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Daniela Venanzi - Financial performance measures and value creation: a review
working paper december 27, 2010
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Financial performance measures and value creation: a review

di
Daniela Venanzi

Full Professor of Corporate Finance
Department of Business & Law Roma Tre University

December 27, 2010

Contents

1. Introduction
2. Criticisms of the accounting-based measures of performance
3. Competing financial performance measures
3.1. Trends in performance measurement
3.2. Economic value measures
Economic value added (EVA)
Cash flow return on investment (CFROI)
Shareholder value added (SVA)
4. The metrics war
4.1. The association between economic value measures and stock returns
4.2. The association between economic value measures and DCF approach
4.3. Managerial implications of economic value measures
5. A comparison: strengths and weaknesses of the economic value measures

References
Abstract

Corporate financial performance measured in terms of accounting-based ratios has been viewed as
inadequate as firms began focusing on shareholder value as the primary long-term objective of the
organization. Corporate managers have been facing a period where a new economic framework that
better reflects economic value and profitability had to be implemented in their companies. The
increased efficiency at the capital markets requires that capital allocation within companies
become more efficient: a value based management framework that better reflects opportunities
and pitfalls, is therefore necessary. Subsequently, value metrics were devised that explicitly
acknowledged that both equity and debt have costs, and thus there was a need to incorporate
financing risk-return into performance calculations. The focus of this article is a review of the main
value-based measures: the economic value added (EVA), the cash flow return on investment
(CFROI) and the shareholder value added (SVA). The objective is contributing to the developing
dialogue on the appropriateness of different financial performance measures by reviewing their
differences as well as their similarities in terms of measurement, association with market financial
performance and DCF approach, implications on managerial incentives, and by highlighting their
respective strengths and weaknesses.
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1. INTRODUCTION
Periodic measurement of firm performance is conducted for several reasons: it helps investors to
formulate their expectations concerning the future earning potential of firms; it supplies a plausible
feedbackonhowwellthecompanyhasachieveditsgoals;itfurnishesthebasisofanadequatebonusplan
thatgivesincentivestoachievethefirmsgoalsandrewardstheresultsofproperdecisions.
Corporate financial performance measured in terms of accountingbased metrics has been viewed as
inadequate as firms began focusing on shareholder value as the primary longterm objective of the
organization: they fail to take into account the factors that drive shareholder value. Subsequently,
financialbased value measures and value metrics were devised that explicitly acknowledged that both
equity and debt have costs, and thus there was a need to incorporate financing riskreturn into
performance calculations. The focus of this article is a review of the main valuebased measures: the
economic value added (EVA) described by Stewart (1991), the cash flow return on investment (CFROI)
approach of the Boston Consulting Group and the shareholder value approach (SVA) described by Alfred
Rappaport (1986). Information and empirical results about the efficacy of the different approaches are
limitedandcontradictoryandseemtobeprimarilyprovidedbyauthorswithstrongcommercialinterestin
theoutcomeofanyreasearchintotheeffectivenessofthemethodologies.Thispaperaimsatcontributing
to the developing dialogue on the appropriateness of different financial performance measures, with
respect to their association with stock returns or DCF approach and their implications on managerial
incentivesandcompensation.Itwouldbeamistaketobelievethatanysinglemeasureisperfectlysuitedto
alltypesoffinancialdecisionsupport,meanwhileitcouldbeveryusefultocomparethedifferentmeasures
by highlighting their respective strengths and weaknesses as well as their similarities. This paper is
organized as follows. First, we summarize the shortcomings of the accountingbased measures of
performance;therefore,weillustratetheeconomicmeasures,highlightingtheirdifferencesincalculation.
Subsequently, we compare the economic measures effectiveness by reviewing firstly the empirical
evidence on their association with market measures of return; secondly, their linkage with DCF approach
and finally their impact on management behaviour when used in compensation system. A final review of
thestrengthsandweaknessesofeachvaluebasedmetricswillconcludetheanalysis.
2. CRITICISMSOFTHEACCOUNTINGBASEDMEASURESOFPERFORMANCE
Valueisafunctionof1)investments2)cashflow3)economiclifeand4)capitalcost.Themechanismthatis
used on the market to establish value using these four factors is what we call the Discounted Cash Flow
(DCF) approach. This is the reason why we use DCF methods when we calculate on investments that we
plantomakeinacompany.Theobjectivefordoingthisistobeabletoestablishandexecutestrategiesand
investments that increase shareholder value. But in practice something peculiar seems to occur
(Weissenrieder,1997).Aftertheinvestmenthasbeenmadecompanies,analystsandmediaabandonthis
thinking and enter the world of P/Eratios, profit per share, ROI, balance sheets, P&L statements, book
equity, goodwill, depreciation methods We try to follow up the value creation and profitability of
investmentsthatwehavemadebyusingaccountingdata.Rappaport(2005)callthisdiseasetheshortterm
earningsobsession.
Accountingdoesnothandleanyoffourfactorsthewayafinancialframeworkshouldhandlethem.What
kind of information does the organization need for strategic decision making and for managing the
company'scurrentoperations?Choosingsomethingfortheonlyreasonthatitlooksmuchlikewhatwesee
todayfromourcurrentframework(accounting)wouldbeamistake.
Compelling evidenceindicatesthat managersareobsessedwithearnings.Arecentsurvey of400financial
executives shows that the vast majority view earnings as the most important performance measure they
reporttooutsiders(Grahametal.,2005).Thetwokeyearningsbenchmarksarequarterlyearningsforthe
samequarterlastyearandtheanalystconsensusestimateforthecurrentquarter.Executivesbelievethat
meetingearningsexpectationshelpsmaintainorincreasethestockprice,providesassurancetocustomers
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andsuppliers,andbooststhereputationofthemanagementteam.Failuretomeetearningstargetsisseen
asasignofmanagerialweaknessand,ifrepeated,canleadtoacareerthreateningdismissal.
Managing for shortterm earnings compromises shareholder value. In the following section some
fundamental shortcomings of the traditional accountingbased metrics both as value measure and
performancemeasurearesummarized.
a) inaccuracyandsubjectivityoftheaccountingnumbers
The accounting principles provide companies with room to manipulate the accounting figures. Earnings
number may be computed using alternative and equally acceptable accounting methods: a change in
accounting method for financial reporting purposes can materially impact earnings but does not alter the
companys cash flows and therefore should not affect its economic value. This could produce two
implications:
comparisonsamongdifferentfirmsaswellasdifferentyearsofthesamecompanyarenotreliable
managers can assume moral hazard behaviours that can induce various manipulations of accounting
data. A 2005 survey of 400 USA financial executives (Graham et al., 2005) reveals that companies
manage earnings with more than just accounting gimmicks: a startling 80% of respondents said they
would decrease valuecreating spending on research and development, advertising, maintenance, and
hiringinordertomeetearningsbenchmarks.Morethanhalftheexecutiveswoulddelayanewproject
evenifitentailedsacrificingvalue.Managerspushrevenuesintothecurrentperiodanddeferexpenses
to future periods: they borrow from the future to satisfy today earnings expectations. Jensen (2004)
cited WorldCom, Enron Corporation, Nortel Networks, and eToys as companies that pushed earnings
management beyond acceptable limits to meet expectations and ended up destroying part or all of
theirvalue.AswellasJensen,wecouldciteCirioandParmalatassimilarexamples.
Moreover, accounting numbers can be distorted by inflation: in determining traditional accounting

measures of return, both numerator and denominator of the accounting ratios add up not homogeneous
numbers,i.e.numbersnotexpressedinthesamemonetaryunit.Forexample,inflationcanincreaseROI
by increasing capital turnover (sales are in current numbers, meanwhile invested capital is not). On the
contrary, measures based on DCF calculations are not affected by inflation: in determining valuebased
measures of performance it is enough to use homogeneous numbers (real or nominal) of cash flows and
discountrates.ThereforeROIcoulddependontheaverageageofthefixedassetsofthefirm.
Despite, International Financial Reporting Standards (IFRS) attempting to reduce the possibility of such
manipulations,valuationmethodologiessuchasmarktomarkettendtoexacerbatetheproblem.
b) nonalignmentwiththeorganizationalgoalofmaximizingshareholderwealth
Accountingbasedmeasuresofreturnomittoconsiderthecostofinvestedcapital,bothintermsofrisk
free rate and risk premium. Therefore, maximizing earnings or return does no imply to maximize
shareholdervalue.
Maximizingearningsomittoaccountfortheamountofcapitalinvestedtoproduceearnings.Itcouldresult
convenientanyinvestmentthatproduceearnings,nomatterwhatreturnitearnsorwhatriskitbears.This
case being true, a company always prefers to retain and reinvest its earnings, never to pay them out to
investors. Instead, it could be demonstrate that cutting the firms dividends to increase investment will
raisethestockpriceif,andonlyif,thenewinvestmentearnsarateofreturnonnewinvestmentsgreater
than its cost of capital, i.e. the rate investors can expect to earn by investing in alternative, equally risky,
securities.
WhenweuseaccountingratesofreturnlikeROIorROA,werisktoincurinthesameproblem.Toillustrate,
amanagerthatusesROIinitsinvestmentdecisionswillbeencouragedonlytoselectprojectsthatequalor
exceed his/her SBUs or divisions current ROI regardless of the value creation of that investment in the
longerterm:projectsofthesameSBUordivisioncandifferinriskandcostofcapitalfromtheaveragerisk
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andcostofcapitalofthemixofassetsinplace.Obviouslythesemeasuresencouragemanagersmuchmore
to act in ways that are incongruent with the corporate objective of maximizing shareholder wealth when
managersaremeasuredandrewardedonmaximizingthem.
Inmarketingterms,itisimperativeforbusinessestoallocatecapitaltoendeavoursthatwouldbeclassified
asstarsintheBostonConsulting Group(BCG)matrix,andputtosleepthosethatwouldbeclassifiedas
dogs. Traditional accounting performance measures may not enable management to identify between
theseandinfactmayencouragedogstobefedmore.
In order to avoid these misleading behaviors, hurdle rates or minimum acceptable rates for ROI are often
based on an estimate of the business units (or divisions) cost of capital. The essential problem with this
approach is that ROI is an accrual accounting return and is being compared to a cost of capital measure
whichisaneconomicreturndemandedbyinvestors.
Wecandemonstratethataccountingreturnofinvestmentdiffersfromeconomicreturnofinvestmentas
wellasapplesdifferfromoranges(thecaseofasingleprojectcanbeextendedeasilytomanyprojects):
ACCOUNTING ONEYEAR RETURN: (cash flow depreciation other non cash charges + capital
expenditures + incremental investments in working capital)/ average (over the year) net book value
(i.e.bookvalueminusaccumulateddepreciation);
ECONOMIC ONEYEAR RETURN = (cash flow + change in present value)/ investment present value at
beginning of year. We can define the change of the present value over the year as economic
depreciation.Theeconomicreturn(r)canbederivedasfollows(CF
t
and
VA
t
arecashflowandpresent
valueinyeart,respectively):
IA
0
=
CF
1
(1 +r)
+
IA
1
(1 +r)
IA
0
(1 +r) = CF
1
+IA
1

r =
CF
1
+(IA
1
-IA
0
)
IA
0
=
CF
1
+ IA
IA
0

Notethatunlikeeconomicincomethatdependsstrictlyoncashflows,bookincome(thenumeratorofthe
accountingreturn)departsfromcashflowsinceitdoesnotincorporatecurrentyearsinvestmentoutlays
for working capital or fixed capital. In addition, non cash items such as depreciation and provisions for
deferredcostsorlossesaredeductedtoarriveatbookincome.Furthermore,depreciationrepresentsthe
allocation of cost over the expected economic life of an asset. Accountants do not attempt nor do they
claim to estimate changes in present value. If depreciation and the change in present value differ, then
bookincomewillnotbeanaccuratemeasureofeconomicincome.
Therefore, ROI is not an accurate or reliable estimate of the DCF return. Solomon (1967) demonstrates
thattheextenttowhichROIoverstatestheeconomicorDCFreturnisacomplexfunctionofthefollowing
factors(inparenthesesthesignoftheeffectontheoverstatement):
lengthofprojectlife(+)
capitalizationpolicy()
thespeedofdepreciationpolicy(+)
thetimelagbetweenoutlaysandtherecoupmentoftheseoutlaysfromcashinflows(+)
the growth rate of new investments (): if a company grows rapidly, its mix will be more heavily
weighted with new investments for which ROIs will be relatively low. Thus, the ROI of a growth
company will be lower than that a steadystate one, investments economic returns being equal.
Whengrowthrateandeconomicrateofreturnareequal,ROIisequaltoo.ROIdiffersfromeconomic
returnwhenthegrowthrateisgreaterorsmallerthantheeconomicreturn.
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Hefoundalsothatthereisnosystematicpatternintheerrorthatallowsacorrectiontobemade.
Thefollowingexample(Tables1and2),referringtoaninvestmentinanewrestaurant,showsthatwhile
therestaurantinvestmentisexpectedtoyieldaneconomicreturnof15%,theROIresultsaresubstantially
different. ROI progresses from a negative figure in the first year to 200% in the fifth year when the
restaurantfacilitiesarealmostfullydepreciated.Thus,ROIunderstatestheeconomicrateofreturninthe
first two years and significantly overstates it for the last three years. The fiveyear average ROI is
approximately23%,almosttwicethe15%DCFrateofreturn.Astheaboveexampleillustrates,accounting
ROI typically understates rates of return during the early stage of an investment and overstates rates in
laterstagesastheassetbasecontinuestodecrease.Somemightopposethattheseerrorsoffsetoneother
overtimeasthefirmmovestowardabalancedmixofoldandnewinvestments.Unfortunately,theerrors
are not offsetting. Table 3 illustrates this problem. One restaurant (identical to the investment discusses
earlier)peryearisopenedduringthefirstfiveyears.Thus,beginninginthefifthyearthefirmwillfinditself
inasteadystatesituation.ThesteadystateROIis23%,whichsignificantlyoverstatesthe15%economic
rateofreturn.
In addition to theoretical arguments, also empirical evidence shows that the accounting information does
not by itself adequately explain market valuations nor provide comparability between firms, thus
accountingdataareinadequateinreliablycapturingafirmstrueeconomicperformance.
Empiricaldatafrommanycountriesdemonstratesthefollowingevidence:
nonapparentrelationshipbetweenEPSgrowthandtotalshareholderreturns
weakcorrelationbetweenEPSgrowthandprice/earningsratio(P/Es)
robustcorrelationbetweenmarketvalueandpresentvalueofexpectedcashflows
statistically significant abnormal returns are observed when firms change accounting approach to
valuinginventoriesandcomputingcostofsales:positiveinshiftfromFIFOtoLIFOandnegativeinthe
opposite shift. Therefore, if the inflation rate is non null, market returns result to be influenced by
change in expected cash flows while do not react to change in accounting methods: the shift from
FIFOtoLIFO,infact,ifinflationrateispositive,lessentheaccountingincomeand,allbeingequal,cash
flowsincreasebymeansofsmallertaxpayments
greater correlation with market value added (market value of a company minus book value of its
equityanddebt)ofDCFperformancemeasuresthanaccountingmeasures
greater correlation with market value added of residual income measures of performance, i.e.
measuresthataccountforthecostofcapitalinvested.
Table1Theeconomicreturnofinvestinginanewrestaurant
source:Rappaport(1986)

YEARS(datain000)

Cashflows
176,23
250
350
400
400
Present value
(15%)
(atbeginningofyear)
(1)
1000
973,76
869,8
650,28
347,84
Presentvalue
(15%)
(atendofyear)
973,76
869,8
650,28
347,84
Changeinvalueduringyear
(economicdepreciation)
26,24
103,95
219,52
302,44
347,84
Economicincome

150 146
130,5
97,6
52,2
Economicrateofreturn
(%)
(2)
15 15 15
15
15

(1)Thepresentvalueatthebeginningoftheyeariscalculatedbydiscountingthe
remainingcashflowsat15%(2)EconomicrateofreturncorrespondstoIRR
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Table2TheROIofinvestinginanewrestaurant
source:Rappaport(1986)
Table3ROIinthesteadystate
c) shorttermismofmanagerialdecisionmaking
Accounting measures of performance can orientate management to a mistaken concern about

maximizing current performance measures. For example a manager that is measured on maximizing ROI
willbeencouragedonlytoselectprojectsthatequalorexceedtheircurrentROIregardlessofthepotential
valueofinvestmentsinthelongerterm. Thus, the objectiveof maximizingROI mayresultin projects that
willcreatewealthforshareholdernottobeapproved.Managerscanmaximizecurrentprofitsbyreducing
discretionary expenses that may adversely affect future profitability, by lessening future revenues (for
example R&D expenses or other similar expenses like training and development costs, brand marketing
expenses, advertising, etc.) or increasing future costs (for example plant and machinery maintenance
costs).Theseinvestmentsarecharacterizedbytakingalongtimetotranslateinitialoutflowsintofinancial
results, and as is stated in most strategy textbooks, long term survival of a firm is dependent indeed on
thiskindofinvestments.
In addition, ROI does not account for the postplanning period residual value of the business unit or
company.Normally,onlyasmallportionofafirmsmarketvaluedependsonprofitsgeneratedinafive
yearspan;conversely,thelargerportiondependsoncashflowsgeneratedbeyondthatpoint.Abusiness
5(steadystate)

Accountingincome

(perrestaurant)

1
23,77
+50
+150
+200
+200
2

23,77
+50
+150
+200
+200
3

23,77
+50
+150
+200
4

23,77
+50
+150
5

23,77
+50
6

23,77
Accountingincome(total)

23,77
26,23
176,23

376,23

576,23

576,23

Netbookvalue(perrestaurant)

1
900
700
500
300
100
2

900
700
500
300
100
3

900
700
500
300
4

900
700
500
5

900
700
6

900
Netbookvalue(total)

900
1600
2100
2400
2500
2500
ROIforallrestaurants(%) 2, 6
1,6
8,4
15,7
23,0

23,0

YEARS(datain000)

1 2
Cashflows

176,23

250

350

400

400

Depreciation

(strightline)

200

200

200

200

200

Accountingincome
23,77

50

150

200

200

Netbookvalue
(atbeginningofyear)
1000

800

600

400

200

Netbookvalue

(atendofyear)
800

600

400

200

Averagebookvalue
ROI(%)

900

2,6

700

7,1

500

30
300

66,7

100

200

7
attempting to increase its market share and competitive position will likely increase its new product
development and marketing spending, price aggressively, and invest in expanded production capacity and
working capital (Rappaport 1986). While these activities will strengthen the organization long term
strategicpositionandincreasemarketvalue,ROIislikelydeclineoverthenextseveralyears.Conversely,a
harvestingstrategyallowserosioninmarketshareandwillgeneratebetterplanningperiodROIs,butthe
residualvalueislikelytobeverysmall.
3. COMPETINGFINANCIALPERFORMANCEMEASURES
3.1 Trendsinperformancemeasurement
The choice of performance measures is one of the most critical challenges facing organizations.
Performance measurement systems play a key role in developing strategic plans, evaluating the
achievementoforganizationalobjectivesandcompensatingmanagers.
Many managers feel that traditional accountingbased measurement systems no longer adequately fulfil
thesefunctions.
A 1996 survey by the Institute of Management Accounting (IMA) found that only 15 percent of the
respondents' measurement systems supported top management's business objectives well, while 43
percentwerelessthanadequateorpoor.
In response, firms increasingly are implementing new performance measurement systems to overcome
these limitations. Sixty percent of the IMA respondents, for example, reported they were undertaking a
majoroverhaulorplanningtoreplacetheirperformancemeasurementsystems.
The perceived inadequacies in traditional accountingbased performance measures have motivated a
variety of performance measurement innovations ranging from "improved" financial metrics such as
"economic value" measures to "balanced scorecards" of integrated financial and nonfinancial measures
(IttnerandLarcker,1998).Mosteconomictheoriesanalyzingthechoiceofperformancemeasuresindicate
that performance measurement and reward systems should incorporate any financial or nonfinancial
measurethatprovidesincrementalinformationonmanagerialeffort(subjecttoitscost).
Despite these models, firms traditionally have relied almost exclusively on financial measures such as
budgets, profits, accounting returns and stock returns for measuring performance (Ittner and Larcker,
1998).
Table 4 Uses, quality and perceived importance of financial and non financial performance measures
(LingleandSchiemann,1996)
source:IttnerandLarcker(1998)
SchiemannandAssociatessurveyed203executivesin1996onthequality,usesandperceivedimportance
ofvariousfinancialandnonfinancialperformancemeasures(LingleandSchiemann,1996).Theirresultsare
presented in Table 4. While 82 percent of the respondents valued financial information highly, more than
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90percentclearlydefinedfinancialmeasuresineachperformancearea,includedthesemeasuresinregular
management reviews, and linked compensation to financial performance. In contrast, 85 percent valued
customer satisfaction information highly, but only 76 percent included satisfaction measures in
management reviews, just 48 percent clearly defined customer satisfaction for each performance area or
used these measures for driving organizational change, and only 37 percent linked compensation to
customersatisfaction.Similardisparitiesexistformeasuresofoperatingefficiency,employeeperformance,
communityandenvironment,andinnovationandchange.
More importantly, most executives had little confidence in any of their measures, with only 61 percent
willing to bet their jobs on the quality of their financial performance information and only 41 percent on
the quality of operating efficiency indicators, the highest rated nonfinancial measure (Ittner and Larcker,
1998).
Perceived inadequacies in traditional performance measurement systems as well as the managers

confidenceinfinancialperformancehaveledmanyorganizationstoplacegreateremphasison"improved"
financial measures that are claimed to overcome some of the limitations of traditional financial
performance.Wereviewthistrendinthefollowingsection.
3.2 Economicvaluemeasures
While traditional accounting measures such as earnings per share and return on investment are the most
common performance measures, they have been criticized for not taking into consideration the cost of
capitalandforbeingundulyinfluencedbyexternalreportingrules.
Meanwhilethetraditionaldiscountedcashflow(DCF)modelprovidesforathoroughanalysisofallofthe
different ways in which a firm can increase value, it can become complex, as the number of inputs
increases. It is also very difficult to tie management compensation systems to a discounted cash flow
model,sincemanyoftheinputsneedtobeestimatedandcanbemanipulatedtoyieldtheresultsthatone
wants.
InsteadofexplicitDCFmodelasimplifiedformulabasedDCFapproachcanbeused bymakingsimplifying
assumptions about a business and its cash flow stream (for example, constant revenue growth and
margins) so that the entire DCF can be captured in a concise formula (Copeland et al., 1990). The Miller
Modigliani(MM)formula(Table5),whilesimple,isanexamplethatisparticularlyusefulfordemonstrating
thesourcesofacompanysvalue.TheMMformulavaluesacompanyasthesumofthevalueofthecash
flowofitsassetscurrentlyinplaceplusthevalueofitsgrowthopportunities;becausetheformulaisbased
on sound economic analysis, it can be used to illustrate the key factors that will affect the value of the
company and therefore to show how the two components of value performance can be measured
separately,althoughitislikelytobetoosimpleforrealproblemsolving,unfortunately.
In addition, it was stated that NPV concept is useless unless we can discount the investments complete
cashflowoveritscompletedeconomiclife:inotherwords,itisonlywhenitisconsideredoverthelifeof
thebusiness,andnotinanygivenyear,thatcashflowapproachbecomessignificant.Thus,itcouldbea
measure of performance only if it could be periodized into years, quarters, months or the time period of
the users choice. Moreover, this is what some new economic measures (which will be analyzed below)
trytodo.
If we assume that markets are efficient, we can replace the unobservable value from the discounted cash
flowmodelwiththeobservedmarketprice,andrewardorpunishmanagersbasedupontheperformance
ofthestock.Thus,afirmwhosestockpricehasgoneupisviewedashavingcreatedvalue,whileonewhose
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
packages. While market prices have the advantage of being updated and observable, they are also noisy.
Evenifmarketsareefficient,stockpricestendtofluctuatearoundthetruevalue,andmarketssometimes
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domakebigmistakes.Further,afirmsstockperformanceseemstobemuchmorereliablewhenevaluated
overseveralyears.Thus,afirmmayseeitsstockpricegoup,anditstopmanagementrewarded,evenasit
destroysvalue.Conversely,themanagersofafirmmaybepenalizedasitsstockpricedrops,eventhough
the managers may have taken actions that increase firm value. In addition, market measures of
performancereflectfactorsbeyondmanagerscontrol(suchasdeclininginflationandlowerinterestrates,
for example) as well as tend to aggregate relevant information inefficiently for compensation purposes
(theirforwardlookingcharactermayresultincompensatingforpromisesandnotforactualachievements);
finally, they cannot be disaggregated beyond the firm level. Thus, they cannot be used to analyze the
managersofindividualdivisionsofafirm,andtheirrelativeperformance.
Consultingfirmspromotedavarietyof"economicvalue"measurestoovercomelimitationsofaccounting
basedandmarketmeasures.Weillustrateinthissectionthemostknownmetrics.
Table5TheMillerModiglianiDCFformula(MillerModigliani,1961)
valueofentity=valueofassetsinplace+valueofgrowth
valueofassetsinplace=
L(N0PA1)
wACC

valueofgrowth=K |E(N0PAI)]Nj
-wACC
wACC(1+wACC)
[
where:
E(NOPAT)=expectednetoperatingprofitaftertaxes
(assumedasproxyofexpectedcashflowsaftertaxes)
WACC=weightedaveragecostofcapitalaftertaxes
K=investmentrate(percentageofcashflowsinvestedinnewprojects)
r=rateofreturnoninvestedcapital
N=intervalofcompetitiveadvantage
The foundation for all these "new" performance measures is the concept of residual income (RI),
developed many years ago indeed (Worthington et al., 2001). In the 1920 seminal contribution, Marshall
concluded,thegrossearningsofmanagementwhichamanisgettingcanonlybefoundaftermakingupa
careful account of the true profits of his business, and deducting interest on his capital. Later, the
desirability of quantifying economic profit as a measure of wealth creation was operationalized by
Solomons(1965)asthedifferencebetweentwoquantities,netearningsandthecostofcapital.Asearly
as the 1920s General Motors applied this concept and in the 1950s General Electric labelled it residual
incomeandapplieditasaperformancemeasuretotheirdecentralizeddivisions.Itisdefinedintermsof
aftertaxoperatingprofitslessachargeforinvestedcapital,whichreflectsthefirmsweightedaveragecost
of capital. Close parallels are thereby found in the related (nontrademarked) concepts of abnormal
earnings, excess earnings, excess income, excess realisable profits and super profits (Biddle et al., 1997).
Economic profit (EP) is a variant of RI but as a return of equity. It is the book profit less the equitys book
value(atthebeginningoftheconsideredperiod)multipliedbytherequiredreturntoequity.AsROEisthe
ratio of profit after taxes to book value of equity, we can also express the economic profit as EP
t
=
(R0E - k
c
)Eb:
t-1
,whereEb:
t-1
isthebeginningbookvalueofequityandk
c
isthecostofequity.Itis
obviousthatfortheequitymarketvaluetobehigherthanitsbookvalue,ROEmustbegreaterthank
c
,if
ROEandk
c
areconstant(Fernandez,2003).

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Economicvalueadded(EVA)
Stern Stewart & Co.'s (hereafter Stern Stewart) trademarked "Economic Value Added" (EVA) is the firm's
proprietary adaptation of residual income. EVA is a modified version of residual income where the
modifications consist of accounting adjustments designed to convert accounting income and accounting
capitaltoeconomicincomeandeconomiccapital.Thus,thesignificanceofthedifferencebetweenEVAand
residualincomeisdependentupontheimpactoftheseaccountingadjustments.
EVA is determined as adjusted operating income minus a capital charge, and assumes that a manager's
actionsonlyaddeconomicvaluewhentheresultingprofitsexceedthecostofcapital.

EconomicValueAdded=NOPATcostofcapitalxcapitalinvested
=(ROCcostofcapital)x(capitalinvested)
where
NOPAT=netoperatingprofitaftertaxes
ROC=NOPAT/capitalinvested=returnoncapital(invested).
There are three basic inputs that we need for EVA computation: the return on capital earned on an
investment,thecostofcapitalforthatinvestmentandthecapitalinvestedinit.
There are two ways of estimating NOPAT (Damodaran, 2000). One is to use the reported EBIT on the
income statement and to adjust this number for taxes: NOPAT = EBIT (1 tax rate). When we use this
computation,weignorethetaxbenefitofinterestexpensessinceitisalreadyincorporatedintothecostof
capital(byanaftertaxcostofdebt).Alternatively,wecanarriveatNOPATbystartingwithnetincomeas
follows:NOPAT=netincome+interestexpenses(1taxrate)nonoperatingincome(1taxrate).Adding
backtheaftertaxportionofinterestexpensesensuresthatthetaxbenefitfromdebtdoesnotgetdouble
counted.
Itismoredifficulttoestimatethecapitalinvestedatthelevelofthefirmthanofasingleproject,because
inafirmprojectstendtobeaggregatedandexpensesareallocatedacrossthem.Oneobvioussolutionmay
betousethemarketvalueofthefirm,butmarketvalueincludescapitalinvestednotjustinassetsinplace
butinexpectedfuturegrowth.Ifwewanttoevaluatethequalityofassetsinplace,weneedameasureof
the market value of just these assets. Given the difficulty of estimating market value of assets in place,
manyanalyststurntothebookvalueofcapitalasaproxyforthemarketvalueofcapitalinvestedinassets
inplace(Damodaran,2000).
Wecanuseadoubleapproachtomeasureinvestedcapital.Thecapitalbasedapproachconsidersthebook
values of equity and interest bearing debt (netted against cash balances). The assetbased approach
couldarriveatasimilarresultusingthebookvaluesoftheassetsofthefirmasfollows:
invested capital = net fixed asset + current asset current liabilities cash = net fixed asset + noncash
workingcapital.
The two approaches could give nonequivalent results when the firm has longterm liabilities that are not
interest bearing debt (for example provisions and similar): they will be excluded from the invested capital
computationwhenweusethecapitalapproach.
Thereasonwenetoutcashisconsistentwiththeuseofoperatingincomeasourmeasureofearnings.The
interest income from cash or cash equivalents is not part of operating income. Obviously, for companies
with significant cash balances, exclusion of cash from invested capital and of its interest income from
NOPATcoulddiscouragesmanagerstousecashbalancesefficiently.
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
dealwithacquisitions(Damodaran,2000).Itisalsoinfluencedbytheaccountingclassificationofexpenses
11
intooperatingandcapitalexpenditures,withonlythelattershowingupaspartofcapital.Thelimitationsof
book value as a measure of capital invested has led analysts who use EVA to adjust the book value of
capitaltogetabettermeasureofcapitalinvested.
Similar problems arise when we need to estimate NOPAT and ROC. The operating income that we would
like to estimate would be the operating income made by assets in place. The operating income, usually
measuredasearningsbeforeinterestandtaxesinanincomestatement,maynotbeagoodmeasureofthis
figure,forthesamereasonsthathasledtoadjustthebookvalueofcapitalinvested.
The practitioners who use EVA claim to make many adjustments to the accounting measures of both
operatingincomeandinvestedcapital.SternStewartmakesasmanyas164adjustmentstoarriveatEVA.
Table 6 summarizes some of the adjustments recommended by Stern Stewart (Stewart, 1991) for
converting from book value and book NOPAT to what it calls economic book value and economic NOPAT
respectively(Fernandez2002).
Table6AdjustmentssuggestedbySternStewartforcalculatingtheEVA
Someoftheseadjustmentsinclude(Damodaran,2000):
capitalizinganyoperatingexpensethatisintendedtocreateincomenotinthecurrentperiod,butin
future periods. An example is research and development expenses (other examples are training and
development costs, brand marketing expenses, advertising, etc.), which accounting standards require
be expensed, but which clearly are intended to generate future growth. The standard treatment is to
capitalize research and development expenses and augment the capital invested by this amount
(accrued R&D expenses netted against cumulative amortization). Correspondingly, the operating
income should be considered without these expenses, while the amortization of these capitalized
expensesmustbeyearlydeductedfromNOPAT.Makingthisadjustmentforhightechnologyfirmswill
drastically alter their return on capital, reducing it in most cases considerably. Once you have
12
capitalized R&D, any new R&D increases this asset, but existing R&D will be amortized over time,
reducingit.TherateatwhichtheR&Disamortizedwillbesectorspecificandreflecttherateatwhich
thebenefitsofnewR&Ddecayinthesector;
capitalizing any operating expenses that are really financing expenses in 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
computethepresentvalueofleaseobligationsandtreatitasdebt.Fromafinancialstandpoint,thereis
little difference between operating and capital leases. Therefore, it does make sense to compute the
presentvalueofoperatingleasecommitmentsandtreatthemasdebt,thusincreasingcapitalinvested.
A similar adjustment regards pension provisions: they should be included in computing capital
investedasiftheywereequivalenttodebtandtheirfinancialcosts(forexample,inItalyTFRcostsper
yearareequalto1,5%+75%ofinflationrate)shouldbeaddedbacktoNOPAT;
eliminatinganyitemsthatmaycausethebookvalueofcapitaltodropwithoutreallyimpactingcapital
invested. Here, we have to consider the amortization of goodwill, that reduces the book value of
capital but does not reduce capital invested and should be added back (but only the part of goodwill
referredtoassetinplacemeasuredasdifferencebetweentheacquisitionpriceandthemarketvalue
prior to acquisition should be included in invested capital); earnings prior to the amortization of
goodwillshouldbeconsidered,correspondingly.
Similaradjustmentsregardallowancesforbaddebts,stockobsolescenceandsimilarones;theyshould
be assimilated to equity reserves and then computed in calculating the capital invested;
correspondingly changes (net of taxes) in these allowances (changes are equal to provisions less
utilizationsinthecurrentyear)shouldbeaddedbacktoNOPAT(inthiswayNOPATisaffectedonlyby
cashutilizationsofthisallowances,i.e.whenthelossesortheminorinflowsoccur).
A similar adjustment regards the LIFO reserve. The LIFO reserve is the difference between the
accounting cost of an inventory that is calculated using the FIFO method, and one using the LIFO
method.Inthetypicalinflationaryenvironment,thevalueofaFIFOinventoryishigherthanthevalue
of a LIFO inventory, so the calculation of the LIFO reserve is : LIFO reserve = FIFO valuation LIFO
valuation. Since the reason for valuing an inventory using LIFO is usually to defer the payment of
incometaxes,theLIFOreserveessentiallyrepresentstheamount bywhichan entity'staxableincome
hasbeendeferredbyusingtheLIFOmethod.Reserveshouldbeaddedtoinvestedcapitalandyearto
yearincreasetobeaddedbacktoNOPAT.
Similar examples are the onetime restructuring charges which result in a large negative operating
income when we account for extraordinary losses and declines in book value of capital. Losses from
sales of assets should be added back to invested capital and NOPAT as well as gains should be
subtracted.
Similar adjustments regard stock buybacks. They have a disproportionate impact on book value of
capitalwhenmarketvalueiswellinexcessofbookvalue:infactthebookvalueofequityisreducedby
the market value of the buyback; if the price to book ratio is for example of 10, a buyback of 5%
reducesthebookvalueofequityby50%;
adjusting for any actions that should have caused book value of capital but did not because of
accounting treatment. For example when pooling is used to account for a merger (the book value
remainsinthebalancesheetthebalancesheetthuslookssmallerandthegoodwillisignored,i.e.it
is treated in the same way as internally generated goodwill), the book value of capital is usually
corrected, by augmenting it to reflect the price paid on the acquisition and the premium over book
value.Itshouldbenotedthattheproportionofpremiumpaidforexpectedfuturegrowthpotentialin
theacquiredfirmshouldnotaddedontoarriveatcapitalinvested.

13
Itshouldbenotedtheimpactontaxchargeofmakingtheadjustmentsabove.Forexample,ifweaddback
toNOPATtheR&Dcostspreviouslyexpensed,weimplicitlyincludethetaxshieldoftheseexpensesinthe
NOPAT calculations; conversely, if we add back the R&D expenses after taxes (i.e. the gross amount
multipliedby(1taxrate)),thenweignoreit.Moreover,ifweaddbacktoNOPATtheR&Dexpensesminus
theyearamortizationofthecapitalizedR&Dexpenses,bothaftertaxes,thereforeweareonlyconsidering
thetaxshieldassociatedwiththeamortization.
The above are only some of the suggested adjustments. Young and OByrne (2001) admit that ....even
the most ardent EVA advocate would concede that no company should make more than, say, 15
adjustments.Theyfurtherstatethat1012accountingadjustmentsweremostcommonbutthatnumber
hasnowdeclinedtofiveorfewerandinsomecasenoadjustmentsaremade.Theexplanationtheygivefor
this reduction is: a) managers are reluctant to deviate from GAAPbased numbers; b) companies have
foundthatmostofthesuggestedadjustmentshavelittleimpactonprofitandcapital.
Moreover, external analysts who choose to use EVA have to accept the reality that their estimates of
operatingincomecanadjustonlyforthevariablesonwhichthereispublicinformation.
Andersonetal.(2005)foundthat,inasampleof317USAfirmsoveratenyeartimeperiod,fiveaccounting
adjustments yielded on average an EVA only 7,1 % less than the EVA reported by SternStewart for the
same firms and time period. The two accounting adjustments with the largest impact, R&D and LIFO
reserve, accounted for 92% of the total change in EVA due to the five accounting adjustments. The
inconsistency over time of the differences, both in absolute and percentage terms, between Stern
Stewarts EVA and Anderson et al.s adjusted EVA does not support for the need for a large number of
accountingadjustments.Inaddition,evidenceshowsastronginstabilityofEVAadjustmentsovertimeand
a very strong relationship between adjusted and unadjusted EVA. Therefore, accounting adjustments for
EVAseemtobemuchtodoaboutnothing.
Thethirdandfinalcomponentneededtoestimatetheeconomicvalueaddedisthecostofcapital.Aschool
of thought 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 (Damodaran, 2000). First, 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.
Therefore,itisclearthatusingabookvaluecostofcapitalessentiallyisequivalenttoassumingthatalldebt
is attributable to assets in place, and that all future growth comes from equity. Put another way, if we
adoptedthisrationaleinvaluation,wewoulddiscountcashflowsfromassetsinplaceatthebookcostof
capital,andallcashflowsfromexpectedfuturegrowthatthecostofequity.
Second, using a book value cost of capital for all economic value added estimates, including the portion
thatcomesfromfuturegrowth,willdestroythebasisoftheapproach,whichisthatmaximizingthepresent
valueofeconomicvalueaddedovertimeisequivalenttomaximizingfirmvalue.
Third, if changing capital structure is one tool that can be used to increase EVA, the mechanics work far
betterifmarketvaluecostofcapitalisusedratherthanbookvalue.Fromapracticalstandpoint,usingthe
bookvaluecostofcapitalwilltendtounderstatecostofcapitalformostfirms,andwillunderstateitmore
for more highly levered firms than for lightly levered firms. Understating the cost of capital will lead to
overstating the EVA. Thus, rankings based on book value cost of capital are biased against firms with less
leverage,andbiasedtowardsfirmswithhighleverage.
Cashflowreturnoninvestment(CFROI)
A second economic value measure that has received considerable attention is "Cash Flow Return on
Investment"(CFROI)anditsvariants(proposedbytheBostonConsultingGroup).
CFROI essentially is a modified version of internal rate of return, designed for investments that have
already been made. The CFROI for a firm is compared to the cost of capital to valuate whether a
companys investments are good, neutral or poor investments. To enhance its value then a firm should
increasethespreadbetweenitsCFROIanditscostofcapital.
14
The CFROI is calculated using four inputs (Damodaran, 2000). The first input is the gross investment (GI)
thatthefirmhasinitsassetsinplace.Thisiscomputedbyaddingbackdepreciationtothenetassetvalue
toarriveatanestimateoftheoriginalinvestmentintheasset.Inaddition,nondebtliabilities(allowances)
and intangibles such as goodwill are netted out. Finally, the gross investment is converted into a current
dollarvaluetoreflectinflationthathasoccurredsincetheassetwaspurchased.
The second input is the gross cash flow (GCF) earned in the current year on that asset. This is usually
definedasthesumoftheaftertaxoperatingincomeofafirmandthenonchargesagainstearnings,such
as depreciation and amortization. The operating income should be adjusted for operating leases and any
accountingeffects,muchthesamewaythatitwasadjustedfortocomputeEVA(aswellasGI).
Thethirdinputistheexpectedlifeoftheassets(n)inplace,atthetimeoftheoriginalinvestment,which
variesfromsectortosectorbutreflectstheearninglifeoftheinvestmentsinquestion.Theexpectedvalue
of the assets (SV=salvage value) 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,
adjustedtocurrentdollarterms(practitionersincludealsoinflationadjustedcurrentassets).
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 dollar terms. This is compared to the firms real
cost of capital to evaluate whether 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
equity.
0I = 0CFo
nCPR0I
+
SI
(1 +CFR0I)
n
An alternative formulation of the CFROI allows for setting aside an annuity to cover the expected
replacementcostoftheassetattheendoftheprojectlife.Thisannuityiscalledtheeconomicdepreciation
andiscomputedasfollows:
Economic cprcciotion =
Rcploccmcnt Cost in currcnt Jollors
((1 +k
c
)
n
-1) k
c
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
forafirmoradivisioncanthenbewrittenasfollows:
CFR0I = (uioss Cash Flow Economic Bepieciation) uioss Investment
Appendix shows the equivalence between two formulas, when we assume in deriving the economic
depreciation a discount rate k
c
=CFR0I. The differences in discount rate assumptions account for the
differenceinCFROIestimatedusingthetwomethods.Inthefirstformulatheintermediatecashflowsare
discounted at the CFROI, while in the second, at least the portion of the cash flows that are set aside for
replacement,getreinvestedatthecostofcapital.
IfnetpresentvalueprovidesforthegenesisfortheEVAapproach,theinternalrateofreturn(IRR)isthe
basis for the CFROI approach. In investment analysis, the IRR on a project is computed using the initial
investmentontheprojectandallcashflowsovertheprojectslife.TheIRRcalculationcanbedoneentirely
innominalterms,inwhichcasetheinternalrateofreturnisanominalIRRandiscomparedtothenominal
costofcapital,orinrealterms,inwhichcaseitisarealIRRandiscomparedtotherealcostofcapital.
Atfirstsight,theCFROIseemstodothesamething.Itusesthegrossinvestment(incurrentdollars)inthe
project as the equivalent of the initial investment, assumes that the gross currentdollar cash flow is
maintained over the project life and computes a real internal rate of return. There are, however, some
significantdifferences(Damodaran,2000):
15
theIRRdoesnotrequiretheaftertaxcashflowstobeconstantoveraprojectslife,eveninrealterms,
meanwhile the CFROI approach assumes that real cash flows on assets do not increase over time. It
shouldbenoted,however,thattheCFROIformulacanbemodifiedtoallowforrealgrowth
the second difference is that the IRR on a project or asset is based upon incremental cash flows in the
future.Itdoesnotconsidercashflowsthathaveoccurredalready,thatareviewedassunk.TheCFROI,
on the other hand, tries to reconstruct a project or asset, using both cash flows that have occurred
alreadyandcashflowsthatareyettooccur.Morespecifically,IRRisalwaysforwardlookingwhileCFROI
isnot.Theimplicationsarerelevant:aCFROIthatexceedsthecostofcapitalisusuallyconsideredasign
thatafirmisusingitsassetswell,butthatmightnotbetrue.IftheIRRislessthanthecostofcapital,
thatinterpretationisfalse.
From the CFROI we can derive the cash value added (CVA) by multiplying the spread between CFROI and
WACCbytheinflationadjustedcashinvestment.
Shareholdervalueadded(SVA)
Thethirdeconomic measureistheshareholdervalueadded (SVA)elaboratedbyRappaport(1986)and

AlcarConsultingGroup.ThekeyfactorsindeterminingSVAarethefollowing:
growthrateofsales
rateofoperatingprofitmargin(nettedagainstdepreciation)
(cash)taxrate
rateofincrementalfixedcapitalinvestment,intermsofrateofcapitalintensityofsales,nettedagainst
depreciation(depreciationisimplicitlyconsideredequaltoreplacementinvestmentoffixedcapital)
rateofincrementalworkingcapitalinvestment(intermsofrateofworkingcapitalintensityofsales)
costofcapital,expressedintermsofweightedaveragecostofcapital(WACC)
valuegrowthduration(planningperiodorcompetitiveadvantageperiod).Itcorrespondstothelength
of time that the firm is expected to earn returns in excess of its cost of capital. It depends on how
companysstrategiesaremoreorlessquicklyemulatedbypotentialcompetitors.
Thesevariablesarecombinedinthefollowingmodel(consistentwithDCFapproach)inordertomeasure
thevaluecreationofastrategy(validbothinbackwardandforwardlookingvaluation):
value cieateu by stiategy = change of shaieholuei value geneiateu by stiategy

(with iespect to nonstiategy scenaiio)
shaieholuei value = gioss coipoiate value maiket value of uebt anu othei obligations
gioss coipoiate value = piesent value of opeiating cash flows (uuiing the foiecast peiiou) + teiminal
value (at the enu of the foiecast peiiou) + cash & cash equivalents anu nonopeiating assets (whose
ietuins aie excluueu fiom opeiating CF)
opeiating cash flow

t
= sales
t1
x (1+giowth iate of sales) x iate of opeiating piofit maigin x (1 tax
iate) (sales
t
sales
t1
) x iate of inciemental investment in fixeu assets anu woiking capital.
Cashflowsandterminalvaluearediscountedbythecostofcapital.
The terminal value at the end of the forecast period can account for a great part of a companys (or
business units) market value, depending on growth or harvesting strategies adopted. Terminal value can
be determined by using different approaches in different situations. It can be estimated as a break up
value (when the firm ceases operations at the end of the forecast period) or as a perpetuity of the net
operatingcashflowatthehorizon,assumingasteadystatebeyondthistermoraconstantrateofgrowth
continuingindefinitely.Sometimesmultipleapproachcouldbeused.Weobservethatassumingaconstant
operating cash flow beyond the end of the forecast period does not imply a nongrowth state of the
16
business,butthatfuturenewinvestmentsrateofreturnisequaltotheircostofcapital;thus,incremental
cashflowscanbeignoredincalculatingthevalueofbusiness.
4. THEMETRICSWAR
Considerable debate exists on the relative value relevance of the alternative economic value measures.
Consulting firms battle over the superiority of their economic value measures, charging that competitors'
measureshaveflawsthatcompromisetheirpredictiveability.
A number of impressive claims have been made for each of the economic value measures. Stern Stewart,
forexample,citesinhouseresearchindicatingthat"EVAstandswelloutfromthecrowdasthesinglebest
measureofwealthcreationonacontemporaneousbasis"(Stewart,1991),whileDixonandHedley(1993)of
BraxtonAssociatesciteaninternalstudyshowingtheirCFROImeasureexplains91percentofthevariation
in market capitalization ratios. Advocates of CFROI argue that this metric is vastly superior to traditional
accounting measures and EVA as a performance measure. In an article on the "metric wars" between
consulting firms pushing various economic value measures, a partner at HOLT Value Associates claimed
"CFROIs are ideally suited to displaying longterm track records, whereas a Stern Stewarttype EVA is in
millions of dollars, heavily influenced by asset size, and unadjusted for inflationinduced biases" (Myers,
1996). Responded Stern Stewart cofounder G. Bennet Stewart III "CFROI is literally a consultant's
concoction.Itwasquiteanimaginativedevelopmentbyaconsultingfirm,butitisnotwellgroundedinthe
basicelementsofcorporatefinancetheory.CFROIattemptstomeasureshareholderwealthwhichisnot
clearlyrelatedtomaximizingshareholderwealth"(Myers,1996).
Claims such as these have caused a growing number of firms to adopt various forms of economic value
measures. A 1996 survey by the Institute of Management Accountants (IMA, 1996) found that 35 percent
oftherespondentsusedEVAorsimilarmeasures(upfrom18percentin1995)and45percentexpectedto
usetheminthefuture(upfrom27percentin1995).
Yet,despitetheincreasingemphasisonthesemeasures,researchontheextenttowhichtheyaresuperior
totraditionalaccountingmeasuresislimitedandmixed.
In the next paragraphs we will analyze the different perspectives to whose respect the various metrics
effectivenesscouldbeevaluated.
4.1 Theassociationbetweeneconomicvaluemeasuresandstockreturns
Many empirical studies have investigated the correlation of the most known economic measures with
excess returns, backtesting them against the underlying companies actual wealth creation, as evidenced
bysubsequentstockpriceincreases,orcomparingthemtomarketvalueadded.Moststudiestodatehave
examinedclaimsmadebytheproponentsofeachofthesevaluebasedmeasuresthattheirownmeasures
were better predictors of stock returns than traditional accounting measures or rival firms measures.
Sincetheavowedgoalofthenewperformancemeasuresistoincreaseshareholderwealth,thecorrelation
of such measures with stock returns has an obvious appeal. However a strong statistical correlation with
stock returns does not establish that a performance measure adds value. No measure of performance
could ever have a higher statistical correlation with stock returns that the return itself. Thus, if
correlation were the only goal, firms should solely use their stock price for compensation and ignore all
othermeasures.However,asarguedabove,stockreturnscanbeanoisyandevenamisleadingmeasureof
managers' value added. Therefore, the rationale is that any financial measure used in assessing firms
performance must be highly correlated with shareholders wealth and on the other hand should not be
subjectedtorandomnessinherentinit.
This research domain includes studies that empirically investigate the degree of correlation between
differentperformancemeasures(accountingandvaluebased)andstockmarketreturnsand/orMVAand
its changes. R
2
and panel data regression model have been used to measure value relevance: in these
regression models MVA (level or yeartoyear change) or total shareholder returns are the dependent
variables and the various performance measures are the explanatory variables. In some studies the
17
dependent variable is expressed in terms of abnormal or unexpected returns and the competing
performance measures (the independent variables) are measured in terms of levels and change
specifications(EastonandHarris,1991)orofforecasterrors,asthedifferencebetweentherealizedvalue
of a performance measure and the markets expectation (Biddle et al., 1997). It is assumed that market
expectationsareformedaccordingtoadiscretelinearstochasticprocessinfunctionoflaggedobservations
of the performance measure. In some studies the incremental information content of the economic
measuresisexploredbyintroducingintheregressionmodelthecomponentsinwhichthemeasurecanbe
decomposedasexplanatoryvariables;forexampleinBiddleetal.(1997)theEVAisdecomposedin5parts:
cash flow from operations, operating accruals, aftertax interest expense, capital charge, and accounting
adjustments.
Researchers have employed two approaches, relative vs. incremental information content, to compare
information usefulnessofdifferent measures.Relativeinformationcontentcompareswhichperformance
measure is superior in terms of association with stock returns, while incremental information content
addresses whether one measure adds to the information provided by the other. The two information
contenttypeshavedifferentpracticalimplications.Withknowledgeofrelativeinformationusefulness,one
will be able to choose a single best performance measure among competing ones. On the other hand,
incrementalinformationusefulnesswillhelponedecidewhethertoemploymultiplemeasuresinfinancial
reporting.Evidently,bothareimportantconsiderationsinthechoiceofperformancemeasures.Frequently
incrementalapproachisusedaddingeconomicmeasurestoaccountingmeasuresintheregressionmodel.
The empirical evidence about the association between the economic metrics and marketbased
performance measures is mixed and not definitive. Some studies reveal a stronger association of the
economic measures than the traditional accounting counterparts; others report, conversely, that the last
arebetterpredictorsofstockreturnsthantheformer.
In addition, some studies are concentrated on a specific economic measure (mostly EVA) compared to
moretraditionalmetrics;otherscomparetherelativeexplanatorycontentofalargersetofmetrics.
ManystudiestodatehaveexaminedclaimsthatEVAisabetterpredictorofstockreturnsthantraditional
accountingmeasures.
a) MilunovichandTseui's(1996)examinationofthecomputerserverindustryfoundmarketvalueadded
between 1990 and 1995 more highly correlated with EVA than with earnings per share, earnings per
sharegrowth,returnonequity,freecashflow,orfreecashgrowth.
b) Lehn and Makhija (1997) also found that stock returns over a tenyear period were more highly
correlated with average EVA over the period than with average ROA, ROS, or ROE. In addition, EVA
performedsomewhatbetterthanaccountingprofitsinpredictingCEOturnover.
c) O'Byrne(1996)examinedtheassociationbetweenmarketvalueandtwoperformancemeasures:EVA
and net operating profit after tax (NOPAT). He found that both measures had similar explanatory
power when no control variables were included in the regression models, but that a modified EVA
modelhadgreaterexplanatorypowerwhenindicatorvariablesfor57industriesandthelogofcapital
foreachfirmwereincludedasadditionalexplanatoryvariables.However,O'Byrne(1996)didnotmake
similar adjustments to the NOPAT model, making it impossible to compare results using the different
measures.
OtherstudiessuggestthatEVAispredictiveofstockreturns,butisnottheonlyperformancemeasurethat
tiesdirectlytoastock'sintrinsicvalue,oneoftheprimaryclaimsofEVAadvocates(e.g.Stewart,1991).
a) Chen and Dodd (1997) examined the explanatory power of accounting measures (earnings per share,
ROA and ROE), residual income, and various EVArelated measures. They found that EVA measures
outperformedaccountingearningsinexplainingstockreturns,buttheassociationswerenotasstrong
as suggested by EVA proponents (maximum R
2
= 41.5 percent). In addition, accounting earnings
provided significant incremental explanatory power above EVA, leading the authors to conclude that
18
firms should not follow EVA advocates' prescription to replace traditional accounting measures
completelywithEVA.Finally,residualincomeprovidednearlyidenticalresultstoEVA,withouttheneed
fortheaccountingadjustmentsadvocatedbySternStewart.
b) Biddle et al. (1997) provide the most comprehensive study of EVA's value relevance to date. Their
analysesexaminedthepowerofaccountingmeasures(earningsandoperatingprofits)toexplainstock
market returns relative to EVA and five components of EVA (cash flow from operations, operating
accruals, aftertax interest expense, capital charge, and accounting adjustments). They found that
traditional accounting measures generally outperformed EVA in explaining stock prices. While capital
charges and Stern Stewart's adjustments for accounting "distortions" had some incremental
explanatorypowerovertraditionalaccountingmeasures,thecontributionfromthesevariableswasnot
economicallysignificant.SensitivityanalysesindicatedthattheseresultswererobusttoSternStewart's
grouping of firms into five "types" based on their past operating returns and growth rates, the time
periodexamined,andthedependentvariableusedinthetests(i.e.,stockreturnsorlevelsorthetime
frameusedtocomputethemarketmeasures).
c) Fernandez(2003)analyzed582AmericancompaniesusingEVA,MVA,NOPATandWACCdataprovided
by Stern Stewart. For each of the 582 companies, he calculated the 10year correlations between the
increaseintheMVAeachyearandeachyearsEVA,NOPATandWACC.For296(ofthe582)companies,
the correlation between the increase in the MVA each year and the NOPAT was greater than the
correlationbetweentheincreaseintheMVAeachyearandtheEVA.TheNOPATisapurelyaccounting
parameter,whiletheEVAseekstobeamorepreciseindicatoroftheincreaseintheMVA.Thereare
210 companies for which the correlation with the EVA has been negative. The average correlation
betweentheincreaseintheMVAandEVA,NOPATandWACCwas16%,21%and21.4%.,respectively.
TheaveragecorrelationbetweentheincreaseintheMVAandtheincreasesofEVA,NOPATandWACC
was18%,22.5%and4.1%.Healsofoundthatthecorrelationbetweentheshareholderreturnin1994
1998andtheincreaseintheCVA(accordingtotheBostonConsultingGroup)oftheworlds100most
profitablecompanieswas1.7%.
Chari (2009) presents a review of empirical literature that evaluate the superiority of EVA over other
traditional measures in terms of better association with shareholder returns. He finds that the empirical
findingsaremixed.Only6outofthetotal10studiesexamined(chosenbygivingpreferencetodifferences
in methodology, sample size and country of study) conclude that EVA is superior to other accounting
measures; he attributes the inconsistency in the findings with respect to superiority of EVA to the
methodologyandimpact ofinflation.Infact,recentstudies(Dasetal.,2007)concludethatanonlinearS
shapedfunctionbettercharacterizesreturnearningsrelationship;hence,thelinearassumptioncanleadto
the distortion of the findings in the researches conducted. In addition, discrepancy between accounting
profitsandtrueprofitsalongwithinflationdistortsEVA(whichisbasedonaccountingprofits).
Clinton and Chen (1998) study followed a more comprehensive approach. They analyzed and evaluated
EVA,CFROIandResidualCashFlow(RCF=operatingcashflowcostofcapitalxbeginningcapital)inorder
to examine their correlation with stock prices and stock returns. Furthermore, other performance
measurements analyzed include traditionally reported measures such as operating income and cash flow
as well as the traditionally used ROI. The authors selected a sample of 325 firms from the Standard &
Poors 500 and the Stern Stewart 1996 Performance 1000 databases, for the years 1991 to 1995. They
consistently defined all items of the measurements in order to be comparable and then conducted the
correlation analysis to stock prices and stock returns. While residualbased measures have been heavily
promoted as better choices than ROIbased measures, all three residualbased measures showed a lower
association with stock values than their traditionally reported counterparts. Most of the RI and EVA
correlations with stock prices or stock returns were either insignificant or of unexpected negative signs.
Operating cash flow and adjusted operating income reported the bestperforming categories and have
higher association to stock price and stock return compared to the others. Of the three new
measurements, RCF is the only one that showed encouraging correlations. The more popular RI and ROI,
and the most recently highly promoted EVA and CFROI produced either insignificant or inconsistent
19
correlationsandthereforeindistinguishableintheirrelativelackofcontributiontoassessingfirmvalue.The
authors then suggest RCF as the best choice to use in linking profit to capital and ultimately to market
value.RCFmaintainstheadvantagesofusingacashbasedandaresidualbasedmeasure.Theresidualcash
flowmeasureisconsistentwithcapitalassetinvestmentplanningandisalreadystatedintermsofcashso
adjustmenttoremoveaccountingdistortionsisnotnecessary.
A preliminary conclusion is that the relative ability of different economic value measures to predict stock
returns is unknown. If, as might be expected, one measure does not consistently exhibit superior
predictability, researchers can attempt to determine the factors explaining crosssectional differences in
thepredictiveabilityofalternativeeconomicvaluemeasures.Structuralandenvironmentalvariablessuch
asfirmstrategy,competitiveenvironment,andproductorindustrylife cycle, forexample, arelikely to be
importantdeterminantsoftherelativeexplanatorypowerofdifferenteconomicvaluemeasures,aswellas
theexplanatorypoweroftraditionalaccountingmeasures(IttnerandLarcker,1998).
Inaddition,asDamodaran(2000)observed,wewouldnotexpecttheretobeanycorrelationbetweenthe
magnitudeofEVAandstockreturns,orevenbetweenthechangeinEVAandstockreturns.Thisisbecause
themarketvaluehasbuiltintoitexpectationsoffutureEVAs.Whetherafirmsmarketvalueincreasesor
decreases on the announcement of higher EVA will depend in large part on what the expected change in
EVAwas.Formaturefirms,wherethemarketmighthaveexpectednoincreaseorevenadecreaseinEVA,
theannouncementofanincreasewillbegoodnewsandcausethemarketvaluetoincrease.Forfirmsthat
are perceived to have good growth opportunities and were expected to report an increase in EVA, the
market value will decline if the announced increase in EVA does not measure up to expectations. This
should be no surprise to investors who have recognized this phenomenon with EPS for decades; the
earningsannouncementsoffirmsarejudgedagainstexpectations,andtheearningssurpriseiswhatdrives
prices.ThesameapparentparadoxcanbenotedaboutCFROI. ThereisarelationshipbetweenCFROI and
market value, with firms with high CFROI generally having high market value. This is not surprising, and
mirrors what we noted about EVA earlier. In investing, however, it is changes in market value that create
returns, not market value per se. 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
excessreturnsismoreintriguing.TotheextentthatanyincreaseinCFROIisviewedasapositivesurprise,
firmswiththebiggestincreasesinCFROIshouldearnexcessreturns.Inreality,however,theactualchange
in CFROI has to be measured against expectations; if CFROI increases, but less than expected, the market
valueshoulddrop;ifCFROIdropsbutlessthanexpected,themarketvalueshouldincrease

4.2 TheassociationbetweeneconomicvaluemeasuresandDCFapproach
Fernandez (2002) shows that EP, EVA and CVA, if used for valuation purposes, are consistent with DCF
approach.Analyticallyheshowsthat:

the present value of the EP discounted at the required return to equity, plus the equity book value
equalsthevalueofequity(thepresentvalueoftheequitycashflowdiscountedattherequiredreturn
toequity);
thepresentvalueoftheEVAdiscountedattheWACCplustheenterprisebookvalue(equityplusdebt)
equalstheenterprisemarketvalue(thepresentvalueofthefreecashflowdiscountedattheWACC);
thepresentvalueoftheCVAdiscountedattheWACCplustheenterprisebookvalue(equityplusdebt)
equalstheenterprisemarketvalue(thepresentvalueofthefreecashflowdiscountedattheWACC).

Therefore,throughthepresentvalueofEP,EVAandCVAwegetthesameequityvalueasthediscounting
theequitycashfloworthefreecashflow.Therefore,itispossibletovaluefirmsbydiscountingEVA,EPor
CVA,althoughtheseparametersarenotcashflowsandtheirfinancialmeaningismuchlessclearthanthat
of cash flows. Therefore, we can conclude that maximizing the present value of the EP, EVA or CVA is
equivalenttomaximizingthevalueofthefirmsshares.
20
However,Fernandez(2002)alsoremarksthatmaximizingaparticularyearsEP,EVAorCVAismeaningless:
it may be the opposite to maximizing the value of the firms shares. The claim that the EP, EVA or CVA
measuresthefirmsvaluecreationineachperiodisatremendouserror:itmakesnosensetogivetheEP,
EVAorCVAthemeaningofvaluecreationineachperiod.AsthepresentvalueoftheEVAcorrespondsto
the MVA, it is common for the EVA to be interpreted incorrectly as each periods MVA. In fact, he shows
thatitmayhappenthattheEVAgrowsfromnegativetopositiveinaconsideredperiodbutitdependson
thefactthatsharesbookvaluedecreasesasthefixedassetsaredepreciated.Furthermore,itmayhappen
thattheEVAandtheEPinoneyearhavebeenpositive,andevenhigherthanexpected,butthatthevalue
ofthefirmorbusinessunithasfallenbecausethebusinesssexpectationshavedeteriorated.TheEVA,EP
and CVA do not measure value creation during each period. It is not possible to quantify value creation
duringaperiodonthebasisofaccountingdata.Valuealwaysdependsonexpectations(Fernandez,2002).

EVAandDCFmodel
EVAisathrowbacktothenetpresentvaluerule.Damodaran(2000)demonstratesthatthepresentvalue
oftheEVAsbyaprojectoveritslifeistheNPVoftheproject.
TheNPVofaprojectcanbewrittenasfollows:
NPI =
EBII
t
(1 -t) +EPR
t
(1 +k
c
)
t
t=n
t=1
+
SI
n
(1 +k
c
)
n
-I
where
EPR=depreciationandamortization
SI
n
=salvagevalue
k
c
=costofcapital
I=initialinvestment
n=expectedlifeoftheinvestment

Now consider an alternative investment that requires an initial investment of I, earns exactly the cost of
capitalandallowsfortheentireinvestmenttobesalvagedattheendoftheprojectlifeofnyears.Thenet
presentvalueofthisprojectwillbezero.SolvingforIinthiscase,weget:
I =
k
c
(I)
(1 +k
c
)
t
t=n
t=1
+
I
(1 +k
c
)
n

Substitutingthisintothefirstequation,wegetthenetpresentvalueoftheoriginalprojecttobethe
following:
NPI =
EBII
t
(1 -t) +EPR
t
(1 +k
c
)
t
t=n
t=1
+
SI
n
(1 +k
c
)
n
-
k
c
(I)
(1 +k
c
)
t
t=n
t=1
-
I
(1 +k
c
)
n

Nowweassumethattheprojecthasasalvagevalueofzero,andthatthepresentvalueofdepreciationis
equal to the present value of initial investment, discounted back over the project life. In other words, we
assume that the cash flow from depreciation is really the capital being returned to the firm (alternatively
wecanassumethattheCFsfromdepreciationpaybackISV
n
).
Then,thenetpresentvalueofthisprojectcanbewrittenas:
NPI =
EBII
t
(1 -t)
(1 +k
c
)
t
t=n
t=1
-
k
c
(I)
(1 +k
c
)
t
t=n
t=1

BynotingthatROC=EBIT(1t)/I,thenweget
21
NPI =
(R0C
t
-k
c
)(I)
(1 +k
c
)
t
t=n
t=1
=
EIA
t
(1 +k
c
)
t
t=n
t=1

Thus,theNPVoftheprojectisthepresentvalueoftheEVAsbythatprojectoveritslife.Note,however,
thatthisrelationistrueonlywhentheassumptionsaboveareverified.
ThelinkagebetweenEVAandNPVallowsustolinkthevalueofafirmtotheeconomicvalueaddedbyit
(Damodaran, 2000). Firm value can be expressed in terms of the value of assets in place and expected
futuregrowthasfollows:

Fiim value = value of Assets in Place + value of Expecteu Futuie uiowth
NotethatinaDCFmodel,thevaluesofbothassetsinplaceandexpectedfuturegrowthcanbewrittenin
termsofthenetpresentvaluecreatedbyeach:
Fiim value = Capital Investeu

Assets in Place
+ NPv
Assets in Place
+ NPI
t=
t=1
Futuie Piojects, t

SubstitutingtheEVAversionofNPVbackintothisequation,weget:
Fiim value = Capital Investeu

Assets in Place
+
LvA
t,Asscts in Plccc
(1+k
c
)
t
t=
t=1
+
LvA
t,Futurc Prc]ccts
(1+k
c
)
t
t=
t=1
.
Thus, the value of a firmcan be written as the sum of three components, the capital invested in assets in
place,thepresentvalueoftheEVAsbytheseassets,andtheexpectedpresentvalueoftheeconomicvalue
thatwillbeaddedbyfutureinvestments.

AsimplifiedEVAvaluationmodel(easiertobeusedinboardrooms)canbederivedasfollows(Fabozziand
Grant,2000)
Firm Ioluc =
N0PAI
k
c
+
o:crogc EIA uturc
k
c
1
(1 +k
c
)
I
Theformulameansthatafirmwill:
earnitsNOPATonitsexistingassetsforever
earnpositiveEVAforeveronnewinvestmentsmadeoverperiodT
earnzeroEVAonanynewinvestmentsmadeafterperiodT.
ItisusefultonotethatthebasicEVAmodelaboveassumesthatcompetitionhasnoeffectontheexisting
assetsorthenewinvestmentsmadethroughperiodT,butcompetitiondoeseffectinvestmentsmade
afterT.Inotherwords,ifWalMarthas1000existingstores,thesestoreswillgeneratetheirexisting
level of profitability forever; plus any new stores added during the first T years will also generate
economic profits into perpetuity. All stores added after T, however, will generate zero economic
profits.Unfortunately,thisisaveryunrealisticmodelofhowbusinessworks.Competitionreducesthe
earning power of all assets, existing and future. And we can add that the basic EVA model does not
provideguidanceregardingT.
AnotherwayofpresentingtheseresultsisintermsofMVA(Damodaran,2000).TheMVAisthedifference
between the firm value and the capital invested. Clearly, this value will be positive only if the return on
capitalisgreaterthanthecostofcapital,andwillbeanincreasingfunctionofthespreadbetweenthetwo
numbers. Conversely, the number will be negative if the return on capital is less than the cost of capital.
Notethatthewhilethefirmcontinuestogrowinoperatingincometermsandtakenewinvestmentsafter
the nth year, these marginal investments create no additional value if they earn the cost of capital. A
22
directimplicationisthatitisnotgrowththatcreatesvalue,butgrowthinconjunctionwithexcessreturns.
Thisprovidesanewperspectiveonthequalityofgrowth.Afirmcanbegrowingitsoperatingincomeata
healthy rate, but if it is doing so by investing large amounts at or below the cost of capital, it will not be
creatingvalueandmayactuallybedestroyingit.

Finally,wecanderiveseveralimplicationsfromthefactthatthevalueofafirmcanbewrittenintermsof
the present value of the EVA by both projects in place and expected future projects. First, a policy of
maximizingthepresentvalueofEVAovertimeisequivalenttoapolicyofmaximizingfirmvalue.However,
the notion that the EVA approach requires less information than a DCF valuation, or that it provides a
better estimate of value is false. The EVA approach, done right, should yield the same value as a DCF
valuation, and it requires more information, not less. In fact, the DCF valuation required cash flows and a
discountratetoarriveatavalue.TheEVAapproachrequirestheseinputsandanadditionalone:thecapital
investedinthefirm.ItusesthismeasuretobreakfirmvalueupintocapitalinvestedandEVAcomponents.
Notethatchangingthecapitalinvestednumberhasnoimpactonoverallvalue.Finally,itisoftenclaimed
thattheEVAvaluationsprovideuswithfreshinsightsonvalueenhancementbecauseofitsfocusonexcess
returns, defined in terms of return and cost of capital. A DCF model where growth is linked to the
reinvestment rate and the return on investments accomplishes the same objectives and arrives at the
sameresults.
CFROIandDCFmodel
Damodaran(2000)showsthelinkbetweenCFROIandfirmvalue,bybeginningwithasimplediscounted
cashflowmodelforafirminstablegrowth:
Fiim value =FCFF1(kc gn )
Thiscanberewritten,approximately,intermsoftheCFROIasfollows:
Fiim value = (CFR0I*uIBA)(1 t)(CXBA) WC)(kc gn )

where
FCFF=freecashflowtofirm=EBIT(1t) (Capital Expenuituies Bepieciation) Change in Woiking
Capital
CFROI=cashflowreturnoninvestment
GI=grossinvestment
CFROI*GI=economicincome
DA=depreciationandamortization
CX=capitalexpenditures
WC=changeinworkingcapital
k
c
=costofcapital
g
n
=stablegrowthrate.

More important than the mechanics, however, is the fact that firm value, while a function of the CFROI is
alsoafunctionoftheothervariablesintheequationthegrossinvestment,thetaxrate,thegrowthrate,
thecostofcapitalandthefirmsreinvestmentneeds.
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. Holt Associates and BCG both allow for a fade factor in
CFROI,wherethecurrentCFROIfadestowardstherealcostofcapitalovertime.
A companys current value depends on competitive lifecycle patterns that reflect expected future
economicreturnsandreinvestmentrates(Madden, 2007).Theideaofcompetitivelifecyclesisbasedon
thepremisethatcompetitionandcapitalflowsoperateoverthelongertermtoforcecompanieseconomic
returnstowardthecostofcapital.Duringthehighinnovationstage,returnsareabovetheircostofcapital
and reinvestment exceeds internally generated funds. Attracted by the wealth creation opportunities,
23
competitors attempt to duplicate innovations. Competition results in a tendency of economic return to

fade towards the long term average of the corporate sectors economic returns (which approximates the
corporatesectorslongtermcostofcapital).Thus,corporatereinvestmentratesfallbacktowardthelower,
longtermaveragegrowthrateof theoveralleconomy.Tomaintainwellaboveaverageeconomicreturns
and reinvestment rates over decades, companies must continually reinvent themselves to outperform
competitors.
The "fade factor" can be estimated empirically by looking at firms in different CFROI classes and tracking
themovertime.Thus,afirmthathasacurrentCFROIof20%andrealcostofcapitalof8%willbeprojected
tohavelowerCFROIovertime.
Figure1displayedthelifecyclemodel(panelA)andthelifecycletrackrecordsofKmartandWalMartin
the 19602005 period (panel B and C respectively), where the two companies CFROIs can be observed as
well as a benchmark longterm corporate average CFROI of 6% real to approximate the cost of capital
(Madden, 2007). WalMart has been able to postpone the downward competitive fade of its superior
CFROIs while still reinvesting at very high rates. This occurred because WalMarts founder was skilled in
hiringtalentedpeople,motivatingemployeesanddevelopingstrategiesthatwereextraordinarilyeffective
aswellasastepaheadofhiscompetitors.Hisoriginalstrategywastolocatestoresawayfromlargecities
andtosaturateregionssothestorescouldbeefficientlyservicedbyacentrallylocateddistributioncenter.
Figure1LifeCyclemodelandKmartandWalMartlifecycleperformance
panelAlifecyclemodel
panelBKmartlifecycletrack
panelCWalMartlifecycletrack
source:Madden(2007)
24
His strategy proved correct as population expanded to where his stores were located. The remarkable
achievementofcreatingtheworldslargestretailer,alongwithover1.7millionjobs,andhugeshareholder
value,hadtheadditionalsocialbenefitofincreasingthepurchasingpowerofmillionsofcustomersthrough
itsdiscountpricing(Madden,2007).
Thevalueofthefirm,inthismorecomplexformat,canthenbewrittenasasumofthefollowing:
thepresentvalueofthecashflowsfromassetsinplaceovertheirremaininglife,whichcanbewritten
as
CPR0Iup -uIup
(1+k
c
)
t
t=n
t=1
whereCFROI
aip
istheCFROIonassetsinplace,GI
aip
isthegrossinvestment
inassetsinplaceandk
c
istherealcostofcapital
thepresentvalueoftheexcesscashflowsfromfutureinvestments,whichcanbewritteninrealterms
as
CPR0It,NI - uIt
(1+k
c
)
t
t=
t=1
GI
t
, where CFROI
t,NI
is the CFROI on new investments made in year t
andGI
t
isthenewinvestmentmadeinyeart.NotethatifCFROI
t,NI
=k
c
,thispresentvalueisequalto
zero.
The key to avoiding perpetuity hypothesis is to determine when a companys return on capital is equal to
itscostofcapital(i.e.discountrate).Afterward,nomatterhowmuchafirmgrows,thenetpresentvalue
offutureinvestmentsiszero.
Thus,afirm'svaluewilldependupontheCFROIitearnsonassetsinplaceandboththeabruptnessandthe
speedwithwhichthisCFROIfadestowardsthecostofcapital.Thus,afirmcanpotentiallyincreaseitsvalue
bydoinganyofthefollowing:
increasingtheCFROIfromassetsinplace,foragivengrossinvestment
reducingthespeedatwhichtheCFROIfadestowardstherealcostofcapital
reducetheabruptnesswithwhichCFROIfadestowardsthecostofcapital.
Notethatthisisnodifferentfromananalysisoffirmvalueinthediscountedcashflowformatintermsof
cashflowsfromassetsinplace(increasecurrentCFROI),thelengthofthehighgrowthperiod(reducefade
speed)andthegrowthrateduringthegrowthperiod(keepexcessreturnsfromfallingassteeply).
4.3 Managerialimplicationsofeconomicvaluemeasures
From a managerial accounting standpoint, the key question is not whether economic value measures are
more highly correlated with stock returns than traditional accounting measures, but whether the use of
economic value measures for internal decisionmaking, performance measurement, and compensation
purposesimprovesorganizationalperformance(IttnerandLarcker,1998).
Before debating whether the companies have in fact gained value by adopting the economic value
measures,itisworthnotingthewayinwhichthesemeasureshavebeenputinpractice.
Since EVA is the most popular measure of performance and has widespread application across industries
andcontinents,inthelastdecadewehaveseenanumberofconvertsamongcorporationstoEVA.Most
firms that have adopted EVA as their value enhancement measure have also tied management
compensationtoit.Somefirmshavemadeitthesolebasisforcompensation,whileotherscontinuetouse
it in association with other compensation schemes (i.e. stock grants and stock options). The adopters of
EVAstillmeasureitlookingatyeartoyearchangesratherthanintermsofthepresentvalueofEVAsover
time. The reward may be simply based upon achieving an EVA next year that is greater than this year's
number.Inotherfirms,managersarerewardedonlyiftheybeattheexpectedEVA.Inalmostnocaseisthe
rewardbaseduponthepresentvalueofEVAsovertime.Thispracticedoescreateasignificantpotentialfor
abuse,aswewillseebelow.FirmsthathaveconvertedtoEVAhavedonesonotjustatthefirmlevel,but
also at the level of individual divisions or subunits within the firm. Thus, the success or failure of an
employeeisoftenmeasuredbytheEVAbytheunittowhichthisemployeeismostcloselyconnected.This
practicemakestheestimationproblemsaboutEVAmuchgreater(Damodaran,2000).
SimilarpracticescouldbesupposedaboutCFROI.
25
AsregardSVA,Rappaport(1999)explainsthesuperiorSVAapproachforanincentivepayplanofoperating
managers at business units level (neither for CEO and corporate level executives nor for frontline
managers).SVAputsvalueonchangesinthefuturecashflowsofacompanyorbusinessunit.Accordingto
SVAapproach,businessunitsmanagersshouldberewardedwhenthey createsuperiorSVAin their units.
CalculatingsuperiorSVArequiressixsteps(Rappaport,1999):
first, develop expectations for the standard drivers of valuesales growth, operating margins, and
investments by factoring in historical performance, the unit's business plan, and competitive
benchmarking;
second, convert the expectations about value drivers into annual cashflow estimates and discount
thematthebusinessunit'scostofcapitalinordertoobtainthevalueofeachoperatingunit;
third,aggregatethevaluesofeachoperatingunittoverifythatthesumisapproximatelyequaltothe
company'smarketvalue;
fourth, from the cash flows used to value the operating unit, establish the annual expected SVA over
theperformanceperiodtypicallythreeyears;
fifth,useyearendresultstocomputetheactualSVAattheendofeachyear.Thecalculationwillhethe
sameasinthepreviousstep,withactualnumbersreplacingtheestimates;
sixth, calculate the difference between actual and expected SVA. When the difference is positive, you
havesuperiorSVA.
Since value creation prospects can vary greatly from one business unit to another, an approach based on
expectationsestablishesalevelplayingfieldbyaccountingfordifferencesinbusinessprospects.Managers
whoperformextraordinarilywellinlowreturnbusinesseswillberewarded,whilethosewhodopoorlyin
highreturn businesses will be penalized. Setting the SVA threshold targets at 80% of a designated target
wouldbeappropriate.
In addition, when setting performance pay, it is important to note that value creation is a longterm
phenomenon. Annual performance measures do not account for the longerterm consequences of
operating and investment decisions made today. So looking at a single year reveals little about the long
term ability of a business to generate cash. To motivate managers to focus on opportunities to create
superiorSVAbeyondthecurrentperiod,theperformanceevaluationperiodshouldbeextendedto,say,a
rollingthreeyearcycle.
Moreover, a breakdown of SVA drivers could be used in compensation and operations evaluation for
middle managers and frontline employees, who need to know what specific actions they should take to
increase SVA (being SVA too broad to provide much daytoday guidance to them). For more specific
measures,companiescandevelopleadingindicatorsofvalue,whicharequantifiable,easilycommunicated
current accomplishments that frontline employees can influence directly and that significantly affect the
longtermvalueofthebusinessinapositiveway.Examplesmightincludetimetomarketfornewproduct
launches, employee turnover rate, customer retention rate, and the timely opening of new stores or
manufacturing facilities. The process of identifying leading indicators can be challenging, but improving
leadingindicatorperformanceisthefoundationforachievingsuperiorSVA,whichinturnservestoincrease
longtermshareholderreturns(Rappaport,1999).
A1995surveybySibson&Co.supportsclaimsthatmanyusersofeconomicvaluemeasuresdonotbase
compensation on these measures (see Table 7): while 41.2 percent of respondents used economic value
measures (i.e. measures such as EVA, CFROI, residual income, etc.) for business planning and financial
management purposes, only 16.7 percent used these measures in incentive plans, of which only 26.3
percent made economic value the sole performance measure in these plans. In addition, many of the
respondentsusedeconomicvaluemeasuresonlyinannualincentiveplansandnotinlongtermplans,and
relativelyfewusedthematallorganizationallevels.
Now we can analyze what is the potential for abuse in adopting the economic measures in managerial
compensation,asillustratedabove.

26
Table7Usesofeconomicvaluemeasures
source:IttnerandLarcker(1998)
Assume that a firm adopts EVA and decides to judge managers based upon their capacity to generate
greaterthanexpectedEVA(Damodaran,2000).
To answer this question, let us go back to the following equation, where firm value is decomposed into
capitalinvested,thepresentvalueofEVAbyassetsinplaceandthepresentvalueofEVAbyfuturegrowth.
irm :oluc = copitol in:cstcJ

usscts n pIucc

+
LvA
t,csscts in plccc
(1+k
c
)
t
t=
t=1
+
LvA
t,]uturc prc]ccts
(1+k
c
)
t
t=
t=1

The first two terms in the equation (the capital invested and the present value of EVA by these
investments),arebothsensitivetohowcapitalinvestedismeasured.Ifcapitalinvestedisreduced,keeping
theoperatingincomeconstant,thefirsttermintheequationwilldropbutthepresentvalueofEVAswill
increaseproportionately.
When managers are judged based upon the EVA, there will be strong incentives to keep the capital
investeddown.Thus,ifthereductionincapitalinvestedcamefromclosingdownaplantthatwasnot(and
does not expect to) generate any operating income, the cash flow generated by liquidating the plants
assets will increase value. However, if the reduction is purely cosmetic in terms of its effects on capital
invested,thusdoesnotcreateandmayevendestroyvalue.Someexamplesare:a)accountingchangesthat
reduce the book value of capital, but do not generate tax benefits or higher operating income in future
periods (for example, large onetime restructuring charges); b) game playing once the rules for EVA
measurehavebeendefined(theincentivetoleaseratherthantobuyassets);c)whenEVAisestimated
fordivisions,theallocationofinvestedcapitaltothedivisionswillbebaseduponrulesdevisedbythefirm:
whileexpectedobjectiveandunbiased,theycouldbesubjectiveandoverallocatecapitaltosomedivisions
orunderallocatecapitaltoothers.Thismisallocationislikelytoreflectthepowerofindividualdivisionsto
influencetheprocess:theEVAwillresultoverestimatedforthelastandunderestimatedfortheformer.
Furthermore, the value of a firm is the value of its assets in place and the value of its future growth
prospects.WhenmanagersarejudgedonthebasisofEVAinthecurrentyear,oronyeartoyearchanges,
27
the EVA that is being measured is just that from assets in place. Thus, managers may trade off the EVA
fromfuturegrowthforhigherEVAfromassetsinplace.Inaddition,thepresentvalueoftheEVAisnotjust
afunctionofthedollarEVAbutalsoofthecostofcapital.AfirmcantakeactionsthatincreaseitsEVA,but
still end up with a lower value, if these actions increase its operating risk and cost of capital. When
managers are judged based upon yeartoyear EVA changes, there will be a tendency to shift investments
intoriskierinvestments.Thistendencywillbeexaggeratedifthecostofcapitaldoesnotreflectthechanges
inriskorlagsit(betaestimatesthatarebaseduponhistoricalreturnswilllagchangesinrisk).
In closing, EVA is an approach that is skewed towards assets in place and away from future growth
(Damodaran, 2000). It should not be surprising, therefore, that when EVA is computed at the divisional
levelofafirm,thehighergrowthdivisionsendupwiththelowestEVA(insomecaseswithnegativeEVA).
Again, while these divisional managers may still be judged based upon changes in EVA from year to year,
the temptation at the firm level to reduce or eliminate capital invested in these divisions will be strong,
sinceitwillmakethefirmsoverallEVAlookmuchbetter(Damodaran,2000).
AlthoughtherelationshipbetweenCFROIandfirmvalueislessintuitivethantherelationshipbetweenEVA
and firm value, partly because it is a percentage return, the games that managers can play, when their
performanceisjudgedonthebasisoftheCFROI,aresimilartothosenotedindiscussionofEVA.
Thefirstisthecapitalgame,wheretheCFROIisincreasedwhilethegrossinvestmentisreduced.Sinceitis
theproductofthetwothatdrivesvalue,itispossibleforafirmtoincreaseCFROIandendupwithalower
value.Thus,managersof firmsjudged onthe basisofCFROIwill doeverythingin their powertokeep the
grossinvestmentassmallaspossible.
CFROI,evenmorethanEVA,isfocusedonassetsinplaceanddoesnotlookatfuturegrowth.Totheextent
that managers increase CFROI at the expense of future growth, the value can decrease while CFROI goes
up.Thisisbecausetheeffectsofthegrowthsacrificearelikelytobeobservedinthefadefactor,andunless
thiscanbepreciselyestimatedandcomparedtowhatitshouldhavebeen,thegrowthgamewillcontinue
tobepaid(Damodaran,2000).
While the CFROI is compared to the cost of capital to pass judgment on whether a firm is creating or
destroyingvalue,itrepresentsonlyapartialcorrectionforrisk.Thevalueofafirmisstillthepresentvalue
ofexpectedfuture cashflows.Thus,afirmcanincreaseitsspreadbetweentheCFROIandcostofcapital,
but still end up losing value if the present value effect of having a higher cost of capital dominates the
higherCFROI.
Ingeneral,then,anincreaseinCFROI,byitself,doesnotindicatethatthefirmvaluehasincreases,sinceit
mighthavecomeattheexpenseoflowergrowthand/orhigherrisk.
SincethefocusofSVAisfutureperformance,itisdifficulttoapplywhenmeasuringhistoricperformance.
However, the focus on superior SVA as difference between actual and expected SVA, in a medium term
span, should orient correctly the operating managers to find strategies with the highest potential for
increasingvalue,avoidingtheshorttermperformanceobsession.
Wewillexaminenowempiricalevidenceabouteffectsonmanagerialbehaviourinducedbytheadoptionof
theeconomicvaluemeasures.
Wallace(1997)examinedrelativeperformancechangesin40adoptersofresidualincomebasedmeasures
suchasEVA,EPandCVAandamatchedsampleofnonuserssupportsclaimsthatthesemeasureschange
managerial behaviour. Compared to the control firms, the residual income firms decreased new
investments ( 21%), increased payouts to shareholders through share repurchases (+112%), sold (or
withdrew)100%moreassetsandutilizedassetsmoreintensively,leadingtosignificantlygreaterchangein
residual income. These actions result to be consistent with the strong rate of return discipline associated
withtheexplicitcapitalchargeinresidualincomebasedmeasures.
28
Wallacealsofoundweakevidencethatstockmarketparticipantsrespondedfavourablytotheadoptionof
residualincomebasedcompensationplans.
Kleiman (1999) compared the performance of 71 companies that adopted EVA between 1987 and 1996
withthatofitsmostdirectcompetitorsthatdidnotadopttheEVA.HedemonstratedthatadoptionofEVA
based performance evaluation system resulted in substantial improvements in EBITDA and operating
margins,fasterassetturnsandstrongercashflowgeneration,whichareinturnthedriversofthesuperior
stock market performance of these companies. Sale of assets increases significantly after introduction of
the EVA, too. Thus, adoption of EVA led to substantial internal improvements, which resulted in higher
shareholderreturnsthantheirimmediatecompetitors:2.6%intheyearofintroduction,and5.7%,1%and
11.1%duringthefollowingyears.
NoempiricalevidenceisavailableoneffectivenessofSVAinmanagerialcompensationsystems.
A related issue is whether the performance implications of economic value measures depend upon how
themeasuresareusedwithintheorganization.SternStewartarguesthateffectiveimplementationofEVA
requiresfirmstomakethismeasurethecornerstoneofatotalfinancialmanagementsystemthatfocuses
onEVAforcapitalbudgeting,goalsetting,investorcommunication,andcompensation(Sternetal.,1995).
Stewart (1995) asserts that the poor results from many EVA implementations are attributable to the fact
that EVA use has not become pervasive throughout the organization, especially for compensation
decisions. The firm attributes the lack of success in many EVA implementations to four factors: 1) EVA is
notmadeawayoflife;2)EVAisimplementedtoofast;3)lackofconvictionbytheCEOordivisionhead;4)
inadequatetraining(Stewart,1995).
As reported in a Stern Stewart study (www.EVA.com) companies that implemented EVA in the 1990s
outperformed their peers by an average of 8,3% per annum over the five years following adoptation and
created total excess shareholder wealth of $ 116 billion. A more recent study of the performance of EVA
companiesconcentratingontheperiodsincethepeakofthestockmarketonmarch2000throughmidyear
2002showedthattheportfolioofSternStewartsEVAclientsearnedatotalreturnof36,5%andbeatthe
S&P 500 by a total of 69,8%. The performance differential was even more significant for companies that
havereinforcedEVAasaperformancemeasureanddecisiontoolbytyingmanagementincentivestoEVA.
Thosefirmsearneda64.5%whereascompaniesthatusedEVAonlyforperformancemeasurementearned
a 20,2% return and beat the market by 53,5%. The evidence seems to be consistent with the contention
that EVA works best when it is used in a powerful bonus plan that stimulates the incentives of ownership
anddirectlyalignstheinterestsofmanagersandemployeeswiththoseoftheowners.Buttestsanddata
areprovidedbySternStewart,whichisstronglyinterestedtosupportthemostpervasiveuseofEVA.
Biddleetal.(1998)providesomeevidencethattheuseofeconomicvaluemeasuresincompensationplans
isassociatedwiththemeasureseffectiveness.TheonlysubsampleinwhichEVAoutperformedtraditional
accountingmeasuresinpredictingstockreturnswasfirmsusingEVAincompensationplans.Similarly,the
Sibson&Co.surveyindicatesthat26.3percentoffirmsusingeconomicvaluemeasuresinincentiveplans
reported that these measures were "very successful" and 36.8 percent reported they were "marginally
successful."Noneoftherespondentsstatedthatthemeasureswere"notsuccessful."The31.5percentof
respondentswhowere"notsure"ofthemeasures'effectivenesswereallrecentadopters.
Wallace(1997)alsoidentifiedagroupof36firmsthatusedaresidualincomemeasuretosomeextentin
their decision making, but that have not included the measure in their incentive compensation. On this
sample the same tests performed in the main sample are repeated. The results are generally weaker for
these firms (than 40 adopters in compensation plans), with only significant results observed for the asset
disposition test. The observed results for the financing, operating, and residual income tests are all
insignificant.Theseresultssupportthecontentionthatresidualincomebasedperformancemeasuresonly
workiftheyareusedincompensationplans.

29
Wallace's(1998)surveyofEVAusersfoundthatfirmsincludingEVAintheirincentivecompensationplans
also implemented the measure to a significantly greater degree for capital budgeting and dividend
decisions,butnotforassetdisposal,workingcapitalmanagement,sharerepurchase,orfinancingdecisions.
Firms using EVA in incentive plans also reported significantly greater awareness of the cost of capital,
reduced average accounts receivable age, increased use of debt, increased sales revenues and a longer
accounts payable cycle. However, changes in the degree of selectivity in the choice of new investment
projects, inventory turnover, share repurchases and debt repayment were not statistically different in the
twoEVAusergroups.
5. ACOMPARISON:STRENGTHSANDWEAKNESSESOFTHEECONOMICVALUEMEASURES
Thefollowingtable(Fernandez,2003)proposesacomparisonbetweenEVAandCFROI(throughCVA).
Cwynar(2009)defineEVA,CVAandRIasaccountingbasedvariantsofresidualincomeapproachbecause
they utilize book values of both operating income and invested capital, although more or less adjusted
(unadjustedforRI)inordertoeliminateorlimitthedistortionsofaccountingnumbers.Conversely,SVAis
based directly on the DCF concept. The Refined Economic Value Added" (REVA), elaborated by Bacidore
et al. (1997), is considered a hybrid metric, because it calculates EVA applying the cost of capital to the
openingmarketvalue(ratherthanbookvalue)ofthefirm'sequityplusdebt.
Table8AcomparisonbetweenEVAandCVA
source:adaptedfromFernandez(2003).
If all valuebased metrics have similar goals, then why are there different metrics? A cynic might answer
thatitgivesalltheconsultantssomethingtoargueabout.Althoughthishypothesisdefinitelyhasmerit,the
realityisthatdifferentmetricsarelikelytoservedifferentpurposes(FabozziandGrant,2000).
The principal users of valuebased metrics are money managers/analysts and corporate executives. Each
party has unique needs and access to information when carrying out their daily activities. For instance,
money managers need a metric that allows them to quickly evaluate hundreds and even thousands of
companies on the basis of publicly available information. They evaluate managements skill by looking at
managementshistoricandforecastedtrackrecordrelativetopeers,andthendeterminewhetherthefirm
isoverorundervaluedbasedontheirexpectations.Contrastthistocorporateexecutiveswhohavealmost
limitlessinformationonasinglefirm.Thefirm,however,ismadeupofseveralbusinessunits,hundredsof
projectsandthousandsofemployees.Corporateexecutivesmustnotonlymakestrategicdecisionstohelp
EVA
economicvalueadded
CVA
cashvalueadded
measureof
shareholder
value
creation
EVA=NOPAT(Ebv+D)WACC
CVA=NOPAT+DEPEDEP
(D
O
+Ebv
O
)WACC
(DEP=accountingdepreciation;
EDEP=economicdepreciation)
EVA=(ROCWACC)(D+Ebv)
CVA=(CFROIWACC)x(D
O
+Ebv
O
)
measureof
shareholder
return
ROC=ROA=NOPAT/(D+Ebv)
(NOPAT=netoperatingprofit
aftertaxesandafter
adjustments)
CFROI=(NOPAT+DEP
EDEP)/(D
O
+Ebv
O
)
assetsin
place
D+Ebv=adjustedbookvalue
ofdebtandequity
(D=debt,Ebv=bookvalueof
equity)
(D
O
+Ebv
O
)=workingcapital
requirements+fixedassets+
cumulateddepreciation+inflation
adjustment
30
the firm create shareholder value, they must also promote and instill valuebased management principles
throughouttheorganizationdowntothelowestlevels.Inaddition,theymustdesignandmaintaininternal
management systems to ensure that the firm does not stray from the designated path. Although always
aware of the external demands of the market and pressure from competition, the corporate executives
predominate focus is internal, with a primary emphasis on managing the operational details of running a
business.
In short, money managers want a performance metric that is comparable across a large number of firms
andavaluationsystemthatobjectivelysetstargetvalues.Corporateexecutiveswantthesameproperties,
butaremuchmoreinterestedinasimplemeasurethatiseasytocommunicateandadministerthroughout
thefirm.Canoneframeworkmeettheneedsofbothparties?
As discussed earlier, a primary goal of valuebased metrics is to eliminate the numerous distortions in
accountingdatatoprovidecomparabilityacrosstime,firmsandindustries.Oncewehavecleanedupthe
accounting data, we can evaluate if companies are creating or destroying shareholder wealth and provide
more insightful valuations. EVA and CFROI are similar along this aspect; on the contrary, SVA utilizes in
computationDCFapproachdirectlyanddoesnotintroduceaccountingdistortions.
However, unlike CFROI, EVA includes depreciation twice in the earnings and investment portion (by
subtracting twice as expense in the earnings portion of the calculation and again in the investment value
upon which the cost of capital is subtracted). Utilizing these items in a performance metric can cause
manydifficultiesforamanagerwhoistryingtocomparefirmsacrosstimeandindustriestodetermine
thebestinvestmentopportunity.Forexample,howdoesamanagercompareEVAfortwofirmswhen
onefirmusesaccelerateddepreciationandtheotherstraightline?Orwhataboutfirmshavingsimilar
fixed assets that were purchased at different times? In addition, the manager must determine if the
netassetbaseadequatelyaccountsforthemoneythefirmhasinvestedtogenerateitscashflows(e.g.
thefirmmayhavefullydepreciated,butnotretiredfixedplant)andwhetherdepreciationexpenseis
sufficient to replace the existing fixed assets. These issues have additional implications for the
corporateexecutive. TheEVA calculations reliance on net plant can leadcorporations to confusing
conclusions regarding wealth creation and optimal strategy. Fabozzi and Grant (2000) call this effect
the old plant trap. As a project gets older, EVA increases. Why? Has the projects economics
changed? No, the basic EVA calculation increased only because the plant was depreciated, which
decreased the capital charge each year. In addition, which EVA is the correct EVA, and how does a
managerknowwhethertoacceptorrejecttheproject?Thiscalculationissuehasseriousimplications
on management incentive mechanism. If a company adopt a compensation system that rewards
improvement in EVA, managers are likely to resist growing since each new project will incrementally
decrease their EVA, while doing nothing increases it. Inflation makes the problem even worse (new
investmentsareexpressedatcurrentprices).EVAcandealwiththeoldplanttrapbyreplacingthe
accountingdepreciationwiththeannuity(economic)depreciation.Obviously,suchasolutionisnotas
easy,furtherforexternalanalysts.
Unlike EVA, CFROI is an internal rate of return and not a measure of economic profit. It provides a
consistentbasisfromwhichtoevaluatecompaniesregardlessoftheirsize.ThischaracteristicofCFROIhas
made it very popular in the money management community, as investors need to compare many
companies against each other to make investments decisions (Fabozzi and Grant, 2000). However, CFROI
doesnoteliminatethehurdlerateproblem,inwhichcompaniessetanacceptablerateofreturn(thecost
of capital) and assess performance based on the actual rate achieved. Thus, companies are discouraged
from investing in projects that would be expected to achieve a lower return, compared to the presently
employedassets,evenifitexceeds thehurdlerate. Itwouldresultina greaterpositivecashflowforthe
company,butlowertotalrateontheportfolioofinvestments.Becauseitlowerstheoverallperformance
evaluationcriterion,itdiscouragesapprovaloftheprojecteventhoughitwouldbebeneficialtothewhole
company.Inaddition,aswellasIRR,CFROIisaratebasedmeasureandcanprovideamovingtargetbased
on assumptions regarding reinvestment that may or may not be true (given two projects with equal NPV
butdifferingtimingandamountsforcashflows,IRRwilloftenproducedifferentanswers).Finally,CFROIis
31
a nonlinear measure: therefore, it is not easy for a manager to link how much he needs to improve cash
flowtoobtainatargetincreaseinCFROI.
Unlike EVA and CFROI, the SVA approach is likely to be more appropriate for corporate planning because
corporateplannerswanttounderstandhowchangesinstrategywillaffecttheircompanysvalue.TheSVA
includes strategyspecific forecasts and therefore the strategic implications of the SVA model are more
clearandintuitive.Moreover,itfocusesonthestandarddriversofvalue(salesgrowth,operatingmargins,
investments,costofcapital).However,sincethefocusofSVAisfutureperformance,itisdifficulttoapply
when measuring historic performance and then it could be considered less adequate in compensation
systems.However,asdiscussedabove,sincethefocusofSVAisfutureperformanceshouldorientcorrectly
theoperatingmanagerstofindstrategieswiththehighestpotentialforincreasingvalue.
Wewillsumupasfollowsthestrengthsandweaknessesofthethreevaluebasedmeasuresanalyzed.
EVA
FundamentallyEVAhastwosoundfeatures:
byfocusing attentionon surplusvalue,itdoesstressthatitisnothowmuch incomeafirm makes
thatmarksitssuccess,buthowmuchitmakesinexcessofitscostofcapital
by making this measure an absolute measure (rather then a spread of rates) it helps firms recognize
that refusing projects that earn more than their cost of capital (just because they earn less or a
smallerspreadthandoexistingprojects)canbevaluedestroying.
EVA,ontheotherhand,showsvariousshortcomings.
itisdistortedbytheeffectoftheoldplanttrapandthiscalculationissuehasseriousimplications
onmanagementincentivemechanism
it is not a revolutionary way of thinking about financial decisions (as its proponents claim): EVA is just
NPV presented differently and valuing a firm using EVA requires more information than DCF models,
notless(Damodaran,2000)
it is very dependent on accounting measures of operating income and capital invested, though
adjustments are made to both as demonstrated by a very strong relationship between adjusted and
unadjustedEVA(Andersonetal.,2005)
itcouldbeinconsistentwithvaluecreation.ThevalueofafirmsassetsisthepresentvalueoftheEVAs
generatedbythem.Thus,afirmcouldbegeneratingapositiveEVAinthecurrentyearfromassets,but
theexpectedEVAinfutureyearsmaybenegative,makingtheseassetspoorinvestments.Conversely,
you can have a firm generating negative EVA in the current year, but the assets could still be value
creatingifthepresentvalueofexpectedfutureEVAsispositive.Similarly,ifafirmincreasesitsEVAthis
yearrelativetolastyearsEVAorevenrelativetoexpectations,itcouldnotstatedthatithasincreased
itsvalue,butitmighthavedonesobytradingoffagainstfuturegrowthorincreasingitsriskiness
neither strong nor univocal evidence exists on a higher correlation between EVA or EVAs increases
andmarketvalueincreasesthanothertraditionalmetricsaswellasrivaleconomicvaluemeasures
EVAhasbeencriticizedforbeingtoocomplexforfrontlinemanagerstouse,formotivatingmanagers
to reduce beneficial capital expenditures to improve shortterm EVA, and forignoring the firm's "core
competencies" and providing little actionable information on the longterm drivers of firm value. For
example, AT&T was once touted in the business press as a leading proponent of EVA, but has since
abandoned this measure (Ittner and Larcker, 1998). Prior to an internal reorganization in the early
1990s, performance was evaluated based on measured operating income and measured operating
units (a service volume indicator), and no variable compensation was awarded. In 1992, the firm
adopted EVAfordecisionmakingand compensationpurposes,andimplementedan EVAbasedbonus
plan covering approximately 110,000 employees. However, EVA was supplemented by two new
nonfinancial measures ("customer value added" and "people value added" within two years: the last
was based on employee satisfaction, work force diversity, employee turnover/retention, work force
32
health, and leadership visibility; the former was based on customers' satisfaction with price and with
product, service and contact quality), and was abandoned altogether by 1997 in favour of traditional
accountingmeasures.Threeprimaryreasonsforthemeasure'sdemiseinAT&Twereidentified:
the measure was too complex for most employees to understand, even though AT&T made
relatively few of the accounting adjustments recommended by Stern Stewart. Despite extensive
traininginthecomputationanduseofEVA,employeesoutsideofcorporateheadquartersdidnot
understand how their actions affected EVA results, and felt they had limited ability to impact
corporateorbusinessunitEVAtargets
the company came to recognize that EVA was an historical measure that provided incomplete
informationonkeydriversoffutureperformance,suchasemployeesandcustomers
althoughinternalEVAresultswerepositive,totalshareholderreturnbetweenDecember1992and
December 1996 (the period covered by the EVA measure) was 6.46 percent. The inconsistencies
between reported EVA and stock returns, combined with the hiring of a new CEO who had not
championed the EVA system, led the firm to drop EVA in favour of traditional accounting
performancemeasurestheybelievetobemorecloselyalignedwithanalysts'forecastmodelsand
shareholdervalue.
CFROI
There are some firms with significant capital rationing constraints, where it is critical that investments be
directedtothoseprojectswheretheyearnthehighestpossiblereturnsforthefirm.Forthesefirms,itcan
be argued that value added measures that focus on euro (or 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
percentagerateofreturnallowsthesefirmstogetthemaximumreturnfromlimitedcapital.
Furthermore, as a rate of return, CFROI is well designed as a tool to assist the institutional investors in
picking stocks: for this purpose they need a systematic means of sorting through the historical data of
thousands of businesses to identify potentially undervalued companies and to be able to back test the
model to identify how well it did in the past. Adopting for this purpose an economic metric like SVA, for
example, would simply be too time consuming, because it needs explicit separate yearly cash flow
estimates,costofcapitalandforecastperiodsforeachcompany.
Itisnotclear,however,thatCFROIisasignificantadvanceovereventraditionalaccountingmeasuressuch
asROIorROC.
UnlikeaccountingreturnmeasuresandevenEVA,CFROIfocusesoncashflows.Thisispartiallytrue,since
noncash 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. In addition, CFROI avoids accounting distortions by excluding
depreciation,butaccountingdepreciationaffectcalculationofassetlife(asaveragedepreciationperiod).
The traditional accounting measures of return tend to be overstated because they look at the remaining
bookvalueofassets.Thus,asassetsaredepreciated,thereturnonequityandcapitaltendtoincrease.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, however, tends to work
better for manufacturing firms but does not really hold up for firms that are not capital intensive.
Furthermore,itisarguedthatbyassumingafixedlifeforanassetandcomputinganinternalrateofreturn,
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
firmsthatinvestinplantandequipmentthanitisforfirmsthatinvestinshorttermandintangibleassets.
Furthermore,ifweassumethatassetshaveinfinitelivesandthatcapitalmaintenanceexpendituresoffset
depreciation,theCFROImeasureconvergesonthereturnoncapital.
Moreover,CFROIdoesnoteliminatethehurdlerateproblem,inwhichcompaniessetanacceptablerateof
returnandassessperformancebasedontheactualrateachieved.Thus,companiesarediscouragedfrom
investing in projects that would be expected to achieve a lower return, compared to the presently
employed assets, even if it exceeds the hurdle rate (the cost of capital). As well as IRR, CFROI is a rate
33
basedmeasureandcanprovideamovingtargetbasedonassumptionsregardingreinvestmentthatmayor
maynotbetrue.
Whileitisausefultoolforpickingstocks,itislessusefulforcorporateplanning.Corporateplannerswant
to understand how change in strategy will affect their companys value. Based on a series of average
assumptions(cashflowsdeterminedbya40yearCFROIfadingtocountrywideaverages,constantcostof
capital, etc.) in order to avoid explicit forecasts, CFROI will miss the distinctions (it was defined a sort of
"ProcrusteanBed"approachtocorporatevaluation).
Corporate planners want to understand how changes in strategy will affect their company's value. If you
have the average company with the average strategy and the average investment policy and the average
levelofsystematicriskandyourstrategyisnotgoingtochange,thenCFROIapproachwillmodelyourfirm
effectively. For any company that is not average on all these accounts, the BCG model will miss the
distinctions.Forexample,wouldanaturalresourcescompanyreallywantto"fade"tothesameCFROIand
the asset growth as a computer company? BCG's model would have it that way despite the fact that the
rates of return and investment growth vary significantly from firm to firm and industry to industry
(www.valueanalitix.com). Braxton Associates stated that a valuebased system using CFROI will be
unsuccessful without a value driver analysis that unbundles CFROI into discrete, controllable financial and
operationalvariables(Snyder,1995).
Therefore, it appears as a too complex measure for managers to understand and act upon, even if it is
conceptuallysuperiortotraditionalaccountingmeasuresandEVA.ItwouldbedifficulttoexplainCFROIto
theaverageoperatingmanager,muchlesshis/herspecificroleinmakingithappen.
SVA
Theshareholdervalueapproachhasgainedpopularitymainlybecauseofthefollowingreasons:
itaccountsforrisk,freefromaccountingdistortionsandmeasuresthechangeinvalue
theapproachusescompleteinformation.Itincorporateshistorical,currentandforecastinformationin
determiningtheamountandtimingoffuturecashflows,thevaluegrowthdurationandsystematicand
specificriskinitsanalysis
the SVA methodology concentrates on the residual claimants of the company. By choosing the
strategies which create the highest value for the shareholders, the management also creates the
highestvalueforotherstakeholderslikeemployees,otherinvestorsinthecompanyandcustomers
in the literature many surveys state the high correlation between cash outflow, downside stock price
movementsanddecreasingshareholdervalue.Fromthisresearchandexperience,thediscountedcash
flow approach to understand investor expectations has established its position as a preeminent, but
notexclusive,analyticaltoolforvaluebasedmanagement
the SVA approach is likely to be more appropriate for corporate planning because corporate planners
want to understand how changes in strategy will affect their companys value. The SVA includes
strategyspecificforecastsandthereforethestrategicimplicationsoftheSVAmodelaremoreclearand
intuitive.Operatingmanagersneedtoidentifyandfocusonleadingindicatorstodeliversuperiorvalue
toshareholders.
CommoncriticismsontheSVAapproacharethesubjectivity,thehighsensitivityoftheresidualvalueto
the cash flow, the reliance on CAPM approach for determining the discount rate, the shortcomings in the
area of compensation. We will analyze them shortly, reporting also the arguments in defence by SVA
advocates(www.valueanalitix.com):
subjectivity. It is correct to say that the SVA approach is subjective. The SVA approach preferably
involves specific forecasts about operating factors into the future. Because it incorporates managerial
judgementandstrategicthinking,subjectivityisalsonecessarilyadded.Certainotherapproachesavoid
thissubjectivityonlyatthecostofrelyingonhistoricaldataandapplyingrestrictiveassumptionsabout
thefuture
34
sensitivity of the residual value. Residual value is highly sensitive to the cash flow in the last forecast
period and the rate of growth in perpetuity. To address the cash flow concern, the SVA approach
excludes nonrecurrent events and normalizes the cash flow used as the basis for residual value. That
residualvalueshouldbehighlysensitivetothegrowthinperpetuityassumption.Afirmthatcancreate
valueindefinitelyintothefuture(i.e.onewithaperpetuitygrowthgreaterthanzero)shouldbemuch
more valuable than one that does not. It should be stressed that the perpetuity with growth
assumptionforresidualvalueisonlyapplicabletotheveryfewfirmsthathaveaneconomicadvantage
thatcannotbereducedbycompetition.
reliance on CAPM. The SVA approach does not solely rely on CAPM as a mean of determining the
discount rate. The SVA methodology can incorporate any method of estimating systematic risk, be it
CAPM,APToranyotherapproach.
shortcomings in the area of compensation. Compared to the EVA, the SVA approach is likely to pose
themostimportantquestioninperformancemeasurementwhetheracompanyearnsabetterreturn
onitsinvestmentthanitscostofcapitallessdirectly.Adirectresultofaskingthisquestionisthatthe
focus is on returns higher than the cost of capital, even if that return is decreasing. Since the focus of
SVA is future performance, it is difficult to apply when measuring historic performance. However, the
focusonsuperiorSVAasdifferencebetweenactualandexpectedSVA,inamediumtermspan,should
orientcorrectlytheoperatingmanagerstofindstrategieswiththehighestpotentialforincreasingSVA,
unlikeEVAandCFROIthatcaninducedistortingbehaviours.
AppendixFormulasofCFROI
Fromthefollowingformula
0I = 0CFo
nCPR0I
+
SI
(1 +CFR0I)
n
wecandemonstratehowthefollowingalternativeformulationoftheCFR0Icanbederived,ifweassume
inderivingtheeconomicdepreciationadiscountrateofk
c
= CFR0I =k
CFR0I = (uioss Cash Flow Economic Bepieciation) uioss Investment.
Statingthat:
EB=economicdepreciation=(uI Sv) * s
nk
,wheres
nk
=((1 +k)
n
-1) k isthefinalvalueofann
periodannuitywithinterestratek

multiplyingeachmemberoftheaboveequationby(1+k)
n
andthereforesubtractingbyeachmemberuI,
wecanrewritetherelationshipasfollows:
uI |(1+ k)
n
1] = uCF * s
nk
EB * s
nk
.

Being|(1+ k)
n
1] = k * s
nk
and o
nk
= s
nk
* (1+k)
n
, wecanget
k*uI = uCF EB thereforek = (uCF EB)uI (quoderatdemonstrandum).

35
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Financial performance measures and value creation: a review

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

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

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

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

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

CFR0I = (uioss Cash Flow Economic Bepieciation) uioss Investment

Thethirdeconomic measureistheshareholdervalueadded (SVA)elaboratedbyRappaport(1986)and

value cieateu by stiategy = change of shaieholuei value geneiateu by stiategy

opeiating cash flow

Fiim value = Capital Investeu

Fiim value = Capital Investeu

Fiim value =FCFF1(kc gn )

Fiim value = (CFR0I*uIBA)(1 t)(CXBA) WC)(kc gn )

competitors attempt to duplicate innovations. Competition results in a tendency of economic return to

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

irm :oluc = copitol in:cstcJ

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

CFR0I = (uioss Cash Flow Economic Bepieciation) uioss Investment.

k*uI = uCF EB thereforek = (uCF EB)uI (quoderatdemonstrandum).

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