Value Creation and Enhancement: Back to the Future
Stern School of Business
44 West Fourth Street
New York, NY 10012
In recent years, firms have turned to their attention increasingly to ways in which they can
increase their value. A number of competing measures, each with claims to being the "best"
approach to value creation, have been developed and marketed by investment banking firms
and consulting firms. In this paper, we begin with a generic discounted cash flow model,
and consider the ways in which value can be created or destroyed in a firm. We then look at
two of the most widely used value enhancement measures, Economic Value Added and
Cash Flow Return on Investment, and consider where these approaches yield similar
results to those obtained from traditional valuation models, and where (and why) there
might be differences. In conclusion, we show that there is little that is new or unique in
these competing measures, and while they might be simpler than traditional discounted cash
flow valuation, the simplicity comes at a cost that is substantial for high growth firms with
shifting risk profiles.
Financial theorists have long argued that the objective in decision making should be
to maximize firm value. Managers and practitioners have often criticized them for being too
single minded about value maximization and for not considering the broader aspects of
corporate strategy or the interests of other stakeholders. In the last decade, however,
managers seem to have come around to the view that value maximization should be, if not
the only, at least the primary objective for their firms. This turn-around can be partly
attributed to the frustration that many of them have felt with strategic consulting and its
failures, or partly to an increase in their ownership of equity in the firms that they manage.
Whatever the reason, the shift of focus to value maximization has created an opening for
investment bankers and consultants to offer their advice on the best ways to create value.
To exploit this opening and differentiate their offerings, firms have come up with
measures that they claim offer new insights into value enhancement. In some cases, these
measures have been promoted as needing less information than traditional approaches, and
in other cases, the claim is made that value is better estimated using these new measures. In
this paper, we return to basics. We begin with a generic model of value, where we relate
value to expected cash flows in the future and consider all of the potential routes that are
available for a firm to create value. In the process, we consider the interaction between
corporate finance and the other functional areas of the firm, as well as the role that
corporate strategy can play in value creation. We then look at two of the most widely used
value enhancement strategies,
Added(EVA) and its numerous imitators,
(CFROI) , and examine their roots in discounted cash
flow valuation. We consider how they are used in practice, and the potential limitations
with using each approach. We conclude with the arguments that there is little that is new,
unique or revolutionary in either of these approaches, and that the way in which they are
often used in practice leaves them open to abuse.
The Determinants of Value
The value of any asset is a function of the cash flows generated by that asset, the
life of the asset, the expected growth in the cash flows and the riskiness associated with the
cash flows. Building on one of the first principles in finance, the value of an asset can be
viewed as the present value of the expected cash flows on that asset.
where the asset has a life of N years and r is the discount rate that reflects both the riskiness
of the cash flows and financing mix used to acquire it. If we view a firm as a collection of
assets, this approach can be extended to value a firm, using cash flows to the firm over its
complicated by the fact that while some of the assets of a firm have already been made, and
are thus assets-in-place, a significant component of firm value reflects expectations about
future investments. Thus, to value a firm we need to measure not just the cash flows from
investments already made, but also estimate the expected value from future growth. In the
following section, we will consider some of the basic principles that should guide our
estimates of cash flows, growth and discount rates.
1 . Cash Flow to the Firm
The cash flow to the firm that we would like to estimate should be both after taxes and
after all reinvestment needs have been met. Since a firm includes both debt and equity
investors, the cash flow to the firm should be before interest and principal payments on
The cash flow to the firm can be measured in two ways. One is to add up the cash
flows to all of the different claim holders in the firm. Thus, the cash flows to equity
investors (which take the form of dividends or stock buybacks) are added to the cash flows
to debt holders (interest and net debt payments) to arrive at the cash flow. The other
approach to estimating cash flow to the firm, which should yield equivalent results, is to
estimate the cash flows to the firm prior to debt payments but after reinvestment needs have
EBIT (1 - tax rate)
The difference between capital expenditures and depreciation (net capital expenditures) and
the increase in non-cash working capital represent the reinvestments made by the firm to
generate future or contemporaneous growth.
Another way of presenting the same equation is to cumulate the net capital
expenditures and working capital change into one number, and state it as a percentage of
the after-tax operating income. This ratio of reinvestment to after-tax operating income is
called the reinvestment rate, and the free cash flow to the firm can be written as:
Note that the reinvestment rate can exceed 100%1, if the firm has substantial reinvestment
needs. If that occurs, the free cash flow to a firm will be negative even though after-tax
operating income is positive.
2 . Expected Growth
In valuation, it is the expected future cash flows that determine value. While the
definition of the cash flow, described in the last section, still holds, it is the forecasts of
earnings, net capital expenditures and working capital that will yield these cash flows. One
of the most significant inputs into any valuation is the
income. While one could use past growth or consider analyst forecasts to make this
1 In practical terms, this firm will have to raise external financing, either from debt or equity or both, to
cover the excess reinvestment.
estimate, the fundamentals that drive growth are simple. The expected growth in operating
income is a product of a firm's
, i.e., the proportion of the after-tax
operating income that is invested in net capital expenditures and changes in non-cash
working capital, and the
reinvestments , measured as the return on the
EBIT (1 - tax rate)
Both measures should be forward looking and the return on capital should represent the
expected return on capital on future investments. Having said that, it is often based upon
the firm's return on capital on assets in place, where the book value of capital is assumed to
measure the capital invested in these assets. Implicitly, we assume then that the current
accounting return on capital is a good measure of the true returns earned on assets in place,
and that this return is a good proxy for returns that will be made on future investments.
3 . Discount Rate
The expected cashflows need to be discounted back at a rate that reflects the cost of
financing these assets. The cost of capital is a composite cost of financing, that reflects the
costs of both debt and equity, and their relative weights in the financing structure:
where the cost of equity represents the rate of return required by equity investors in the
firm, and the cost of debt measures the current cost of borrowing, adjusted for the tax
benefits of borrowing. The weights on debt and equity have to be market value weights.
Without getting into the specifics of models of risk and return in finance, the cost of
equity should reflect the risk added on by an investment to a diversified portfolio and can
be measured with a beta (in the single-factor model) or betas.
4 . Asset Life
Publicly traded firms do not have finite lives. Given that we cannot estimate cash flows
forever, we generally impose closure in valuation models by stopping our estimation of
cash flows sometime in the future and then computing a terminal value that reflects all cash
flows beyond that point. A number of different approaches exist for computing the terminal
value, including the use of multiples. The approach that is most consistent with a
discounted cash flow model is one where we assume that cash flows, beyond the terminal
year, will grow at a constant rate forever, in which case the terminal value can be estimated
/ (Cost of Capital
where the cost of capital and the growth rate in the model are sustainable forever. It is this
fact, i.e., that they are constant forever, that allows us to put some reasonable constraints
on them. Since no firm can grow forever at a rate higher than the growth rate of the
economy in which it operates, the stable growth rate cannot be greater than the overall
growth rate of the economy. In the same vein, stable growth firms should be of average
risk . Finally, the relationship between growth and reinvestment rates that we noted earlier
can be used to generate the free cash flow to the firm in the first year of stable growth:
where the ROC is the return on capital that the firm can sustain in stable growth. In the
special case where ROC is equal to the cost of capital, this estimate simplifies to become the
Thus, in every discounted cash flow valuation, there are two critical assumptions we need
to make on stable growth. The first relates to when the firm that we are valuing will become
a stable growth firm, if it is not one already. The second relates to what the characteristics
of the firm will be in stable growth, in terms of return on capital and cost of capital.
5 . Bringing it All Together
In summary, then, to value any firm, we begin by estimating how long high growth
will last, how high the growth rate will be during that period and the cash flows during the
period. We end by estimating a terminal value and discounting all of the cash flows,
including the terminal value, back to the present to estimate the value of the firm. Figure 1
summarizes the process and the inputs in a discounted cash flow model.
This spreadsheet allows you to estimate the value of a firm, when there is the potential
for high growth for a period of time.
Figure 1: Firm Value
Cashflow to Firm
* Return on Capital
Firm is in stable growth:
Grows at constant rate
- Value of Debt
Cost of Equity
Cost of Debt
Based on Market Value
- No default risk
- No reinvestment risk
- Premium for average
- In same currency and
in same terms (real or
nominal as cash flows
A Framework for Value Creation
In this section, we will explore the requirements for an action to be value creating,
and then go on to explore the different ways in which a firm can go about creating value. In
the process, we will also examine the role that marketing decisions, production decisions
and strategic decisions have in value creation.
Value Creating and Value Neutral Actions
For an action to be value creating, it has to do one or more of the following:
flows generated by assets in place currently,
3. increase the
capital that is applied to discount the cash flows
Conversely, an action that does not do affect cash flows, the expected growth rate, the
length of the high growth period or the cost of capital cannot affect value.
While this might seem obvious, there are a number of value-neutral actions taken by
firms that receive disproportionate attention from both managers and analysts. Consider
splits change the number of units of equity in a firm but do
not affect cash flows, growth2 or value.
in inventory valuation and depreciation methods that
statements and do not affect tax calculations have no effect on
cashflows, growth or value.
3. When doing
acquisitions , firms often try to structure the deal in such a way that they
can pool their assets and not show the market premium paid in the acquisition. When
2 There are some who argue that a stock split may affect market perceptions of growth. This may be true
but real growth can be affected only by changes in the reinvestment rate or the return on capital.
they fail and they are forced to show the difference between market value and book
value as goodwill, their earnings are reduced by the amortization of the goodwill over
subsequent periods. This amortization is not tax deductible, however, and thus does
not affect the cash flows of the firm. Thus, whether a firm adopts purchase or pooling
accounting, and how long it takes to write off the goodwill do not really make any
difference to value.
Ways of Increasing Value
A firm can increase its value by increasing cash flows from current operations,
increasing expected growth and the period of high growth and by reducing its composite
cost of financing. In reality, however, none of these is easily accomplished and is likely to
reflect all of the qualitative factors that we are often accused of ignoring in valuation - the
quality of management, the strength of brand name, strategic decisions and good
1. Increase Cash Flows From Assets In Place
The first place to look for value is in the assets in place of the firm. These assets reflect
investments that have already been made by the firm and they generate the current operating
income for the firm. To the extent that these investments earn less than their cost of capital,
or are earning less than they could, if optimally managed, there is potential for value
1.1: Poor Investments: Keep, Divest or Liquidate
Every firm has some investments that can be categorized as poor investments, earning
less than what they need to make to break even (the cost of capital) and sometimes even
losing money. At first sight, it would seem to be a simple argument to make that
investments that do not earn their cost of capital should either be liquidated or divested. If,
in fact, one could get back the original capital on liquidation, this would be true, but that
assumption is not generally true. To see why, consider three different measures of value
for an existing investment. The first is the
, and reflects the present value
of the expected cash flows from continuing the investment through the end of its life. The
, which is the net cash flow that the firm will
receive if it terminated the project today. Finally, there is the
price that will be paid by the highest bidder for this investment.
Whether a firm should continue with an existing project, liquidate the project or sell
it to someone else will depend upon which of the three values- continuing, liquidating or
divestiture - is highest. If the continuing value is the highest, the firm should continue with
the project to the end of its life, even though it might be earning less than the cost of capital.
If the liquidation or divestiture value is higher than the continuing value, there is a potential
for an increase in value. The value increment can then be summarized below:
1.2: Improving Operating Efficiency
The operating efficiency of a firm plays a large role in determining its operating
margin and, thus, its operating income. If a firm can increase its operating margin on
existing assets, it will generate additional value. There are a number of indicators of this
potential, but the most important is a measure of how much a firm's operating margin
deviates from its peer group. Firms whose current operating margins are well below their
industry average have to start off with the presumption, at least, that there is a tangible
reason for the difference and try to "fix" it.
In most firms, this is the first leg of value enhancement and it takes the form of cost
cutting and layoffs. At the same time, note that these actions are value enhancing only if the
resources that are pruned are not contributing adequately either to current operating income
or to future growth. It is all too easy for companies, however, to show increases in current
operating income by cutting back on expenditures (such as research and training) that are
designed to create future growth.
1.3: Reducing the Tax Burden
The value of a firm is the present value of its after-tax cash flows. Thus, any action that can
reduce the tax burden on a firm, for a given operating income, will increase value. While
there are some aspects of the tax code that offer no flexibility to the firm, the tax rate of a
firm can be reduced over time by doing any or all of the following:
1. Multinational firms that generate earnings in different markets may be able to
locales to low-tax or no-tax locales.
2. A firm may be able to acquire
forwards that can be used to
shield future income. In fact, this might provide the rationale for a profitable firm
acquiring an unprofitable one.
3. A firm can use
management to reduce the
paid over time on income
because the marginal tax rate on income tends to rise, in most tax regimes, as income
increases. By using risk management to smooth income over time, firms can make their
income more stable and reduce their exposure to the highest marginal tax rates. This is
especially the case when there are windfall or supernormal profit taxes.
1.4: Reducing net capital expenditures on assets in place
The net capital expenditures refers to the
, and, as a cash outflow, it reduces the free cash flow to the firm. Part of
the net capital expenditure is designed to generate future growth, but part of is to maintain
assets in place. If a firm can reduce its net capital expenditures on assets in place, it will
increase value. During short periods, the capital expenditures can even be lower than
depreciation for assets in place, creating a cash inflow from net capital expenditures.
There is generally a trade off between capital maintenance expenditures and the life
of asset in place. A firm that does not make any capital expenditures on assets in place will
generate much higher after-tax cash flows from these assets, but the assets will have a far
shorter life. At the other extreme, a firm that reinvests all of the cash flows it gets from
depreciation back into capital maintenance may be able to extend the life of its assets in
place significantly. This trade-off, again, is often ignored when firms embark on cost
cutting and reduce or eliminate capital maintenance expenditures. While these actions
increase cash flows from assets in place in the current period, the firm might actually lose
value as it depletes these assets faster.
1.5: Reducing non-cash Working capital
The non-cash working capital in a firm can be measured as the difference between
non-cash current assets, generally inventory and accounts receivable, and the non-debt
portion of current liabilities, generally accounts payable. Since money invested in non-cash
working capital is tied up and cannot be used elsewhere; thus, increases in non-cash
working capital represent cash outflows, while decreases represent cash inflows. For
retailing firms and firms in the service industry, this item may be a much larger drain in
cash flows than traditional capital expenditures.
At first sight, the path to value creation seems simple. Reducing non-cash working
capital as a percent of revenues should increase cash flows, and therefore, value. This,
however, assumes that there are no negative consequences for growth and operating
income. Firms generally maintain inventory and provide credit because it allows them to
sell more. If cutting back on one or both results in lost sales, the net effect on value may be
The advent of technology and the availability of updated reliable data has made it
easier for firms to plan, and reduced the need for inventory and working capital. In fact, the
average non-cash working capital as a percent of revenues at major US corporations has
dropped from 17.6% in 1988 to 14.5% in 1998.
2. Increase Expected Growth
A firm with low current cash flows can still have high value if it is able to grow
quickly. As noted earlier, higher growth can come either from more reinvestment or a
higher return on capital. Higher growth does not always translate into higher value, since
the growth effect can be offset by changes elsewhere in the valuation. Thus, higher
reinvestment rates usually result in higher expected growth but at the expense of lower cash
flows, since reinvestment reduces the free cash flows. Higher returns on capital also cause
expected growth to increase, but value can still go down if the new investments are in
riskier businesses and there is a more than proportionate increase in the cost of capital.
2.1: Increase the reinvestment rate
The trade off from increasing the reinvestment rate is provided below. On the right,
we present the positive effect of reinvesting more, which is higher growth. On the left, we
measure the negative effect of reinvesting more, which is the drop in free cash flows:
Reduces free cash flow to firm:
Increases Expected Growth:
* ( 1- Reinvestment Rate)
Return on Capital Invested
One could work through the entire valuation and examine if the present value of the
additional cash flows created by higher growth is greater than the present value of the actual
reinvestments made, in cash flow terms. There is, however, a far simpler test that allows
us to determine the effect on value. Note that the net present value of a project measures the
value added by the project to overall firm value and that the net present value is positive
only if the internal rate of return on the project exceeds the cost of capital. If we make the
assumption that the accounting return on capital on a project is a reasonable proxy for the
internal rate of return3, then increasing the reinvestment rate will increase value if and only
if the return on capital is greater than the cost of capital. If the return on capital is less than
3 As we will see later in this paper, the internal rate of return converges on the return on capital as the
project life approaches infinity.
the cost of capital, the positive effects of growth will be more than offset by the negative
effects of making the reinvestment.
Note that the return on capital that we are talking about here is the marginal return
on capital, i.e., the return on capital earned on the actual reinvestment, rather than the
average return on capital. Given that firms tend to take projects in the order of their returns,
the average returns on capital will tend to be greater than the marginal returns on capital.
Thus, a firm with a return on capital of 18% and a cost of capital of 12% may really be
making only 11% on its marginal project. In addition, the marginal return on capital will be
much lower if the increase in the reinvestment rate is substantial. Thus, we have to be
cautious about assuming large changes in the reinvestment rate while keeping the current
return on capital constant.
2.2. Increase the Return on Capital
A firm that is able to increase its return on capital, while keeping the cost of capital
fixed, has found an undiluted value lever. The increase in growth will increase value, and
there are no offsetting effects. If, however, the increase in return on capital comes from the
firm entering new businesses that are far riskier than its existing business, there might be
an increase in the cost of capital that offsets the increase in growth. The general rule for
value creation remains simple, however. As long as the projects, no matter how risky they
are, have a marginal return on capital that exceeds the cost of capital, they will create value.
Using this comparison, firms that have returns on capital that are less than their cost
of capital can get an increase in value from improving their returns on capital, but they
would get an even greater increase in value by not investing at all and returning the cash to
the owners of the business. Liquidation or partial liquidation might be the most value
enhancing strategy for firms trapped in businesses where it is impossible to earn the cost of
2.3: Pricing Decisions, Return on Capital and Value Creation
The return on capital on a project or firm can be written as a function of its after-tax
operating margin and its turnover ratio.
By decomposing the return on capital into margin and turnover ratio components, we get
some insight into how product pricing decisions can be used to enhance value. When firms
increase prices for their products, they improve operating margins but reduce sales (and
turnover ratios). The extent to which revenues will drop will depend upon how elastic the
demand for the product is and how competitive the overall product market is.
Michael Porter4 suggests that when it comes to pricing strategy, there are two basic
routes a firm can take. It can choose to be a
leader , reducing price and hoping to
increase volume sufficiently to compensate. For this strategy to work, the firm needs a cost
advantage over its competitors, to prevent predatory pricing that may make all firms in the
sector worse off. Alternatively, it can attempt to be a
leader , increasing prices and
hoping that the effect on volume will be smaller. From a purely value maximization
standpoint, we can examine which approach yields the higher value and use that approach.
In doing so, however, it is critical that we not assume a static environment5 and consider
the actions that the firm's competitors would take in response to the firm's actions.
5 The effect of pricing actions on value are among the most difficult to analyze, because they are the most
likely to attract counter actions from competitors. Thus, a firm that reduces prices to increase turnover may
find its competitors cutting prices in response, and end up with lower margins and a lower turnover. (The
airlines in the late eighties are a good example)
2.4: Acquisitions and Value Creation
All too often, firms use one set of rules for investment projects and another set of
rules for acquisitions. In general, acquisitions are judged far more loosely than traditional
investments. From a valuation perspective, an acquisition is just a large-scale project. All of
the rules that apply to individual investments apply to acquisitions, as well. For an
acquisition to create value, it has to generate a higher return on capital, after allowing for
synergy and control factors, than the cost of capital.
Put another way, an acquisition will create value only if the present value of the
cash flows on the acquired firm, inclusive of synergy and control benefits, exceeds the cost
of the acquisitions. As noted earlier, a divestiture is the reverse of an acquisition, with a
cash inflow in the current period (from divesting the assets) followed by cash outflows
(i.e., cash flows foregone on the divested asset) in the future. If the present value of the
future cash outflows is less than the cash inflow today, the divestiture will increase value.
A fair-price acquisition or divestiture is value neutral.
It is worth noting that the track record on value creation from acquisitions is not
positive. Studies6 indicate that the return on capital, even on acquisitions that work, barely
exceed the cost of capital, and lags the cost of capital substantially for almost half the firms
in the sample. The odds of creating value from an acquisition strategy should improve
when there is a substantial potential for synergy and when the acquirer does not get into a
bidding war on the acquisition. Thus, a strategy of acquiring private firms, where the
potential synergies are much larger7 and the premium is not on top of market value, should
have better odds of success than a high-profile strategy of acquiring publicly traded
6 These studies include those done by practitioners such as McKinsey and KPMG, as well as some
academic studies that look at post-merger performance of firms relative to their peer group.
3. Lengthen the Period of High Growth
As noted above, every firm, at some point in the future, will become a stable growth
firm, growing at a rate equal to or less than the economy in which it operates. In addition,
growth creates value only if the return on investments exceeds the hurdle rate. Clearly, the
longer the high growth lasts, other things remaining equal, the greater the value of the firm.
Note, however, that no firm should be able to earn excess returns for any length of period
in a competitive product market, since competitors will be attracted by the excess returns
into the business. Thus, implicit in the assumption that there will be high growth, in
conjunction with excess returns, is also the assumption that there exist some barriers to
entry that prevent firms from earning excess returns for extended time periods.
Given this relationship between how long firms can grow at above-average rates and
the existence of barriers to entry, one way firms can increase value is by increasing existing
barriers to entry and coming up with new barriers to entry. Another way of saying the same
thing is to note that companies that earn excess returns have significant competitive
advantages. Nurturing these advantages can increase value.
3.1: The "Brand Name" Advantage
When doing valuation, we are often accused of ignoring intangible assets like brand
name value in coming up with the value for a firm. This is not true, since the inputs to the
traditional discounted cash flow valuation provides plenty of opportunity to consider the
effects of brand name. In particular, firms with more valuable brand names either are able
to under price the competition, and/or sell more than the competitors. They usually end up
with higher returns on capital, higher margins and much more value than their peer group.
Creating a brand name is a difficult, long term and expensive process, but firms can
often build on existing brand names and make them valuable. Conversely, the managers of
7 Private firms are much more likely to be capital-constrained and their owners tend to be undiversified.
Thus, a public firm can increase value substantially from synergy.
a firm who take over a valuable brand name and then dissipate its value, will reduce the
values of the firm substantially. Brand management and advertising can play a role in value
creation. Consider the extraordinary success that Coca Cola has had in increasing its market
value over the last two decades. While there are some who attribute its success to its high
return on equity or capital, they are missing the point. The return on equity and capital is
not the cause of their success, but the consequence of it. It can be traced to the company's
relentless focus on making its brand name more valuable globally8. In contrast, the near
death experience of Apple Computers in 1996 and 1997, and the travails of Quaker Oats
after the Snapple acquisition, suggest that managers can quickly squander the advantage
that comes from valuable brand names.
3.2: Patents, Licenses and Other Legal Protection
The second competitive advantage that companies can possess is a legal one. Firms
may enjoy exclusive rights to produce and market a product because they own the patent
rights on the product. This would be the case in the pharmaceutical and bio-technology
businesses. Alternatively, they may have exclusive licensing rights to service a market, as
is the case with utilities in the United States.
The key to value enhancement is to not just preserve but to increase any competitive
advantages that one possesses. If the competitive advantage that a firm has comes from its
existing patents, it has to work at coming up with new patents that can allow it to maintain
this advantage over time. While spending more money or research and development is
clearly one way, what we said earlier about the efficiency of reinvestment applies here as
well. The companies that will see the greatest increases in value are not necessarily the
companies that spend the most on R&D, but those who have the most productive R&D
8 Companies like Coca Cola and Levi Strauss have taken advantage of the global perception that they
represent American culture, and used it to grow strongly in other markets.
departments not only in generating patents but also in converting patents into commercial
The competitive advantage that comes from exclusive licensing or a legal monopoly
is a mixed blessing and may not lead to value enhancement. When a firm is granted these
rights by another entity, say the government, that entity usually preserves the right to
control the prices charged and margins earned through regulation. In the United States, for
instance, much of the regulation of power and phone utilities was driven by the objective of
ensuring that these firms did not earn excess returns. In these circumstances, firms may
actually gain in value by giving up their legal monopolies, if they get pricing freedom in
return. One can argue that this has already occurred, in great part, in the airline and long
distance telecommunications businesses, and will occur in the future in other regulated
businesses. In the aftermath, the firms that retain competitive advantages will gain value at
the expense of others in the business.
3.3: Switching Costs
There are some businesses where neither brand name nor patenting provides
adequate protection against competition. Products have short life cycles, competition is
fierce and customers develop little loyalty to companies or products. This was arguably the
case with the computer software business in the late eighties, and it still describes a
significant portion of that business today. How, then, in such a business did Microsoft
succeed so well in establishing its presence in the word processing, presentation and
spreadsheet markets? While many would attribute its success entirely to the fact that it
owned the operating system underlying the software, there is another reason. Microsoft
recognized earlier than most firms that the most significant barrier to entry in the software
business is the cost to the end-user of switching from one product to a competitor. In fact,
Microsoft Excel, early in its life, was impeded by the fact that most users, at that stage,
were using Lotus and did not want to bear the switching cost. In the last decade, Microsoft
has worked to make it easier for end-users to switch into their products (by allowing Excel
to open Lotus spreadsheets, for instance), and made it more and more expensive for them
to switch out. Thus, a user who has Microsoft Office installed on his or her system, who
wants to try to switch from Microsoft Word to WordPerfect has to run multiple gauntlets -
Will the conversion work well on the hundreds of Word files that exist already? Will he or
she still be able to cut and paste from Microsoft Excel and Power Point into Word
documents or not? The end result, of course, is that it becomes very difficult for
There are a number of other businesses where the switching cost concept can be
used to augment an argument for value enhancement or debunk it. To provide and example
of the latter, we remain wary of the capacity of companies like Yahoo and Excite to
continue to earn excess returns. These companies' primary product remain a search engine
for the internet, and there is little cost to an end-user from switching from one engine to
another, and no barriers to new search engines being developed. Unless these firms can
come up with a compelling strategy for increasing switching costs, assuming that growth
will continue for extended periods seems dangerous.
3.4: Cost Advantages
There are other potential barriers to entry that firms can use to enhance value. There
are a number of ways in which firms can establish a cost advantage over their competitors,
and use this cost advantage as a barrier to entry:
bigger firms advantages over smaller firms. This is the advantage, for instance, that the
Home Depot has used to gain market share at the expense of its smaller and often local
cost advantage over its competitors.
Southwest Airlines, with its non-unionized labor force, has an advantage over its
competitors, as do natural resource companies which have access to reserves that are
less expensive to exploit.
These cost advantages will show up in valuation in one of two ways: One is that the firm
with the cost advantage may charge the same price as its competitors, but have a much
higher operating margin. The other is that the firm may charge lower prices than its
competitors and have a much higher capital turnover ratio. In fact, the net effect of
increasing margins or turnover ratios or doing both will show up in the return on capital,
and through it in expected growth.
The cost advantage from economies of scale can be augmented by the fact that the
high capital requirements impede new firms from entering the business. In businesses like
aerospace and automobiles, the competition is almost entirely among existing competitors.
The absence of new competitors may allow these firms to maintain above-normal returns,
though the intra-firm competition will constrain how high returns get.
4. Reduce the cost of financing
The cost of capital for a firm was defined earlier to be a composite cost of debt and
equity financing. The cash flows generated over time are discounted back to the present at
the cost of capital. Holding the cash flows constant, reducing the cost of capital will
increase the value of the firm. In this section, we will explore the ways in which a firm may
bring its cost of capital down, or more generally, increase its firm value by changing both
financing mix and type.
4.1. Changing Operating Risk
The operating risk of a firm is a direct function of the kinds of products or services
it provides, and the degree to which these products are services are discretionary to the
customer. The more discretionary they are, the greater the operating risk faced by the firm.
Both the cost of equity and cost of debt of a firm are affected by the operating risk of the
business or businesses in which it operates. In the case of equity, only that portion of the
operating risk that is not diversifiable will affect value.
Firms can reduce their operating risk by making their products and services less
discretionary to their customers. Advertising clearly plays a role, but coming up with new
uses for a product/service may be another.
4.2: Reducing Operating Leverage
The operating leverage of a firm measures the proportion of its costs that are fixed.
Other things remaining equal, the greater the proportion of the costs of a firm that are fixed,
the more volatile its earnings will be, and the higher its cost of capital will be. Reducing the
proportion of the costs that are fixed will make firms much less risky and reduce their cost
This can be accomplished in a number of different ways:
4. By using outside contractors for some services; if business does not measure up, the
firm is not stuck with the costs of providing this service.
5. By tying expenses to revenues; in particular, with wage contracts tying wages paid to
revenues made will reduce the proportion of the costs that are fixed.
4.3: Changing the Financing Mix
The third approach to reducing the cost of capital is to change the mix of debt and
equity used to finance the firm. Debt is always cheaper than equity, partly because lenders
bear less risk and partly because of the tax advantage associated with debt. Taking on debt
increases the risk (and the cost) of both debt (by increasing the probability of bankruptcy)
and equity (by making earnings to equity investors more volatile). The net effect will
determine whether the cost of capital will increase or decrease if the firm takes on more
debt. This effect is illustrated in the following graph:
WACC AND FIRM VALUE AS A FUNCTION OF LEVERAGE
It is important to note, however, that firm value will increase as the cost of capital decreases
if and only if the operating cash flows are unaffected by the higher debt ratio. If, as the debt
ratio increases, the riskiness of the firm decreases, and this, in turn, affects the firm's
operations and cash flows, the firm value may decrease even as cost of capital declines. If
this is the case, the objective function when designing the financing mix for a firm has to be
restated in terms of firm value maximization rather than cost of capital minimization.
4.4: Changing Financing Type
The fundamental principle in designing the financing of a firm is to ensure that the
cash flows on the debt should match as closely as possible the cash flows on the asset.
By matching cash flows on debt to cash flows on the asset, a firm reduces its risk of
default and increases its capacity to carry debt, which, in turn, reduces its cost of capital,
and increases value.
Firm Value, Cash Flows on Debt and Default Risk
In the graph above, for instance, the firm has substantial debt but never runs the risk of
bankruptcy because the value of debt moves up and down with firm value. In fact, if the
same firm had used an equal amount of short term debt with fixed value to finance its
operations, it would have run a much higher risk of bankruptcy.
Firms that mismatch cash flows on debt and cash flows on assets (by using short
term debt to finance long term assets, debt in one currency to finance assets in a different
currency or floating rate debt to finance assets whose cash flows tend to be adversely
impacted by higher inflation) will end up with higher default risk, higher costs of capital
and lower firm value. To the extent that firms can use derivatives and swaps to reduce these
mismatches, firm value can be increased.
The Value Enhancement Chain
Looking at the spectrum of actions that firms can take to increase value, we can
categorize them on several levels. One is in terms of whether they affect cash flows from
assets in place, growth, the financing cost or the length of the growth period. There are two
other levels at which we can distinguish between actions that create value:
: There are very few
actions that increase value without any qualifiers. Among these would be the
divestitures of assets where the divestiture value exceeds the continuing value, and the
growth. Most actions have both positive and negative effects on value and it is the net
effect that will determine whether it is value enhancing. In some cases, the trade off is
largely determined by the firms and the odds are much better for value creation. An
example would be a firm changing its mix of debt and equity to reduce the cost of
capital. In other cases, however, the net effect on value will be a function of how
increase margins may not work as a value enhancement measure, if competitors react
and change prices as well.
: There are some actions that generate an immediate
increase in value. Among these we would include the divestiture and cost cutting
actions mentioned above. Many actions, however, are designed to create value in the
long term. Thus, building up brand name value is clearly positive for value creation in
the long term, but is unlikely to affect value today.
The following table summarizes a value enhancement chain, where actions that create value
are categorized both on how quickly they create value and how much control the firm has
over the value creation. Under the first column, titled "Gimmes", we have categorized
those actions where the firm has considerable control over the outcome and where the
payoff in terms of value creation is immediate. Under the second column, titled "Odds on",
we have included actions that are likely to create value in the near or medium term and
where the firm still continues to exercise significant control over the outcome. Under the
third column, titled "Might Work", we include actions that would create value in a static
environment, but might not if competitors react by matching or beating the firm.
The Value Enhancement Chain
Payoff in long term
1. Divest assets/projects with 1. Reduce net working capital 1. Change pricing strategy to
Assets in Place
requirements, by reducing
maximize the product of
profit margins and turnover
receivable, or by increasing
2. Move to more efficient
2. Reduce capital maintenance
technology for operations to
expenditures on assets in
expenses that generate no
revenues and no growth.
3. Reduce marginal tax rate
4. Take advantage of tax law to
increase cash flow
capital Increase reinvestment rate or
Increase reinvestment rate or
expenditures that are expected to marginal return on capital or
marginal return on capital or
earn less than the cost of capital
existing both in new businesses.
Length of High Growth Period
1. Build up brand name
services can be patented and advantages to create higher 2. Increase
protected, do so
return on capital.
switching from product and
reduce cost of switching to
Cost of Financing
1. Use swaps and derivatives 1. Change financing type and Reduce the operating risk of the
to match debt more closely
use innovative securities to firm, by making products less
reflect the types of assets
discretionary to customers.
2. Recapitalize to move the
firm towards its optimal 2. Use the optimal financing
3. Make cost structure more
flexible to reduce operating
Alternatives to the Traditional Valuation Model
The traditional discounted cash flow model provides for a rich and thorough
analysis of all of the different ways in which a firm can increase value, but it can become
complex, as the number of inputs increases. It is also very difficult to tie management
compensation systems to a discounted cash flow model, since many of the inputs need to
be estimated and can be manipulated to yield the results that one wants.
If we assume that markets are efficient, we can replace the unobservable value from
the discounted cash flow model with the observed market price, and reward or punish
managers based upon the performance of the stock. Thus, a firm whose stock price has
gone up is viewed as having created value, while one whose stock price goes down has
destroyed value. Compensation systems based upon the stock price, including stock grants
and warrants, have become a standard component of most management compensation
While market prices have the advantage of being updated and observable, they are
also noisy. Even if markets are efficient, stock prices tend to fluctuate around the true
value, and markets sometimes do make big mistakes. Thus, a firm may see its stock price
go up, and its top management rewarded, even as it destroys value. Conversely, the
managers of a firm may be penalized as its stock price drops, even though the managers
may have taken actions that increase firm value. The other problem with using stock prices
as the basis for compensation is that it cannot be disaggregated beyond the firm level.
Thus, it cannot be used to analyze the managers of individual divisions of a firm, and their
In the last decade, while firms have become more focused on value creation, they
have remained suspicious of market gyrations. While they might understand the notion of
discounted cash flow value, they are unwilling to tie compensation to a value that is based
upon dozens of estimates. In this environment, new mechanisms for measuring value that
are simple to estimate and use, do not depend too heavily on market movements, and do
not require a lot of estimation, find a ready market. The two mechanisms that seem to have
made the most impact are:
, and its variants, which measures the dollar surplus value
created by a firm on its existing investment, and
Investment , which measured the percentage return made by a
firm on its existing investments
Each approach has its proponents, and each is claimed to be an improvement on traditional
approaches. In this part of the paper, we look at each approach, how it is measured and the
links to traditional valuation. We also look at the conditions under which firms using these
approaches to judge performance and evaluate managers may end up making decisions that
are value-destroying rather than value-creating.
Economic Value Added
The economic value added is a measure of the dollar surplus value created by an
investment or a portfolio of investments. It is computed as the product of the "excess
return" made on an investment or investments and the capital invested in that investment or
investments. The excess return itself is defined as the difference between the return made
on the investment and the composite cost of financing that investment.
Looking at the definition of economic value added, there are three basic inputs that
we need for its computation - the return on capital earned on a investment, the cost of
capital for that investment and the capital invested in it.
a. Capital Invested
How much capital is there invested in an investment or investments? This question,
which may seem trivial at first sight, is not easy to answer at the level of individual
projects, especially when these projects have been on the books for long time periods. It
becomes even more difficult at the level of the firm, where projects tend to be aggregated
and expenses are allocated across them. One obvious solution may be to use the market
value of the firm, but market value includes capital invested not just in assets in place but in
expected future growth9. Since we want to evaluate the quality of assets in place, we need a
measure of the market value of just these assets.
Given the difficulty of estimating market value of assets in place, it is not surprising
that many analysts turn to the book value of capital as a proxy for the market value of
capital invested in assets in place. The book value, however, is a number that reflects not
just the accounting choices made in the current period, but also accounting decisions made
over time on how to depreciate assets, value inventory and deal with acquisitions. It is also
influenced by the accounting classification of expenses into operating and capital
expenditures, with only the latter showing up as part of capital.
The limitations of book value as a measure of capital invested has led analysts who
use EVA to adjust the book value of capital to get a better measure of capital invested.
Some of these adjustments include:
, but is designed to create income in future periods. An obvious example is
research and development expenses, which accounting standards in the United States
require be expensed, but which clearly are intended to generate future growth. The
9 As an illustration, computing the return on capital at Microsoft using the market value of the firm,
instead of book value, results in a return on capital of about 3%. It would be a mistake to view this a sign
of poor investments on the part of the firm's managers.
standard treatment is to capitalize research and development expenses10 and augment
the capital invested by this amount.
disguises . The
most common illustration of this is operating 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 compute the present value of lease
obligations and treat it as debt. From a financial standpoint, there is little difference in
terms of commitment to make payments between operating and capital leases.
Therefore, it does make sense to compute the present value of operating lease
commitments and treat them as debt, thus increasing capital invested.
. Here, we would consider one-time restructuring charges and
the amortization of goodwill. Though both actions reduce the book value of capital,
they do not reduce capital invested and should be added back. Similarly stock
buybacks11 have a disproportionate impact on book value of capital when market value
is well in excess of book value.
10 The easiest approach to capitalizing R&D expenses is to cumulate the expenses over time, and view the
cumulated amount as the "book value" of R&D. There are some in accounting, such as Baruch Lev at
NYU, who have suggested far better ways of dealing with expenses like R&D.
11 When firms buy back stock, the book value of equity is reduced by the market value of the buy back.
Thus, a firm with a price to book ratio of 10, that buys back 5% of its stock, can reduce its book value of
equity by 50%.
the premium paid on the acquisition. Thus, when pooling is used to account for a
merger, the book value of capital is usually augmented to reflect the price paid on the
acquisition and the premium12 over book value.
The book value of capital reflects the initial values at which equity and debt were
issued, any retained earnings since then and any stock buybacks or issues in the interim.
The older the firm, the more extensive the adjustments that have to be made to book value
of capital to get to a reasonable estimate of the market value of capital invested in assets in
place. Since this requires that we know and take into account every accounting decision
over time, there are cases where the book value of capital is too flawed to be fixable. Here,
it is best to estimate the capital invested from the ground up, starting with the assets owned
by the firm, estimating the market value of these assets and cumulating this market value.
This approach requires a substantial amount of private information, since firms generally
do not make available an inventory list of every asset that they own to outsiders, and may
be feasible only if one has access to that information either as a consultant to the firm or as
b. Return on Capital
Many of the issues that apply with capital invested also apply when measuring
return on capital. The conventional definition of return on capital uses after-tax operating
income and capital invested:
12 To be consistent with the notion that the capital invested should only measure investment in assets in
place, the portion of the premium that is paid for expected future growth potential in the acquired firm
should not be added on to arrive at capital invested.
The operating income that we would like to estimate would be the operating income made
by assets in place. The operating income, usually measured as earnings before interest and
taxes in an income statement, may not be a good measure of this, for several reasons:
There are some expenses, such as R&D expenses, that accountants treat as operating
expenses that are really designed to generate future growth. Reducing operating income
due to these expenses is in a sense unfair to the assets in place, since they do not benefit
from these expenses. The appropriate response is to consider operating income without
these expenses, while capitalizing R&D expenses13.
Making this adjustment for high-technology firms will drastically alter their return on
capital, reducing it in most cases considerably. While R&D expenses may be an
obvious example of an operating expense that is really a capital expenditure, there are
other expenses such as training and development that can be considered in the same
vein. Even more invidious is the fact that there might be expenses embedded in other
categories that are designed to create future growth.
are really disguised financial expenses. The example that we used in the previous
section, operating lease expenses, provides a simple case. To get an adjusted operating
income, we need to add back operating lease expenses to operating income.
Simultaneously, we need to estimate the present value of expected lease commitments
over time, and treat them as the equivalent of debt, which will increase capital invested
13 Once you have capitalized R&D, any new R&D increases this asset, but existing R&D will get
amortized over time, reducing it. The rate at which the R& D is amortized will be sector-specific and reflect
the rate at which the benefits of new R& D decay in the sector.
Operating Lease Adjusted
Value of Operating Lease Expenses)
These are two of many adjustments that need to be made to the accounting measure of
operating income to arrive at the corrected measure of operating income generated by assets
in place. The practitioners who use EVA claim to make many more14. While I would not
contest that claim, I would make two counter points. First, many of these adjustments are
at the margin and do not affect economic value added very much. Second, many of these
adjustments can be made only by someone who either works with the management of the
firm (as a consultant) or as an insider. External analysts who choose to use economic value
added have to accept the reality that their estimates of operating income can adjust only for
the variables (such as R&D and operating lease expenses) on which there is public
c. Cost of Capital
The third and final component needed to estimate the economic value added is the
cost of capital. There are two schools of thought when it comes to estimating the cost of
capital for this purpose. The first school argues that the cost of capital should be estimated
using book value weights for debt and equity, since the return on capital and capital
invested are measured in book value terms. This argument does not really hold up, for the
following reasons. First, note that it is not the book value of capital that we should really be
measuring in capital invested, but the market value of assets in place. When we think about
it in those terms, it is clear that using a book value cost of capital essentially is equivalent to
assuming that all debt is attributable to assets in place, and that all future growth comes
from equity. Put another way, if we adopted this rationale in valuation, we would discount
cash flows from assets in place at the book cost of capital, and all cash flows from expected
14 As an example, Bennett Stewart in his treatise on EVA, titled "Quest for Value" claims that Stern
Stewart makes as many as 164 adjustments to operating income to arrive at the EVA.
future growth at the cost of equity. Second, using a book value cost of capital for all
economic value added estimates, including the portion that comes from future growth, will
destroy the basis of the approach, which is that maximizing the present value of economic
value added over time is equivalent to maximizing firm value. Third, if changing capital
structure is one tool that can be used to increase economic value added, the mechanics work
far better if market value cost of capital is used rather than book value.
From a practical standpoint, using the book value cost of capital will tend to
understate cost of capital for most firms, and will understate it more for more highly
levered firms than for lightly levered firms. Understating the cost of capital will lead to
overstating the economic value added. Thus, rankings based on book value cost of capital
are biased against firms with less leverage, and biased towards firms with high leverage.
EVA and NPV: The Parallels
One of the foundations of investment analysis in traditional corporate finance is the
net present value rule. The net present value of a project, which reflects the present value of
expected cash flows on a project, netted against any investment needs, is a measure of
dollar surplus value on the project. Thus, taking projects with positive net present value
will increase the value of the firm, while taking projects with negative net present will
Economic value added is a throwback to the net present value rule. As we will see,
in the following simple proof, the present value of the economic value added by a project
over its life is the net present value of the project. To illustrate, consider a project with the
the end of which it is assumed to have a salvage value of SV . The project will have
depreciation of Depr in year t.
2. The project will generate earnings before interest and taxes in year t of EBIT and the
firm has a marginal tax rate of t.
3. The firm is assumed to have a cost of capital of kc
The net present value of this project can be written as follows:
Now consider an alternative investment that requires an initial investment of I, earns exactly
the cost of capital and allows for the entire investment to be salvaged at the end of the
project life of n years. The net present value of this project will be zero. Solving for I in
this case, we get:
Substituting this into equation (1), we get the net present value of the original project to be
Now assume that
1. the project has a salvage value of zero, and
2. that the present value of depreciation is equal to the present value of initial investment,
discounted back over the project life. In other words, assume that the cash flow from
depreciation is really the capital being returned to the firm.
Then, the net present value of this project can be simplified, and written as:
Thus, the net present value of the project is the present value of the economic value added
by that project over its life. Note, however, that when the salvage value is large and/or the
present value of depreciation tax benefits is greater than or lesser than the present value of
the capital invested, the present value of economic value added will not yield the correct15
net present value for the project.
EVA and DCF Value
The linkage between economic value added and net present value allows us to link
the value of a firm to the economic value added by it. To see this, let us begin with a simple
formulation of firm value in terms of the value of assets in place and expected future
Note that in a discounted cash flow model, the values of both assets in place and expected
future growth can be written in terms of the net present value created by each:
Assets in Place
Assets in Place
Future Projects, t
Substituting the economic value added version of net present value in equation (6) back into
this equation, we get:
t, Assets in Place
EVA t, Future Projects
Assets in Place
Thus, the value of a firm can be written as the sum of three components, the capital
invested in assets in place, the present value of the economic value added by these assets,
and the expected present value of the economic value that will be added by future
15 As an example, consider a thirty-year project with heavy infrastructure investments, using accelerated
depreciation for tax purposes. The net present value computed for this project using the economic value
added alone will understate the net present value, since the salvage value is likely to be large and/or the
present value of depreciation is likely to exceed the present value of capital invested.
Illustration 1: DCF Value and Economic Value Added
As a simple illustration, consider a firm that has assets in place in which it has
of 15% is expected to be sustained in the future, and the company has a cost of capital
2. At the beginning of each of the next 5 years, the firm is expected to make investments
capital, and the cost of capital is expected to remain 10%.
3. After year 5, the company will continue to make investments and earnings will grow
5% a year, but the new investments will have a return on capital of only 10%, which is
also the cost of capital.
4. All assets and investments are expected to have infinite lives16. Thus, the assets in place
and the investments made in the first five years will make 15% a year in perpetuity,
with no growth.
This firm can be valued using an economic value added approach as follows:
Capital Invested in Assets in Place
16 Note that this assumption is purely for convenience, since it makes the net present value easier to
Note that the present values are computed on the basis of the perpetuity assumption. In
additon, the present value of the economic value added by the investments made in future
years are discounted back to the present, using the cost of capital. To illustrate, the present
value of the economic value added by investments made at the beginning of year 2 is
using equation (7) as follows:
t, Assets in Place
EVA t, Future Projects
Assets in Place
Another way of presenting these results is in terms of Market Value Added (MVA).
The market value added, in this case, is the difference between the firm value and the
return on capital is greater than the cost of capital, and will be an increasing function of the
spread between the two numbers. Conversely, the number will be negative if the return on
capital is less than the cost of capital.
Note that the while the firm continues to grow in operating income terms and take
new investments after the fifth year, these marginal investments create no additional value
because they earn the cost of capital. A direct implication is that it is not growth that creates
value, but growth in conjunction with excess returns. This provides a new perspective on
the quality of growth. A firm can be growing its operating income at a healthy rate, but if it
is doing so by investing large amounts at or below the cost of capital, it will not be creating
value and may actually be destroying it.
This firm could also have been valued using a traditional discounted cash flow
model, with free cashflows to the firm discounted back at the cost of capital. The following
table summarizes expected free cash flows and the firm value, using the cost of capital of
10% as the discount rate. In looking at this valuation, note the following:
4. The capital expenditures occur at the beginning of each year, and thus are shown in the
investment in year 1 and so on.
5. In year 5, the net investment needed to sustain growth is computed by using two
and that the return on capital on new investments starting in year 6 (which is shown in
year 5) would be 10%.
The value of the firm obtained by discounting free cash flows to the firm at the cost
Firm Value using DCF Valuation
EBIT (1-t) from Assets in Place
EBIT(1-t) from Investments- Yr 1
EBIT(1-t) from Investments- Yr 2
EBIT(1-t) from Investments -Yr 3
EBIT(1-t) from Investments - Yr 4
EBIT(1-t) from Investments- Yr 5
- Net Capital Expenditures
PV of Terminal Value
Return on Capital
Cost of Capital
Implication of this Valuation
There are several implications that flow from the fact that the value of a firm can be
written in terms of the present value of the economic value added by both projects in place
and expected future projects.
1. The first is good news for those who are proponents of economic value added. A
policy of maximizing the present value of economic value added over time is equivalent
to a policy of maximizing firm value, and is thus consistent with traditional corporate
2. The second implication, however, is that the notion that the economic value added
approach requires less information than a discounted cash flow valuation, or that it
provides a better estimate of value is false. The economic value added approach, done
right, should yield the same value as a DCF valuation, and it requires
, not less. To see why, consider the valuation of the firm in illustration 1.
The discounted cash flow valuation required cash flows and a discount rate to arrive at
a value. The economic value added approach requires these inputs and an additional one
- the capital invested in the firm. It uses this measure to then break firm value up into
capital invested and economic value added components. Note that changing the capital
invested number has no impact on overall value.
3. It is often claimed that the economic value added valuations provide us with fresh
insights on value enhancement because of its focus on excess returns, defined in terms
of return and cost of capital. A discounted cash flow model where growth is linked to
the reinvestment rate and the return on investments accomplishes the same objectives
and arrives at the same results.
eva.xls: This spreadsheet allows you to convert a discounted cash flow valuation into
an EVA valuation, and vice versa.
EVA in Practice
In the last decade, we have seen a number of converts among corporations to
economic value added. Without debating, at this stage, whether the companies have in fact
gained value by doing so, it is worth noting the way in which economic value added has
been put in practice at these firms
1. Most firms that have adopted economic value added as their value enhancement
measure have also tied management compensation, often at all levels, to it. Some firms
have made it the sole basis for compensation, while others continue to augment it with
other compensation schemes, including stock grants and options.
2. The firms that use economic value added to judge success or failure still measure it
looking at year to year changes rather than in terms of the present value of economic
value added over time. In some firms, the reward is simply based upon delivering an
economic value added next year that is greater than this year's number. In other firms,
managers are rewarded only if they beat the expected economic value added, rather than
last year's economic value added. In almost no case is the reward based upon the
present value of economic value added over time. While one can see the reasons for not
considering expected economic value added, which are subjective estimates, this does
create a significant potential for abuse, as we will see in the next section.
3. Firms that have converted to economic value added have done so not just at the firm
level, but also at the level of individual divisions and sub-divisions within the firm.
Thus, the success or failure of an employee is often measured by the economic value
added by the unit to which this employee is most closely connected. While this clearly
makes sense from a corporate finance perspective, it makes the estimation problems we
referred to in our earlier section much greater.
There is another group of converts to economic value added. These include equity
research analysts and portfolio managers, who view economic value added as a way of
earning excess returns. Here, the practice is still much more primitive. First, many of these
users have far less information than those in the first group. Firms that adopt economic
value added, and their consultants, can use internal information to augment public
information and arrive at better estimates. Portfolio managers or equity research analysts
often have to work with just public information and make rough adjustments to arrive at
noisier estimates of economic value added. Second, the year-to-year comparisons among
these users still seem to simply compare this year's economic value added to last year's
number, and conclude that increases in economic value added are good news for investors
while decreases are bad news. As we will see in a subsequent section, this can be a
dangerous assumption to make.
EVA and Firm Value: Potential Conflicts
Assume that a firm adopts economic value added and decides to judge managers
based upon their capacity to generate greater-than-expected economic value added. What is
the potential for abuse? Is it possible for a manager to deliver greater than expected
economic value added, while destroying firm value at the same time? If so, how can we
protect against these practices? These are the questions that we would like to consider in
this section. To answer these questions, let us go back to equation (7), where we
decomposed firm value into capital invested, the present value of economic value added by
assets in place and the present value of economic value added by future growth.
t, Assets in Place
EVA t, Future Projects
Assets in Place
The Capital Invested Game
The first two terms in the equation above, the capital invested and the present value
of economic value added by these investments, are both sensitive to how capital invested is
measured. If capital invested is reduced, keeping the operating income constant, the first
term in the equation will drop but the present value of economic value added will increase
proportionately. To illustrate, consider the firm that we valued in illustration 1. Assume that
investments remain unchanged. The firm value can then be written as:
Capital Invested in Assets in Place
The value of the firm is unchanged, but the value is redistributed to the economic value
added component. When managers are judged based upon the economic value added, there
will be strong incentives to keep the capital invested down.
There are some actions that managers take to reduce capital invested that can be
truly value creating. Thus, in the above example, if the reduction in capital invested came
from closing down a plant that was not (and does not expect to) generate any operating
are some actions, however, that are purely cosmetic in terms of their effects on capital
invested and thus do not create and may even destroy value. Among these I would include:
periods : The most egregious examples of
these are large one-time restructuring charges, which result in large negative operating
incomes and declines in book value of capital. To the extent that these actions are
transparent, the economic value added and capital invested can be corrected to reflect
the real values.
most meticulous measurers of economic value added have to specify the way in which
capital invested is measured for economic value added purposes. While the managers
who are measured on economic value added may not be able to control how much
capital they are assigned in the initial iteration, they can play the game to reduce capital
invested in future periods. As an example, assume that the capital invested includes the
present value of operating lease expenses as a component of capital, but that this
present value is consistently lower than the attributed capital invested when the same
asset is purchased. Over time, we should not be surprised to see more assets being
leased rather than bought. The response on the part of the measurer is to create new
rules and methods to fight the game playing, but the irony is that the game playing
becomes easier and more prevalent as the number of rules increases.
To illustrate the potential value destructiveness of this approach, assume that the
managers of the firm in illustration 1 are able to replace half of the assets that they own
now with leased assets. Assume further that the estimated capital invested in these
The value of the firm can now be written as:
Capital Invested in Assets in Place
Firms : When economic value added is estimated
for divisions, the capital invested at the divisional level is a function of a number of
allocation decisions made by the firm. A significant component of the allocation will be
based upon rules devised by the firm. While we would like these rules to be objective
and unbiased, they are often subjective and over allocate capital to some divisions and
under allocate capital to others. If this misallocation were purely random, we could
accept this as noise and use changes in economic value added to measure success.
Given the natural competition that exists among divisions in a firm for the marginal
investment dollar, however, these allocations are also likely to reflect the power of
individual divisions to influence the process. Thus, the economic value added will be
over estimated for those divisions that are under allocated capital, and under estimated
for divisions that are over allocated capital.
The Future Growth Game
The value of a firm is the value of its assets in place and the value of its future
growth prospects. When managers are judged on the basis of economic value added in the
current year, or on year-to-year changes, the economic value added that is being measured
is just that from assets in place. Thus, managers may trade off the economic value added
from future growth for higher economic value added from assets in place.
Again, this point can be illustrated simply using the firm in illustration 1. The firm,
in that example, earned a return on capital of 15% on both assets in place and future
investments. Assume that there are actions that the firm can take to increase the return on
capital on assets in place to 16%, but that this action reduces the return on capital on future
investments to 12%. The value of this firm can then be estimated as follows:
Capital Invested in Assets in Place
Note that the value of the firm has decreased, but the economic value added in year 1 is
higher now than it was before. In fact, the economic value added at this firm for each of the
next five years is graphed below for both the original firm and this one.
Annual EVA: With and Without Growth Trade Off
EVA (Growth Trade Off)
The growth trade off, while leading to a lower firm value, results in economic value added
in each of the first three years that is larger than it would have been without the trade off.
Practitioners who use economic value added would respond with the contention that
the compensation mechanism can be designed to punish managers who do this trade off.
For instance, managers at some firms that adopt economic value added are compensated
partially based upon the economic value added this year, but another part is held back in a
compensation bank and is available to the manager only after a period (say three or four
years). Thus, managers who increase the current economic value added at the expense of
future growth can be punished. There are significant limitations with these approaches.
First, the limited tenure that managers have with firms implies that this measure can at best
look at economic value added over the next 3 or 4 years. The real costs of the growth trade
off are unlikely to show up until much later. Second, while these approaches are really
designed to punish managers who increase economic value added in the current period
while reducing economic value added in future periods. In the more subtle case, where the
economic value added continues to increase but at a rate lower than it otherwise would
have, it is difficult to devise a punishment for managers who trade off future growth. In the
example, above, for instance, the economic value added with the growth trade off increases
over time. The increases are smaller than they would have been without the trade off, but
that number would not have been observed anyway.
The Risk Shifting Game
The value of a firm is the sum of the capital invested and the present value of the
economic value added. The latter term is therefore not just a function of the dollar economic
value added but also of the cost of capital. A firm can take actions that increase its economic
value added, but still end up with a lower value, if these actions increase its operating risk
and cost of capital.
Again, using the same firm used in illustration 1, assume that the firm is able to
increase its return on capital on both assets in place and future investments from 15% to
16.25%. Simultaneously, assume that the cost of capital increases to 11%. The economic
value added in each year for the next five years by this firm is contrasted with the original
economic value added in each year in the following figure:
EVA: Higher Risk and Return
While the economic value added in each year is higher with the high risk strategy, the value
of the firm is as follows:
Capital Invested in Assets in Place
Note that the risk effect dominates the higher excess dollar returns, and the value of the
The consequences of this are dangerous for firms that adopt economic value added
based objective functions. When managers are judged based upon year-to-year economic
value added changes, there will be a tendency to shift investments into riskier investments.
This tendency will be exaggerated if the cost of capital does not reflect the changes in risk
In closing, economic value added is an approach that is skewed towards assets in
place and away from future growth. It should not be surprising, therefore, that when
economic value added is computed at the divisional level of a firm, the higher growth
divisions end up with the lowest economic value added, and in some cases with negative
economic value added. Again, while these divisional managers may still be judged based
upon changes in economic value added from year to year, the temptation at the firm level to
reduce or eliminate capital invested in these divisions will be strong, since it will make the
EVA and Market Value
As we noted earlier, there is new group of converts to economic value added that
numbers among it equity research analysts and portfolio managers. They want to use
economic value added as a tool for finding undervalued assets and earning excess returns.
In addition to all of the issues that we raised in the last section, there are additional
problems that arise when economic value added is used as an investment tool.
Noise in Estimates
and portfolio managers) depend almost entirely on publicly available information. This is in
contrast to estimates made by managers and their consultants, where internal information
can be used to refine and better the estimate. Thus, the adjustments made to book value to
17 In fact, beta estimates that are based upon historical returns will lag changes in risk. With a five-year
return estimation period, for instance, the lag might be as long as three years and the full effect will not
show up for five years after the change.
arrive at capital invested and to operating income to estimate return on capital tend to be
fairly crude and the resulting estimates reflect this.
The Effect of Expectations
There is a second and far more serious problem with using economic value added
as an investment tool. While an increase in economic value added will generally lead to an
increase in firm value, barring the growth and risk games described earlier, it may or may
not increase the stock price. This is because the market value has built into it expectations
of future economic value added. Thus, a firm like Microsoft is priced on the assumption
market value increases or decreases on the announcement of higher economic value added
will depend in large part on what the expected change in economic value added was. For
mature firms, where the market might have expected no increase or even a decrease in
economic value added, the announcement of an increase will be good news and cause the
market value to increase. For firms that are perceived to have good growth opportunities
and were expected to report an increase in economic value added, the market value will
decline if the announced increase in economic value added does not measure up to
expectations. This should be no surprise to investors who have recognized this
phenomenon with earnings per share for decades; the earnings announcements of firms are
judged against expectations, and the earnings surprise is what drives prices.
We would therefore not expect there to be any correlation between the magnitude of
the economic value added and stock returns, or even between the change in economic value
added and stock returns. Stocks that report the biggest increases in economic value added
would not necessarily be good investments18. These priors are confirmed by a study done
by Richard Bernstein at Merrill Lynch, who examined investment strategies based on both
added earned an annual return on 12.9% between February 1987 and February 1997,
while the S&P index returned 13.1% a year over the same period.
over the previous year earned an annual return of 12.8% over the same time period.
While neither of these findings are surprising given our earlier discussion, they should
give those who want to use economic value added as an investment tool pause. There are
those who have criticized this study on measurement issues, i.e., on whether the economic
value added at these companies was estimated correctly, but they are missing the point. As
long as expected changes are not considered, this approach is doomed to failure. In contrast
to earnings per share, however, there is no simple database like Zacks or IBES that can be
used to generate expected values.
Is there a way in which economic value added could be used as an investment tool?
The only way to do it, in my view, is to build up a model for estimating expected economic
value added. This model would have a time-series component as well as measures of the
fundamentals that we argued were responsible for firms being able to maintain excess
returns over long periods. Of course, this would mean bringing in many of the subjective
judgments that traditional valuation models claim to make that proponents of economic
value added have found objectionable.
18 A study by Kramer and Pushner found that differences in operating income (NOPAT) explained
differences in market value better than differences in EVA.
19 See Quantitative Viewpoint, Merrill Lynch, December 19, 1997.
The Bottom Line on EVA
The evolution of EVA from a measure of performance to the magic bullet that can
make a company's stock price go up is testimony to our capacity to take good products and
oversell them. Fundamentally, economic value added is a sound measure. By focusing
attention on "surplus" value, it does bring home the point out that it is not how much
income a firm makes that marks its success, but how much it makes in excess of its dollar
financing costs. By making this measure an absolute measure, rather than a percentage
spread, it helps firms recognize that turning away projects that earn more than their cost of
capital, just because they earn a smaller spread than do existing projects can be value
destroying. In fact, with relatively few assumptions, we have shown that an objective of
maximizing economic value added is equivalent to the traditional objective of maximizing
If the proponents of economic value added stopped at this point, I would have no
disagreements with them. There are some, who in the process of selling the measure, go
well beyond these claims. In the following section, I list out a series of claims about
economic value added that are fundamentally false:
that economic value added is either new or revolutionary flies in the face of history and
corporate financial theory. EVA is just net present value presented differently. There is
little in the measure that can claim to be original other than its name.
: Much of the selling of EVA has
been built on the premise that unlike its competitors, such as earnings per share or
return on equity, economic value added is not an accounting measure. In truth,
economic value added is very dependent upon accounting measures of operating
income and capital invested, though adjustments are made to both.
20 See Quantitative Viewpoint, Merrill Lynch, February 3, 1998
investment : This is
clearly untrue, if economic value added is computed based upon capital invested in an
asset rather than its current market value. To illustrate, assume that you bought a
building is a poor investment, since it earns less than its cost of capital and the firm
would be better off selling it.
statement might be true if the only alternatives to using economic value added were
accounting return measures and simple cash flow approaches (like payback). If the
alternative is net present value, using EVA does not result in better investment
decisions. In fact, since net present value is the more general approach, it is EVA that is
likely to lead to errors on project choice.
: As we illustrated in an earlier section, discounted cash flow
valuation and economic value added should yield the same firm values, as long as the
assumptions made are consistent across the approaches.
: This is clearly false. Valuing a firm using EVA requires more
information than discounted cash flow models, not less. To the argument that users of
discounted cash flow models have to make assumptions about terminal value, and those
who use EVA do not, the response is that they both require that we make assumptions
about reinvestment rates, return on capital and cost of capital in stable growth. In fact,
the terminal value in a firm valuation model can be written as:
EBIT (1- t) (1 - Reinvestment Rate)
In the special case where the return on capital is equal to the cost of capital in stable
growth, the terminal value calculation simplifies to the following:
added generated by them. Thus, a firm could be generating a positive economic value
added in the current year from assets, but the expected economic value added in future
years may be negative, making these assets poor investments. Conversely, you can
have a firm generating negative economic value added in the current year, but the assets
could still be value creating if the present value of expected future economic value
added is positive.
: The MVA as shown earlier is nothing more than the
present value of the surplus value. While EVA and MVA are highly correlated, so are
market to book ratios and returns on capital and price to book ratios and returns on
equity. In short, this is a truism that applies anytime you look at ratios of market value
to book value.
might have done so by trading off against future growth or increasing its riskiness. If it
did so, the firm value can decrease even as EVA increases.
: Since the economic value added is defined as the
excess of earnings over the cost of capital, it is often argued that it is a risk adjusted
measure. Thus, it is argued that a firm that increases EVA, even with higher risk,
should be more valuable. The problem with this argument is that while EVA may be
risk-adjusted, it still has to be discounted back to the present to arrive at firm value.
Consequently, a firm which posts higher EVA numbers while increasing its operating
risk and cost of capital, may reduce its value.
For a firm to increase market value, the reported increase in EVA has to be greater than
expected. Thus, a firm that was expected to increase EVA by 30% will see its market
value go down if EVA increases by only 20%.
income : Though this statement is often
backed up by empirical results by backers of EVA, the results are actually mixed. Even
the studies that claim to show a correlation between increases in EVA and increases in
stock prices find very low correlations, and there are several independent studies that
indicate almost no correlation between EVA and stock returns21.
Cash Flow Return on Investment
The cash flow return on investment attempts to measure the expected return on an
investment, using its cash flows and considering the time value of money. In other words,
it a modified version of internal rate of return, designed for investments that have already
been made. In the form in which it is used by its proponents, the CFROI for a firm is
good, neutral or poor investments. To enhance its value then, a firm should increase the
spread between its CFROI and its cost of capital.
21 See the Merrill study referred to earlier in the paper, as well as a paper by Bacidore et al. in the Financial
Analysts Journal, May-June 1997.
The cash flow return on investment for a firm is calculated using four inputs. The
(GI) that the firm has in its assets in place. This is computed by
adding back depreciation to the net asset value to arrive at an estimate of the original
investment it the asset. In addition, non-debt liabilities and intangible assets such as
goodwill are netted out. Finally, the gross investment is converted into a current dollar
value to reflect inflation that has occurred since the asset was purchased.
The second input is the
(GCF) earned in the current year on that
asset. This is usually defined as the sum of the after-tax operating income of a firm and the
non-charges against earnings, such as depreciation and amortization. The operating income
is adjusted for operating leases and any accounting effects, much the same way that it was
adjusted for to compute economic value added.
The third input is the
(n) in place, at the time of the
original investment, which varies from sector to sector but reflects the earning life of the
investments in question. The
(SV) at the end of this life, in
current dollars, is the final input. This is usually assumed to be the portion of the initial
investment, such as land and buildings, that is not depreciable, adjusted to current dollar
The CFROI is the internal rate of return of these cash flows, i.e, the discount rate
that makes the net present value of the gross cash flows and salvage value equal to the
gross investment, and can thus be viewed as a composite internal rate of return, in current
assets in place are value creating or value destroying. The real cost of capital can be
estimated using the real costs of debt and equity, and market value weights for debt and
To illustrate, consider a firm with the following characteristics. The assets on its
remaining life of 7 years and 25% of the assets are non depreciable. The accumulated
To estimate the CFROI,
The CFROI based upon these inputs is 11.71%. This can then be compared to the real cost
of capital to evaluate whether the firm's asset are value creating.
An alternative formulation of the CFROI allows for setting aside an annuity to cover
the expected replacement cost of the asset at the end of the project life. This annuity is
called the economic depreciation and is computed as follows:
Replacement Cost in Current dollars (k )
Where n is the expected life of the asset and the expected replacement cost of the asset is
defined in current dollar terms to be the difference between the gross investment and the
salvage value. The CFROI for a firm or a division can then be written as follows:
Gross Cash Flow - Economic Depreciation
In the example above, for instance, assuming a real cost of capital of 8%, the economic
depreciation could be estimated as follows:
The CFROI can then be calculated as follows:
The differences in reinvestment rate assumptions account for the difference in CFROI
estimated using the two methods. In the first approach, intermediate cash flows get
reinvested at the internal rate of return, while in the second, at least the portion of the cash
flows that are set aside for replacement get reinvested at the cost of capital. In fact, if we
estimated that the economic depreciation using the internal rate of return of 11.71%, the
two approaches would yield identical results22.
CFROI and IRR
If net present value provides for the genesis for the economic value added approach
to value enhancement, the internal rate of return is the basis for the CFROI approach. In
investment analysis, the internal rate of return on a project is computed using the initial
Where the ATCF is the after-tax cash flow on the project, and SV is the expected salvage
value of the project assets. This analysis can be done entirely in nominal terms, in which
case the internal rate of return is a nominal IRR and is compared to the nominal cost of
capital, or in real terms, in which case it is a real IRR and is compared to the real cost of
At first sight, the CFROI seems to do the same thing. It uses the gross investment
(in current dollars) in the project as the equivalent of the initial investment, assumes that the
gross current-dollar cash flow is maintained over the project life and computes a real
internal rate of return. There are, however, some significant differences.
assets do not increase over time. This may be reasonable for investments in mature
markets, but will understate project returns if there is real growth. It should be noted,
however, that the CFROI approach can be modified to allow for real growth.
upon incremental cash flows in the future. It does not consider cash flows that have
tries to reconstruct a project or asset, using both cash flows that have occurred already
and cashflows that are yet to occur. To illustrate, consider the project described in the
previous section. At the time of the original investment, assuming that the inputs for
initial investment, after-tax cash flows and salvage value are unchanged, both the
internal rate of return and the CFROI of this project would have been 11.71%. The
CFROI is, however, being computed three years into the project life and remains at
11.71%, since none of the original inputs have changed. The IRR of this project will
change, though. It will now be based upon the current market value of the asset, the
expected cash flows over the remaining life of the asset and a life of seven years. Thus,
on this project would be computed to be only 6.80%.
Given the real cost of capital of 8%, this would mean that the CFROI is greater than the
cost of capital, while the internal rate of return is lower. Why is there the difference
between the two approaches and what are the implications? The reason for the
difference between the CFROI and the IRR can be traced to the fact that IRR is always
forward looking while CFROI is not. The implications are profound. A CFROI that
exceeds the cost of capital is usually considered a sign that a firm is deploying its assets
well, but that might not be true. If the IRR is less than the cost of capital, that
interpretation is false, since the owners of the firm would be better off selling the asset
and getting the market value for it rather than continue its operation.
CFROI and DCF Value
To link the cash flow return on investment with firm value, let us begin with a
simple discounted cash flow model for a firm in stable growth:
Note that this can be rewritten, approximately, in terms of the CFROI as follows:
requirements. If we assume a 10% cost of capital, a 40% tax rate and a 5% stable growth
rate, it would be valued as follows:
More important than the mechanics, however, is the fact that firm value, while a function of
Again, sophisticated users of CFROI do recognize the fact that value comes not just
from the CFROI on assets in place but also on future investments. In fact, Holt Associates
and BCG both allow for a fade factor in CFROI, where the current CFROI fades towards
the real cost of capital over time. The "fade factor" is estimated empirically by looking at
firms in different CFROI classes and tracking them over time. Thus, a firm that has a
current CFROI of 20% and real cost of capital of 8% will be projected to have lower
CFROI over time. The value of the firm, in this more complex format, can then be written
as a sum of the following:
which can be written as
aip * GIaip
, where CFROI
is the CFROI on assets in
place, GI is the gross investment in assets in place and k is the real cost of capital.
written in real terms as
Thus, a firm's value will depend upon the CFROI it earns on assets in place and both the
abruptness and the speed with which this CFROI fades towards the cost of capital. Thus, a
firm can potentially increase its value by doing any of the following:
Note that this is no different from our earlier analysis of firm value in the
discounted cash flow format in terms of cash flows from assets in place (increase current
CFROI), the length of the high growth period (reduce fade speed) and the growth rate
during the growth period (keep excess returns from falling as steeply).
CFROI and Firm Value: Potential Conflicts
The relationship between CFROI and firm value is less intuitive than the
relationship between EVA and firm value, partly because it is a percentage return.
Notwithstanding this fundamental weakness, the games that managers can play, when their
performance is judged on the basis of the CFROI are similar to those noted in our
discussion of economic value added.
1. Reduce Gross Investment: The first is the capital game, where the CFROI is increased
while the gross investment is reduced. Since it is the product of the two that drives
value, it is possible for a firm to increase CFROI and end up with a lower value. In the
example above, for instance, raising the CFROI to 40% while reducing the gross
firm. Thus, managers of firms judged on the basis of CFROI will do everything in their
power to keep the gross investment as small as possible.
2. Sacrifice Future Growth: CFROI, even more than EVA, is focused on assets in place
and does not look at future growth. To the extent that managers increase CFROI at the
expense of future growth, the value can decrease while CFROI goes up. This is
because the effects of the growth sacrifice are likely to be observed in the fade factor,
and unless this can be precisely estimated and compared to what it should have been,
the growth game will continue to be paid.
3. The Risk Trade Off: While the CFROI is compared to the cost of capital to pass
judgment on whether a firm is creating or destroying value, it represents only a partial
correction for risk. The value of a firm is still the present value of expected future cash
flows. Thus, a firm can increase its spread between the CFROI and cost of capital, but
still end up losing value if the present value effect of having a higher cost of capital
dominates the higher CFROI.
In general, then, an increase in CFROI, by itself, does not indicate that the firm value has
increases, since it might have come at the expense of lower growth and/or higher risk.
CFROI and Market Value
There is a relationship between CFROI and market value, with firms with high
CFROI generally having high market value. This is not surprising, and mirrors what we
noted about economic value added earlier. In investing, however, it is changes in market
value that create returns, not market value per se. On this score, the relationship tends to be
much weaker. Since market values reflect expectations, there is no reason to believe that
firms that have high CFROI will earn excess returns.
The relationship between changes in CFROI and excess returns is more intriguing.
To the extent that any increase in CFROI is viewed as a positive surprise, firms with the
biggest increases in CFROI should earn excess returns. In reality, however, the actual
change in CFROI has to be measured against expectations; if CFROI increases, but less
than expected, the market value should drop; if CFROI drops but by less than expected, the
market value should increase.
The Bottom Line on CFROI
There are some firms with significant capital rationing constraints, where it is
critical that investments be directed to those projects where they earn the highest possible
returns for the firm. For these firms, it can be argued that value added measures that focus
on dollar value may lead to a misallocation of resources, since they implicitly assume that
there is sufficient capital to take on all good projects. Using a percentage rate of return
allows these firms to get the maximum return from limited capital. It is not clear, however,
that CFROI is a significant advance over even traditional accounting measures such as ROE
or ROC. Let us consider some of its stated advantages:
1. It is claimed that unlike accounting return measures and even EVA, CFROI focuses on
cash flows. This is partially true, since non-cash charges are added back to arrive at the
gross cash flow, but the cash flow used in CFROI calculations is not the cash flow
available for claimholders in the firm because it is prior to capital expenditures and it is
stated in real terms.
2. There are practitioners who argue that traditional accounting measures of return tend to
be overstated because they look at the remaining book value of assets. Thus, as assets are
depreciated, the return on equity and capital tend to increase. By focusing on the gross
investment, rather than the net, and adjusting for current dollars, it is argued that CFROI
provides a superior measure of return on an investment. This argument tends to work
better for manufacturing firms but does not really hold up for firms that are not capital
3. Third, it is argued that by assuming a fixed life for an asset and computing an internal
rate of return, the CFROI provides a better measure of return than traditional accounting
measures which often divide current earnings by book value of investment. This, again, is
a far better argument with capital intensive firms that invest in plant and equipment than it is
for firms that invest in short term and intangible assets. Furthermore, if we assume that
assets have infinite lives and that capital maintenance expenditures offset depreciation, the
CFROI measure converges on the return on capital.
A Postscript on Value Enhancement
The value of a firm rests on three components. The first is its capacity to generate
cash flows from assets in place, with higher cash flows translating into higher value. The
second is its willingness to reinvest to create future growth, and the quality of these
reinvestments. Other things remaining equal, firms that reinvest well and earn significant
excess returns on these investments will have higher value. The final component of value is
the cost of capital, with higher costs of capital resulting in lower firm values. To create
value then, a firm has to
6. Generate higher cash flows from assets in place, without affect its growth prospects or
its risk profile
7. Reinvest more and with higher excess returns, without increasing the riskiness of its
8. Reduce the cost of financing its assets in place or future growth, without lowering the
returns made on these investments
All value enhancement measures are variants on these simple themes. Whether these
approaches measure dollar excess returns, as does economic value added, or percentage
excess returns, like CFROI, they have acquired followers because they seem simpler and
less subjective than traditional valuation approaches. This simplicity comes at a cost, since
these approaches make subtle assumptions about other components of value that are often
not visible or recognized by many users. Approaches that emphasize economic value
added, and reward managers for increasing the same, often assume that this increase is not
being accomplished at the expense of future growth or by increasing risk. Practitioners
who judge performance based upon the cash flow return on investment make similar
Investors and portfolio managers who use short cuts to valuation face these
problems and more, since they have to consider not just how well or badly firms performed
on these measures but have to measure them against market expectations. It is only those
firms that deliver results that are better than expected that can be expected to earn excess
Is there a something of value in the new value enhancement measures? Absolutely,
but only in the larger context of valuation. One of the inputs we need for traditional
valuation models is the return on capital (to get expected growth). Making the adjustments
to operating income suggested by those who use economic value added, and augmenting it
with a cash flow return, as is the case with CFROI, may help us come up with a better
estimate of this number. The terminal value computation in traditional valuation models,
where small changes in assumptions can lead to large changes in value, becomes much
more tractable if we think in terms of excess returns on investments rather than in terms of
just growth and discount rates. Finally, the empirical evidence that has been collected by
practitioners who use CFROI on fade factors can be invaluable in traditional valuation
models, where practitioners sometimes make the mistake of assuming that current project
returns will continue forever.
Value enhancement is clearly on the minds of many managers today. As they look
at various approaches to value enhancement, they should consider a few facts. The first is
that no value enhancement mechanism will work at generating value unless there is a
commitment on the part of managers to making value maximization their primary objective.
If managers put other goals first, then no value enhancement mechanism will work.
Conversely, if managers truly care about value maximization, they can make almost any
mechanism work in their favor. The second is that while it is sensible to connect whatever
value enhancement measure you have chosen to compensation, there is a down side.
Managers, over time, will tend to focus their attention on making themselves look better on
that measure even it that can be accomplished only by reducing firm value. Finally, there
are no magic bullets that create value. Value creation is hard work in competitive markets
and almost involves a trade off between costs and benefits. Everyone has a role in value
creation, and it certainly is not the sole domain of financial analysts. In fact, the value
created by financial engineers is smaller and less significant than the value created by good
strategic, marketing, production or personnel divisions.
Bernstein, R., An Analysis of EVA, Merrill Lynch Quantitative Viewpoint, December 19
(1997) and February 3 (1998)
Dillon, R.D,. and J.E. Owers, EVA as a Financial Metric: Attributes, Utilization and
Relationship to NPV, Financial Practice and Education, Spring/Summer 1997