summarizes some of the adjustments recommended by Stern Stewart (Stewart, 1991) for

convertingfrombookvalue andbookNOPATtowhat itcallseconomicbookvalueandeconomicNOPAT

respectively(Fernandez2002).

Table6AdjustmentssuggestedbySternStewartforcalculatingtheEVA

Someoftheseadjustmentsinclude(Damodaran, 2000):

capitalizinganyoperatingexpensethatisintended tocreateincomenotinthecurrentperiod,butin

futureperiods.Anexample is researchanddevelopmentexpenses (otherexamplesare trainingand

developmentcosts,brandmarketingexpenses,advertising,etc.),whichaccountingstandardsrequire

beexpensed,butwhichclearlyare intendedtogeneratefuturegrowth.Thestandardtreatment isto

capitalize research and development expenses and augment the capital invested by this amount

(accrued R&D expenses netted against cumulative amortization). Correspondingly, the operating

income should be considered without these expenses, while the amortization of these capitalizedexpensesmustbeyearlydeductedfromNOPAT.Makingthisadjustmentforhightechnologyfirmswill

drastically alter their return on capital, reducing it in most cases considerably. Once you have

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capitalized R&D, any new R&D increases this asset, but existing R&Dwill be amortized over time,

reducingit.TherateatwhichtheR&Disamortizedwillbesectorspecificandreflecttherateatwhich

thebenefitsofnewR&Ddecayinthesector;

capitalizinganyoperatingexpensesthatarereallyfinancingexpenses indisguises.Themostcommon

illustrationof

this

isoperating

lease

expenses,

which

reduce

operating

income

in

the

period

in

which

they are paid. This is in contrast to the treatment of capital leases, where firms are required to

computethepresentvalueofleaseobligationsandtreatitasdebt.Fromafinancialstandpoint,thereis

littledifferencebetweenoperatingandcapital leases.Therefore, itdoesmakesensetocomputethe

presentvalueofoperatingleasecommitmentsandtreatthemasdebt,thusincreasingcapitalinvested.

A similar adjustment regards pension provisions: they should be included in computing capital

investedasif theywereequivalenttodebtandtheirfinancialcosts(forexample,inItalyTFRcostsper

yearareequalto1,5%+75%ofinflationrate)shouldbeaddedbacktoNOPAT;

eliminatinganyitemsthatmaycause thebookvalueofcapitaltodropwithoutreallyimpactingcapital

invested.Here,we have to consider the amortization of goodwill, that reduces the book value of

capital

but

does

not

reduce

capital

invested

and

should

be

added

back

(but

only

the

part

of

goodwill

referredtoassetinplace measuredasdifferencebetweentheacquisitionpriceandthemarketvalue

prior to acquisition should be included in invested capital); earnings prior to the amortization of

goodwillshouldbeconsidered,correspondingly.

Similaradjustments regardallowancesforbaddebts,stockobsolescenceandsimilarones;theyshould

be assimilated to equity reserves and then computed in calculating the capital invested;

correspondingly changes (net of taxes) in these allowances (changes are equal to provisions less

utilizationsinthecurrentyear)shouldbeaddedbacktoNOPAT(inthiswayNOPATisaffectedonlyby

cashutilizationsofthisallowances,i.e.whenthelossesortheminorinflowsoccur).

A similar adjustment regards the LIFO reserve. The LIFO reserve is the difference between the

accounting cost of an inventory that is calculated using the FIFOmethod, and one using the LIFO

method.Inthetypicalinflationaryenvironment,thevalueofaFIFOinventoryishigherthanthevalue

of a LIFO inventory, so the calculationof the LIFO reserve is : LIFO reserve = FIFO valuation LIFO

valuation. Since the reason for valuing an inventory using LIFO is usually to defer the payment of

incometaxes,theLIFOreserveessentiallyrepresentstheamountbywhichanentity'staxableincome

hasbeendeferredbyusingtheLIFOmethod.Reserveshouldbeaddedtoinvestedcapitalandyearto

yearincreasetobeaddedbacktoNOPAT.

Similar examples are the onetime restructuring chargeswhich result in a large negative operating

incomewhenweaccount forextraordinary lossesanddeclines inbookvalueofcapital.Losses from

sales of assets should be added back to invested capital and NOPAT as well as gains should be

subtracted.

Similar adjustments regard stock buybacks. They have a disproportionate impact on book value of

capitalwhenmarketvalueiswellinexcessofbookvalue:infactthebookvalueofequityisreducedby

themarket valueof thebuyback; if theprice to book ratio is for exampleof10, a buybackof5%

reducesthebookvalueofequityby50%;

adjusting for any actions that should have caused book value of capital but did not because of

accounting treatment. For examplewhen pooling is used to account for amerger (the book value

remainsinthebalancesheetthebalancesheetthuslookssmaller andthegoodwillisignored,i.e.it

is treated in the same way as internally generated goodwill), the book value of capital is usually

corrected,byaugmenting it to reflect thepricepaidon theacquisitionand thepremiumoverbook

value.Itshouldbenotedthattheproportionofpremiumpaidforexpectedfuturegrowthpotentialin

theacquiredfirmshouldnotaddedontoarriveatcapitalinvested.

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Itshouldbenotedtheimpactontaxchargeofmakingtheadjustmentsabove.Forexample,ifweaddback

toNOPAT theR&Dcostspreviouslyexpensed,weimplicitlyincludethetaxshieldoftheseexpensesinthe

NOPAT calculations; conversely, ifwe add back the R&D expenses after taxes (i.e. the gross amount

multipliedby(1 taxrate)),thenweignoreit.Moreover,ifweaddbacktoNOPATtheR&Dexpensesminus

theyearamortizationofthecapitalizedR&Dexpenses,bothaftertaxes,thereforeweareonlyconsidering

thetax

shield

associated

with

the

amortization.

Theabove areonlysomeofthesuggested adjustments.YoungandOByrne(2001)admit that....even

the most ardent EVA advocate would concede that no company should make more than, say, 15

adjustments. They furtherstatethat 1012accountingadjustmentsweremostcommonbutthatnumber

hasnowdeclinedtofiveorfewerandinsomecasenoadjustmentsaremade.Theexplanationtheygivefor

this reduction is: a)managers are reluctant to deviate fromGAAPbased numbers; b) companies have

foundthatmostofthesuggestedadjustmentshavelittleimpactonprofitandcapital.

Moreover, external analystswho choose to use EVA have to accept the reality that their estimates of

operatingincomecanadjustonlyforthevariablesonwhichthereispublicinformation.

Andersonetal.(2005)foundthat,inasampleof317USAfirmsoveratenyeartimeperiod,fiveaccounting

adjustments

yielded

on

average

an

EVA

only

7,1

%

less

than

the

EVA

reported

by

Stern

Stewart

for

the

same firms and time period. The two accounting adjustmentswith the largest impact, R&D and LIFO

reserve, accounted for 92% of the total change in EVA due to the five accounting adjustments. The

inconsistency over time of the differences, both in absolute and percentage terms, between Stern

StewartsEVAandAndersonetal.sadjustedEVAdoesnot support for theneed fora largenumberof

accountingadjustments.Inaddition,evidenceshowsastronginstabilityofEVAadjustmentsovertime and

averystrong relationshipbetweenadjustedandunadjustedEVA.Therefore,accountingadjustments for

EVAseemtobemuchtodoaboutnothing.

Thethirdandfinalcomponentneededtoestimatetheeconomicvalueaddedisthecostofcapital.Aschool

of thought argues that the cost of capital should be estimated using book valueweights for debt and

equity,sincethereturnoncapitalandcapital investedaremeasured inbookvalueterms.Thisargument

doesnot reallyhold up, for the following reasons (Damodaran, 2000). First, it isnot thebook valueof

capital thatwe should reallybemeasuring in capital invested, but themarket valueof assets in place.

Therefore,itisclearthatusingabookvaluecostofcapitalessentiallyisequivalenttoassumingthatalldebt

isattributable toassets inplace,and thatall future growth comes fromequity.Putanotherway, ifwe

adoptedthisrationaleinvaluation,wewoulddiscountcashflowsfromassets inplaceatthebookcostof

capital,andallcashflowsfromexpectedfuturegrowthatthecostofequity.

Second,usingabookvaluecostofcapital foralleconomicvalueaddedestimates, including theportion

thatcomesfromfuturegrowth,willdestroythebasisoftheapproach,whichisthatmaximizingthepresent

valueofeconomicvalueaddedovertimeisequivalenttomaximizingfirmvalue.

Third, ifchangingcapitalstructure isone tool thatcanbeused to increaseEVA, themechanicswork far

betterifmarketvaluecostofcapitalisusedratherthanbookvalue.Fromapracticalstandpoint,usingthe

bookvaluecostofcapitalwilltendtounderstatecostofcapitalformostfirms,andwillunderstateitmore

formorehighly levered firms than for lightly levered firms.Understating the costof capitalwill lead to

overstatingtheEVA.Thus,rankingsbasedonbookvaluecostofcapitalarebiasedagainstfirmswith less

leverage,andbiasedtowardsfirmswithhighleverage.

Cashflowreturnoninvestment(CFROI)

A second economic valuemeasure that has received considerable attention is "Cash Flow Return on

Investment"(CFROI)anditsvariants(proposedbytheBostonConsultingGroup).

CFROI essentially is amodified version of internal rate of return, designed for investments that have

already beenmade. The CFROI for a firm is compared to the cost of capital to valuate whether a

companys investmentsaregood,neutralorpoor investments.Toenhance its value thena firm should

increasethespreadbetweenitsCFROIanditscostofcapital.

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TheCFROI iscalculatedusingfour inputs(Damodaran, 2000).Thefirst input isthegross investment(GI)

thatthefirmhasinitsassetsinplace.Thisiscomputedbyaddingbackdepreciationtothenetassetvalue

toarriveatanestimateoftheoriginalinvestmentintheasset.Inaddition,nondebtliabilities(allowances)

and intangiblessuchasgoodwillarenettedout.Finally, thegross investment isconverted intoacurrent

dollarvaluetoreflectinflationthathasoccurredsincetheassetwaspurchased.

Thesecond

input

isthe

gross

cash

flow

(GCF)

earned

in

the

current

year

on

that

asset.

This

isusually

definedasthesumoftheaftertaxoperatingincomeofafirmandthenonchargesagainstearnings,such

asdepreciationandamortization.Theoperating incomeshouldbeadjusted foroperating leasesandany

accountingeffects,muchthesamewaythatitwasadjustedfortocomputeEVA(aswellasGI).

Thethirdinputistheexpectedlifeof theassets(n)inplace,atthetimeoftheoriginalinvestment,which

variesfromsectortosectorbutreflectstheearninglifeoftheinvestmentsinquestion.Theexpectedvalue

of theassets(SV=salvagevalue)attheendofthis life, incurrentdollars, isthefinal input.This isusually

assumed tobe theportionof the initial investment, such as land andbuildings that isnotdepreciable,

adjustedtocurrentdollarterms(practitionersincludealsoinflationadjustedcurrentassets).

The CFROI is the internal rate of return of these cash flows, i.e. the discount rate thatmakes the net

presentvalueof thegrosscash flowsand salvagevalueequal to thegross investment,andcan thusbe

viewed

as

a

composite

internal

rate

of

return,

in

current

dollar

terms.

This

is

compared

to

the

firms

real

costofcapitaltoevaluatewhetherassets inplacearevaluecreatingorvaluedestroying.Therealcostof

capitalcanbeestimatedusing the realcostsofdebtandequity,andmarketvalueweights fordebtand

equity.

1

An alternative formulation of the CFROI allows for setting aside an annuity to cover the expected

replacementcostoftheassetattheendoftheprojectlife.Thisannuityiscalledtheeconomicdepreciation

andiscomputedasfollows:

1 1

where n is the expected lifeof the asset and the expected replacement costof the asset is defined in

currentdollartermstobethedifferencebetweenthegrossinvestmentandthesalvagevalue.TheCFROI

forafirmoradivisioncanthenbewrittenasfollows:

CFROI Gross Cash Flow Economic Depreciation /Gross Investment

Appendix shows the equivalence between two formulas, when we assume in deriving the economic

depreciation a discount rate kcCFROI. The differences in discount rate assumptions account for the

differenceinCFROIestimatedusingthetwomethods.Inthefirstformulatheintermediatecashflowsare

discounted attheCFROI,whileinthesecond,at leasttheportionofthecashflowsthataresetasidefor

replacement, getreinvestedatthecostofcapital.

IfnetpresentvalueprovidesforthegenesisfortheEVA approach,theinternalrateofreturn(IRR)isthe

basis for theCFROIapproach. In investmentanalysis, the IRR onaproject iscomputedusing the initial

investmentontheprojectandallcashflowsovertheprojectslife.TheIRRcalculation canbedoneentirely

innominalterms,inwhichcasetheinternalrateofreturnisanominalIRRandiscomparedtothenominal

costofcapital,orinrealterms,inwhichcaseitisarealIRRandiscomparedtotherealcostofcapital.

Atfirstsight,theCFROIseemstodothesamething.Itusesthegrossinvestment(incurrentdollars)inthe

project as the equivalent of the initial investment, assumes that the gross currentdollar cash flow is

maintainedover theproject lifeand computes a real internal rateof return.Thereare,however, some

significantdifferences(Damodaran, 2000):

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theIRRdoesnotrequiretheaftertaxcashflowstobeconstantovera projectslife,eveninrealterms,

meanwhile theCFROIapproachassumes that real cash flowsonassetsdonot increaseover time. It

shouldbenoted,however,thattheCFROIformula canbemodifiedtoallowforrealgrowth

theseconddifferenceisthattheIRRonaprojectorasset isbaseduponincrementalcashflows inthe

future.Itdoesnotconsidercashflowsthathaveoccurredalready,thatareviewedassunk.TheCFROI,on theotherhand, tries to reconstruct aprojector asset,usingboth cash flows thathaveoccurred

alreadyandcashflowsthatareyettooccur.Morespecifically,IRRisalwaysforwardlookingwhileCFROI

isnot.Theimplicationsarerelevant:aCFROIthatexceedsthecostofcapitalisusuallyconsideredasign

thatafirmisusing itsassetswell,butthatmightnotbetrue.IftheIRRislessthanthecostofcapital,

thatinterpretationisfalse.

FromtheCFROIwecanderivethecashvalueadded(CVA)bymultiplying thespreadbetweenCFROIand

WACCbythe inflationadjustedcashinvestment.

Shareholdervalueadded(SVA)

Thethirdeconomicmeasureistheshareholdervalueadded(SVA) elaborated by Rappaport(1986)and

AlcarConsultingGroup.ThekeyfactorsindeterminingSVAarethefollowing:

growthrateofsales

rateofoperatingprofitmargin(nettedagainst depreciation)

(cash)taxrate

rateofincremental fixedcapitalinvestment,intermsofrateofcapitalintensityofsales,nettedagainst

depreciation(depreciationisimplicitlyconsideredequaltoreplacementinvestmentoffixedcapital)

rateofincrementalworkingcapitalinvestment(intermsofrateofworkingcapitalintensityofsales)

costofcapital,expressedintermsofweightedaveragecostofcapital(WACC)

valuegrowthduration(planningperiodorcompetitiveadvantageperiod).Itcorrespondstothelength

of

time

that

the

firm

is

expected

to

earn

returns

in

excess

of

its

cost

of

capital.

It

depends

on

how

companysstrategiesaremoreorlessquicklyemulatedbypotentialcompetitors.

Thesevariablesarecombinedinthefollowingmodel(consistentwithDCF approach)inordertomeasure

thevaluecreationofastrategy(validbothinbackwardandforwardlookingvaluation):

value created by strategy change of shareholder value generated by strategy

with respect to nonstrategy scenario

shareholder value gross corporate value market value of debt and other obligations

gross corporate value present value of operating cash flows during the forecast period terminal

value at the end of the forecast period cash & cash equivalents and nonoperating assets whose

returns are excluded from operating CF

operating cash flowt salest1x 1growth rate of sales x rate of operating profit margin x 1 tax

rate salest salest1 x rate of incremental investment in fixed assets and working capital.

Cashflowsandterminalvaluearediscountedbythecostofcapital.

The terminal value at the endof the forecast period can account for a great partof a companys (or

businessunits)marketvalue,dependingongrowthorharvestingstrategiesadopted.Terminalvaluecan

bedeterminedbyusingdifferentapproaches indifferent situations. Itcanbeestimatedasabreakup

value (when the firmceasesoperationsat theendof the forecastperiod) orasaperpetuityof thenet

operatingcashflowatthehorizon,assumingasteadystatebeyondthistermoraconstantrateofgrowth

continuingindefinitely.Sometimesmultipleapproachcouldbeused.Weobservethatassumingaconstant

operating cash flow beyond the end of the forecast period does not imply a nongrowth state of the

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business,butthatfuturenewinvestmentsrateofreturnisequaltotheircostofcapital;thus,incremental

cashflowscanbeignoredincalculatingthevalueofbusiness.

4. THEMETRICSWAR

Considerabledebate

exists

on

the

relative

value

relevance

of

the

alternative

economic

value

measures.

Consultingfirmsbattleoverthesuperiorityoftheireconomicvaluemeasures,chargingthatcompetitors'

measureshaveflawsthatcompromisetheirpredictiveability.

Anumberof impressiveclaimshavebeenmadeforeachoftheeconomicvaluemeasures.SternStewart,

forexample,citesinhouseresearchindicatingthat"EVAstandswelloutfromthecrowdasthesinglebest

measureofwealthcreationonacontemporaneousbasis"(Stewart,1991),whileDixonandHedley(1993)of

BraxtonAssociatesciteaninternalstudyshowingtheirCFROImeasureexplains91percentofthevariation

inmarketcapitalization ratios.AdvocatesofCFROIargue that thismetric isvastlysuperior to traditional

accountingmeasures and EVA as a performancemeasure. In an article on the "metricwars" between

consulting firmspushing variouseconomic valuemeasures, apartneratHOLTValueAssociates claimed

"CFROIsare ideally suited todisplaying longterm track records,whereasa Stern StewarttypeEVA is in

millions

of

dollars,

heavily

influenced

by

asset

size,

and

unadjusted

for

inflation

induced

biases"

(Myers,

1996). Responded Stern Stewart cofounder G. Bennet Stewart III "CFROI is literally a consultant's

concoction.Itwasquiteanimaginativedevelopmentbyaconsultingfirm,butitisnotwellgroundedinthe

basicelementsofcorporatefinancetheory.CFROIattemptstomeasureshareholderwealthwhichisnot

clearlyrelatedtomaximizingshareholderwealth"(Myers,1996).

Claims suchas thesehavecausedagrowingnumberof firms toadoptvarious formsofeconomicvalue

measures.A1996surveybytheInstituteofManagementAccountants(IMA,1996)foundthat35percent

oftherespondentsusedEVAorsimilarmeasures(upfrom18percentin1995)and45percentexpectedto

usetheminthefuture(upfrom27percentin1995).

Yet,despitetheincreasingemphasisonthesemeasures,researchontheextenttowhichtheyaresuperior

totraditionalaccountingmeasuresislimitedandmixed.

In thenextparagraphswewill analyze thedifferentperspectives towhose respect thevariousmetrics

effectivenesscouldbeevaluated.

4.1

Theassociationbetweeneconomicvaluemeasuresandstockreturns

Many empirical studies have investigated the correlation of themost known economicmeasureswith

excessreturns,backtestingthemagainsttheunderlyingcompaniesactualwealthcreation,asevidenced

bysubsequentstockpriceincreases,orcomparing them tomarketvalueadded.Moststudiestodatehave

examinedclaimsmadebytheproponentsofeachofthesevaluebasedmeasuresthattheirownmeasures

were better predictors of stock returns than traditional accountingmeasuresor rival firmsmeasures.

Sincetheavowedgoalofthenewperformancemeasuresistoincreaseshareholderwealth,thecorrelation

ofsuchmeasureswithstockreturnshasanobviousappeal.Howeverastrongstatisticalcorrelationwith

stock returnsdoesnotestablish that a performancemeasure adds value.Nomeasureof performance

could ever have a higher statistical correlation with stock returns that the return itself. Thus, if

correlationwere theonlygoal, firms should solelyuse their stockprice for compensationand ignoreall

othermeasures.However,asarguedabove,stockreturnscanbeanoisyandevenamisleadingmeasureof

managers' value added. Therefore, the rationale is that any financialmeasure used in assessing firms

performancemust behighly correlatedwith shareholderswealth andon theother hand shouldnot be

subjectedtorandomnessinherentinit.

This research domain includes studies that empirically investigate the degree of correlation between

differentperformancemeasures(accounting andvaluebased)andstockmarketreturnsand/orMVAand

its changes. R2 and panel data regressionmodel have been used tomeasure value relevance: in these

regressionmodelsMVA (levelor yeartoyear change) or total shareholder returns are thedependent

variables and the various performance measures are the explanatory variables. In some studies the

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dependent variable is expressed in terms of abnormal or unexpected returns and the competing

performance measures (the independent variables) are measured in terms of levels and change

specifications(EastonandHarris,1991)orofforecasterrors,asthedifferencebetweentherealizedvalue

ofaperformancemeasureand themarketsexpectation (Biddleetal.,1997). It isassumed thatmarket

expectationsareformedaccordingtoadiscretelinearstochasticprocessinfunctionoflaggedobservations

ofthe

performance

measure.

In

some

studies

the

incremental

information

content

of

the

economic

measuresisexploredbyintroducingintheregressionmodel thecomponentsinwhichthemeasurecanbe

decomposedasexplanatoryvariables;forexamplein Biddleetal.(1997)theEVAisdecomposedin5parts:

cash flow fromoperations,operatingaccruals,aftertax interestexpense,capitalcharge,andaccounting

adjustments.

Researchers have employed two approaches, relative vs. incremental information content, to compare

informationusefulnessofdifferentmeasures. Relativeinformationcontentcompareswhichperformance

measure is superior in terms of associationwith stock returns,while incremental information content

addresseswhether onemeasure adds to the information provided by the other. The two information

contenttypeshavedifferentpracticalimplications.Withknowledgeofrelativeinformationusefulness,one

will be able to choose a single best performancemeasure among competingones.On theother hand,

incremental

information

usefulness

will

help

one

decide

whether

to

employ

multiple

measures

in

financial

reporting.Evidently,bothareimportantconsiderationsinthechoiceofperformancemeasures.Frequently

incrementalapproachisusedaddingeconomicmeasurestoaccountingmeasuresintheregressionmodel.

The empirical evidence about the association between the economic metrics and marketbased

performancemeasures ismixed and not definitive. Some studies reveal a stronger association of the

economicmeasuresthanthetraditionalaccountingcounterparts; othersreport,conversely,thatthe last

arebetterpredictors ofstockreturnsthantheformer.

In addition, some studies are concentrated on a specific economicmeasure (mostly EVA) compared to

moretraditionalmetrics;otherscomparetherelativeexplanatorycontent ofalargersetofmetrics.

ManystudiestodatehaveexaminedclaimsthatEVAisabetterpredictorofstockreturnsthantraditional

accountingmeasures.

a)

MilunovichandTseui's(1996)examinationofthecomputerserverindustryfoundmarketvalueadded

between1990and1995morehighlycorrelatedwithEVA thanwithearningspershare,earningsper

sharegrowth,returnonequity,freecashflow,orfreecashgrowth.

b)

Lehn andMakhija (1997) also found that stock returns over a tenyear period weremore highly

correlatedwith averageEVAover theperiod thanwithaverageROA,ROS,orROE. Inaddition,EVA

performedsomewhatbetterthanaccountingprofitsinpredictingCEOturnover.

c)

O'Byrne(1996)examinedtheassociationbetweenmarketvalueandtwoperformancemeasures:EVA

and net operating profit after tax (NOPAT). He found that bothmeasures had similar explanatory

powerwhen no control variableswere included in the regressionmodels, but that amodified EVA

modelhadgreaterexplanatorypowerwhenindicatorvariablesfor57industriesandthelogofcapital

foreachfirmwereincludedasadditionalexplanatoryvariables.However,O'Byrne(1996)didnotmake

similaradjustmentstotheNOPATmodel,making it impossibletocompareresultsusingthedifferent

measures.

OtherstudiessuggestthatEVAispredictiveofstockreturns,butisnottheonlyperformancemeasurethat

tiesdirectlytoastock'sintrinsicvalue,oneoftheprimaryclaimsofEVAadvocates(e.g.Stewart,1991).

a)

ChenandDodd(1997)examinedtheexplanatorypowerofaccountingmeasures(earningspershare,

ROA and ROE), residual income, and various EVArelatedmeasures. They found that EVAmeasures

outperformedaccountingearningsinexplainingstockreturns,buttheassociationswerenotasstrong

as suggested by EVA proponents (maximum R2 = 41.5 percent). In addition, accounting earnings

providedsignificant incrementalexplanatorypoweraboveEVA, leading theauthors toconclude that

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firms should not follow EVA advocates' prescription to replace traditional accounting measures

completelywithEVA.Finally,residualincomeprovidednearlyidenticalresultstoEVA,withouttheneed

fortheaccountingadjustmentsadvocatedbySternStewart.

b) Biddle et al. (1997) provide themost comprehensive studyof EVA's value relevance to date. Their

analysesexaminedthepowerofaccountingmeasures(earningsandoperatingprofits)toexplainstock

marketreturns

relative

to

EVA

and

five

components

of

EVA

(cash

flow

from

operations,

operating

accruals, aftertax interest expense, capital charge, and accounting adjustments). They found that

traditionalaccountingmeasuresgenerallyoutperformedEVA inexplainingstockprices.Whilecapital

charges and Stern Stewart's adjustments for accounting "distortions" had some incremental

explanatorypowerovertraditionalaccountingmeasures,thecontributionfromthesevariableswasnot

economicallysignificant.SensitivityanalysesindicatedthattheseresultswererobusttoSternStewart's

groupingof firms into five "types"basedon theirpastoperating returnsandgrowth rates, the time

periodexamined,andthedependentvariableusedinthetests(i.e.,stockreturnsorlevelsorthetime

frameusedtocomputethemarketmeasures).

c)

Fernandez(2003)analyzed582AmericancompaniesusingEVA,MVA,NOPATandWACCdataprovided

bySternStewart.Foreachofthe582companies,hecalculatedthe10yearcorrelationsbetweenthe

increase

in

the

MVA

each

year

and

each

years

EVA,

NOPAT

and

WACC.

For

296

(of

the

582)

companies,

the correlation between the increase in theMVA each year and theNOPATwas greater than the

correlationbetweentheincreaseintheMVAeachyearandtheEVA.TheNOPATisapurelyaccounting

parameter,whiletheEVAseekstobeamorepreciseindicatoroftheincreaseintheMVA. Thereare

210 companies forwhich the correlationwith the EVA has been negative. The average correlation

betweentheincreaseintheMVAandEVA,NOPATandWACCwas16%,21%and21.4%.,respectively.

TheaveragecorrelationbetweentheincreaseintheMVAandtheincreasesofEVA,NOPATandWACC

was18%,22.5%and4.1%.Healsofoundthatthecorrelationbetweentheshareholderreturnin1994

1998andtheincreaseintheCVA(accordingtotheBostonConsultingGroup)oftheworlds100most

profitablecompanieswas1.7%.

Chari (2009) presents a review of empirical literature that evaluate the superiority of EVA over other

traditionalmeasures intermsofbetterassociationwithshareholderreturns.He findsthattheempirical

findingsaremixed.Only6outofthetotal10studiesexamined(chosenbygivingpreferencetodifferences

inmethodology, sample size and country of study) conclude that EVA is superior to other accounting

measures; he attributes the inconsistency in the findings with respect to superiority of EVA to the

methodologyandimpactofinflation.Infact,recentstudies(Dasetal.,2007)concludethatanonlinearS

shapedfunctionbettercharacterizesreturnearningsrelationship;hence,thelinearassumptioncanleadto

thedistortionof the findings in the researches conducted. In addition,discrepancybetween accounting

profitsandtrueprofitsalongwithinflationdistortsEVA(whichisbasedonaccountingprofits).

ClintonandChen (1998)study followedamore comprehensiveapproach.Theyanalyzedandevaluated

EVA,CFROIandResidualCashFlow(RCF=operatingcashflowcostofcapitalxbeginningcapital) inorder

to examine their correlation with stock prices and stock returns. Furthermore, other performance

measurementsanalyzed includetraditionallyreportedmeasuressuchas operating incomeandcashflow

aswell as the traditionallyusedROI.Theauthors selecteda sampleof325 firms from theStandard&

Poors500 and the Stern Stewart 1996Performance1000 databases, for the years 1991 to1995.They

consistentlydefinedall itemsof themeasurements inorder tobecomparableand thenconducted the

correlation analysis to stockpricesand stock returns.While residualbasedmeasureshavebeenheavily

promotedasbetterchoicesthanROIbasedmeasures,allthreeresidualbasedmeasuresshoweda lower

association with stock values than their traditionally reported counterparts. Most of the RI and EVA

correlationswith stockpricesor stock returnswereeither insignificantorofunexpectednegative signs.

Operating cash flow and adjusted operating income reported the bestperforming categories and have

higher association to stock price and stock return compared to the others. Of the three new

measurements,RCF istheonlyonethatshowedencouragingcorrelations.ThemorepopularRIandROI,

and the most recently highly promoted EVA and CFROI produced either insignificant or inconsistent

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correlationsandthereforeindistinguishableintheirrelativelackofcontributiontoassessingfirmvalue.The

authors then suggestRCF as thebest choice touse in linkingprofit to capital andultimately tomarket

value.RCFmaintainstheadvantagesofusingacashbasedandaresidualbasedmeasure.Theresidualcash

flowmeasureisconsistentwithcapitalassetinvestmentplanningandisalreadystatedintermsofcashso

adjustmenttoremoveaccountingdistortionsisnotnecessary.

Apreliminaryconclusion isthat therelativeabilityofdifferenteconomicvaluemeasurestopredictstock

returns is unknown. If, as might be expected, one measure does not consistently exhibit superior

predictability, researchers canattempt todetermine the factorsexplaining crosssectionaldifferences in

thepredictiveabilityofalternativeeconomicvaluemeasures.Structuralandenvironmentalvariablessuch

asfirmstrategy,competitiveenvironment,andproductorindustrylifecycle,forexample,arelikelytobe

importantdeterminantsoftherelativeexplanatorypowerofdifferenteconomicvaluemeasures,aswellas

theexplanatorypoweroftraditionalaccountingmeasures(IttnerandLarcker,1998).

Inaddition,asDamodaran(2000)observed,wewouldnotexpecttheretobeanycorrelationbetweenthe

magnitudeofEVAandstockreturns,orevenbetweenthechangeinEVAandstockreturns. Thisisbecause

the

market

value

has

built

into

it

expectations

of

future

EVAs.

Whether

a

firms

market

value

increases

or

decreasesontheannouncementofhigherEVAwilldepend in largepartonwhattheexpectedchange in

EVAwas.Formaturefirms,wherethemarketmighthaveexpectednoincreaseorevenadecreaseinEVA,

theannouncementofanincreasewillbegoodnewsandcausethemarketvaluetoincrease.Forfirmsthat

areperceived tohave good growthopportunities andwere expected to report an increase inEVA, the

market valuewilldecline if theannounced increase inEVA doesnotmeasureup toexpectations.This

should be no surprise to investorswho have recognized this phenomenonwith EPS for decades; the

earningsannouncementsoffirmsarejudgedagainstexpectations,andtheearningssurpriseiswhatdrives

prices.ThesameapparentparadoxcanbenotedaboutCFROI.ThereisarelationshipbetweenCFROIand

marketvalue,with firmswithhighCFROIgenerallyhavinghighmarketvalue.This isnot surprising,and

mirrorswhatwenotedaboutEVAearlier.In investing,however, it ischanges inmarketvaluethatcreate

returns,notmarketvalueperse.Sincemarketvalues reflectexpectations, there isno reason tobelieve

that firmsthathavehighCFROIwillearnexcessreturns.Therelationshipbetweenchanges inCFROIand

excessreturnsismoreintriguing.TotheextentthatanyincreaseinCFROIisviewedasapositivesurprise,

firmswiththebiggestincreasesinCFROIshouldearnexcessreturns.Inreality,however,theactualchange

inCFROIhastobemeasuredagainstexpectations; ifCFROI increases,but lessthanexpected,themarket

valueshoulddrop;ifCFROIdropsbutlessthanexpected,themarketvalueshouldincrease

4.2TheassociationbetweeneconomicvaluemeasuresandDCFapproach

Fernandez (2002) shows thatEP,EVA andCVA, if used for valuationpurposes, are consistentwithDCF

approach.Analyticallyheshowsthat:

thepresentvalueof theEPdiscountedat the required return toequity,plus theequitybookvalue

equalsthevalueofequity(thepresentvalueoftheequitycashflowdiscountedattherequiredreturn

toequity);

thepresentvalueoftheEVAdiscountedattheWACCplustheenterprisebookvalue(equityplusdebt)

equalstheenterprisemarketvalue(thepresentvalueofthefreecashflowdiscountedattheWACC);

thepresentvalueoftheCVAdiscountedattheWACCplustheenterprisebookvalue(equityplusdebt)

equals theenterprisemarketvalue(thepresentvalueofthefreecashflowdiscountedattheWACC).

Therefore, throughthepresentvalueofEP,EVAandCVAwegetthesameequityvalueasthediscounting

theequitycashfloworthefreecashflow.Therefore,itispossibletovaluefirmsbydiscountingEVA,EPor

CVA,althoughtheseparametersarenotcashflowsandtheirfinancialmeaningismuchlessclearthanthat

ofcash flows. Therefore,wecanconclude thatmaximizing thepresentvalueof theEP,EVAorCVA is

equivalenttomaximizingthevalueofthefirmsshares.

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However,Fernandez(2002)alsoremarksthatmaximizingaparticularyearsEP,EVAorCVAismeaningless:

itmaybe theopposite tomaximizing thevalueof the firms shares.Theclaim that theEP,EVAorCVA

measuresthefirmsvaluecreationineachperiodisatremendouserror:itmakesnosensetogivetheEP,

EVAorCVAthemeaningofvaluecreationineachperiod.AsthepresentvalueoftheEVAcorrespondsto

theMVA, it iscommonfortheEVAtobe interpreted incorrectlyaseachperiodsMVA. Infact,heshows

thatitmay

happen

that

the

EVA

grows

from

negative

to

positive

in

aconsidered

period

but

itdepends

on

thefactthatsharesbookvaluedecreasesasthefixedassetsaredepreciated.Furthermore,itmayhappen

thattheEVAandtheEPinoneyearhavebeenpositive,andevenhigherthanexpected,butthatthevalue

ofthefirmorbusinessunithasfallenbecausethebusinesssexpectationshavedeteriorated.TheEVA,EP

andCVAdonotmeasurevaluecreationduringeachperiod. It isnotpossible toquantifyvaluecreation

duringaperiodonthebasisofaccountingdata.Valuealwaysdependsonexpectations(Fernandez,2002).

EVAandDCFmodel

EVAisathrowbacktothenetpresentvaluerule.Damodaran(2000)demonstrates thatthepresentvalue

oftheEVAs byaprojectoveritslifeistheNPVoftheproject.

The

NPV

of

a

project

can

be

written

as

follows:

1 1

1

where

=depreciationandamortization=salvagevalue=costofcapital=initialinvestmentn=expectedlifeoftheinvestment

Now

consider

an

alternative

investment

that

requires

an

initial

investment

of

I,

earns

exactly

the

cost

of

capitalandallowsfortheentireinvestmenttobesalvagedattheendoftheprojectlifeofnyears.Thenet

presentvalueofthisprojectwillbezero.SolvingforIinthiscase,weget:

1

1

Substitutingthisintothefirstequation, wegetthenetpresentvalueoftheoriginalprojecttobethe

following:

1

1

1

1

1 Nowweassumethattheprojecthasasalvagevalueofzero,andthatthepresentvalueofdepreciationis

equaltothepresentvalueof initial investment,discountedbackovertheproject life.Inotherwords,we

assumethatthecashflowfromdepreciation isreallythecapitalbeingreturnedtothefirm(alternatively

wecanassumethattheCFsfromdepreciationpaybackI SVn).

Then,thenetpresentvalueofthisprojectcanbewrittenas:

1

1

1

BynotingthatROC=EBIT(1t)/I,thenweget

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1

1

Thus,theNPV oftheprojectisthepresentvalueoftheEVAs bythatprojectoveritslife.Note,however,

thatthis

relation

istrue

only

when

the

assumptions

above

are

verified.

ThelinkagebetweenEVA andNPVallowsustolinkthevalueofafirmtotheeconomicvalueaddedbyit

(Damodaran,2000). Firm value can beexpressed in termsof the valueof assets inplace andexpected

futuregrowthasfollows:

Firm Value Value of Assets in Place Value of Expected Future Growth

NotethatinaDCFmodel,thevaluesofbothassetsinplaceandexpectedfuturegrowthcanbewrittenin

termsofthenetpresentvaluecreatedbyeach:

Firm Value Capital Invested Assets in Place NPVAssets in Place Future Projects, t

SubstitutingtheEVAversionofNPVbackintothisequation,weget:

Firm Value Capital Invested Assets in Place+ , ,

.Thus,thevalueofafirmcanbewrittenasthesumofthreecomponents,thecapital investedinassetsin

place,thepresentvalueoftheEVAs bytheseassets,andtheexpectedpresentvalueoftheeconomicvalue

thatwillbeaddedbyfutureinvestments.

AsimplifiedEVAvaluationmodel(easiertobeusedinboardrooms)canbederivedasfollows(Fabozziand

Grant,2000)

1

1 Theformulameansthatafirmwill:

earnitsNOPATonitsexistingassetsforever

earnpositiveEVAforeveronnewinvestmentsmadeoverperiodT

earnzeroEVAonanynewinvestmentsmadeafterperiodT.

ItisusefultonotethatthebasicEVAmodelaboveassumesthatcompetitionhasnoeffectontheexisting

assetsorthenewinvestmentsmadethroughperiodT,butcompetitiondoeseffectinvestmentsmadeafterT. Inotherwords,ifWalMarthas1000existingstores,thesestoreswillgeneratetheirexisting

level of profitability forever; plus any new stores added during the first T yearswill also generate

economic profits into perpetuity. All stores added after T, however, will generate zero economic

profits.Unfortunately,thisisaveryunrealisticmodelofhowbusinessworks.Competitionreducesthe

earningpowerofallassets,existingand future.AndwecanaddthatthebasicEVAmodeldoesnot

provideguidanceregardingT.

AnotherwayofpresentingtheseresultsisintermsofMVA(Damodaran,2000).TheMVAisthedifference

betweenthefirmvalueandthecapital invested. Clearly,thisvaluewillbepositiveonly if thereturnon

capitalisgreaterthanthecostofcapital,andwillbeanincreasingfunctionofthespread betweenthetwo

numbers.Conversely,thenumberwillbenegative ifthereturnoncapital is lessthanthecostofcapital.Notethatthewhilethefirmcontinuestogrowinoperatingincometermsandtakenewinvestmentsafter

thenth year, thesemarginal investmentscreatenoadditionalvalue if theyearn thecostofcapital.A

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directimplicationisthatitisnotgrowththatcreatesvalue,butgrowthinconjunctionwithexcessreturns.

Thisprovidesanewperspectiveonthequalityofgrowth.Afirmcanbegrowingitsoperatingincomeata

healthyrate,but if it isdoingsoby investing largeamountsatorbelowthecostofcapital, itwillnotbe

creatingvalueandmayactuallybedestroyingit.

Finally,

we

can

derive

several

implications

from

the

fact

that

the

value

of

a

firm

can

be

written

in

terms

of

the present value of the EVA by both projects in place and expected future projects. First, a policy of

maximizingthepresentvalueofEVAovertimeisequivalenttoapolicyofmaximizingfirmvalue.However,

the notion that the EVA approach requires less information than aDCF valuation,or that it provides a

better estimate of value is false. The EVA approach, done right, should yield the same value as aDCF

valuation,and itrequiresmore information,not less.Infact,theDCFvaluationrequiredcashflowsanda

discountratetoarriveatavalue.TheEVAapproachrequirestheseinputsandanadditionalone:thecapital

investedinthefirm.ItusesthismeasuretobreakfirmvalueupintocapitalinvestedandEVAcomponents.

Notethatchangingthecapitalinvestednumberhasnoimpactonoverallvalue. Finally,itisoftenclaimed

thattheEVAvaluationsprovideuswithfreshinsightsonvalueenhancementbecauseofitsfocusonexcess

returns, defined in terms of return and cost of capital. A DCF model where growth is linked to the

reinvestment

rate

and

the

return

on

investments

accomplishes

the

same

objectives

and

arrives

at

the

sameresults.

CFROIandDCFmodel

Damodaran(2000)showsthelinkbetweenCFROIand firmvalue,by beginningwithasimplediscounted

cashflowmodelforafirminstablegrowth:

Firm Value FCFF1/kc gn

Thiscanberewritten,approximately,intermsoftheCFROIasfollows:

Firm Value CFROI*GIDA1 tCXDA WC/kc gn

where

FCFF=freecashflowtofirm=EBIT1t Capital Expenditures Depreciation Change in Working

Capital

CFROI=cashflowreturnoninvestment

GI=grossinvestment

CFROI*GI=economicincome

DA=depreciationandamortization

CX=capitalexpenditures

WC=changeinworkingcapital

kc=costofcapital

gn=stablegrowthrate.

Moreimportantthanthemechanics,however,isthefactthatfirmvalue,whileafunctionoftheCFROI is

alsoafunctionoftheothervariablesintheequationthegrossinvestment,thetaxrate,thegrowthrate,

thecostofcapitalandthefirmsreinvestmentneeds.

Again, sophisticatedusersofCFROIdo recognize the fact thatvaluecomesnotjust from the CFROIon

assets inplacebutalsoon future investments.HoltAssociates andBCGbothallow for a fade factor in

CFROI,wherethecurrentCFROIfadestowardstherealcostofcapitalovertime.

A companys current value depends on competitive lifecycle patterns that reflect expected future

economicreturnsandreinvestmentrates(Madden,2007). Theideaofcompetitivelifecyclesisbasedon

thepremisethatcompetitionandcapitalflowsoperateoverthelongertermtoforcecompanieseconomic

returnstowardthecostofcapital.Duringthehighinnovationstage,returnsareabovetheircostofcapital

and reinvestment exceeds internally generated funds. Attracted by the wealth creation opportunities,

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competitors attempt toduplicate innovations.Competition results in a tendencyofeconomic return to

fadetowardsthe longtermaverageofthecorporatesectorseconomicreturns (whichapproximatesthe

corporatesectorslongtermcostofcapital).Thus,corporatereinvestmentratesfallbacktowardthelower,

longtermaveragegrowthrateoftheoveralleconomy.Tomaintainwellaboveaverageeconomicreturns

and reinvestment rates over decades, companiesmust continually reinvent themselves to outperform

competitors.

The"fadefactor"canbe estimatedempiricallyby lookingatfirms indifferentCFROIclassesandtracking

themovertime.Thus,afirmthathasacurrentCFROIof20%andrealcostofcapitalof8%willbeprojected

tohavelowerCFROIovertime.

Figure1displayedthelifecyclemodel(panelA)andthelifecycletrackrecordsofKmartandWalMartin

the19602005period(panelBandCrespectively),wherethetwocompaniesCFROIscanbeobservedas

well as a benchmark longterm corporate average CFROI of 6% real to approximate the costof capital

(Madden, 2007).WalMart has been able to postpone the downward competitive fade of its superior

CFROIswhilestill reinvestingatveryhighrates.ThisoccurredbecauseWalMarts founderwasskilled in

hiringtalentedpeople,motivatingemployeesanddevelopingstrategiesthatwereextraordinarilyeffective

aswellasastepaheadofhiscompetitors.Hisoriginalstrategywastolocatestoresawayfromlargecities

and

to

saturate

regions

so

the

stores

could

be

efficiently

serviced

by

a

centrally

located

distribution

center.

Figure1 LifeCyclemodelandKmartandWalMartlifecycleperformance

panelA lifecyclemodel

panelBKmartlifecycletrack

panelCWalMartlifecycletrack

source:Madden(2007)

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His strategy proved correct as population expanded towhere his storeswere located. The remarkable

achievementofcreatingtheworldslargestretailer,alongwithover1.7millionjobs,andhugeshareholder

value,hadtheadditionalsocialbenefitofincreasingthepurchasingpowerofmillionsofcustomersthrough

itsdiscountpricing(Madden,2007).

Thevalue

of

the

firm,

in

this

more

complex

format,

can

then

be

written

as

asum

of

the

following:

thepresentvalueofthecashflowsfromassetsinplaceovertheirremaininglife,whichcanbewritten

as whereCFROIaipistheCFROIonassetsinplace,GIaipisthegrossinvestment

inassetsinplaceandkcistherealcostofcapital

thepresentvalueoftheexcesscashflowsfromfutureinvestments,whichcanbewritteninrealterms

as , GIt, whereCFROIt,NI istheCFROIonnew investmentsmade inyeart

and GItisthenewinvestmentmadeinyeart.NotethatifCFROIt,NI=kc,thispresentvalueisequalto

zero.

Thekeytoavoidingperpetuityhypothesisistodeterminewhenacompanysreturnoncapitalisequalto

its costofcapital(i.e.discountrate).Afterward,nomatterhowmuchafirmgrows,thenetpresentvalue

offutureinvestmentsiszero.

Thus,afirm'svaluewilldependupontheCFROIitearnsonassetsinplaceandboththeabruptnessandthe

speedwithwhichthisCFROIfadestowardsthecostofcapital.Thus,afirmcanpotentiallyincreaseitsvalue

bydoinganyofthefollowing:

increasingtheCFROIfromassetsinplace,foragivengrossinvestment

reducingthespeedatwhichtheCFROIfadestowardstherealcostofcapital

reducetheabruptnesswithwhichCFROIfadestowardsthecostofcapital.

Notethatthisisnodifferentfromananalysisoffirmvalueinthediscountedcashflowformatintermsof

cashflowsfromassetsinplace(increasecurrentCFROI),thelengthofthehighgrowthperiod(reducefade

speed)andthegrowthrateduringthegrowthperiod(keepexcessretur

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