venanzi performance

Electronic copy available at: http://ssrn.com/abstract=1716209Electronic copy available at: http://ssrn.com/abstract=1716209Electronic copy available at: http://ssrn.com/abstract=1716209Electronic copy available at: http://ssrn.com/abstract=1716209
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.

Electronic copy available at: http://ssrn.com/abstract=1716209Electronic copy available at: http://ssrn.com/abstract=1716209Electronic copy available at: http://ssrn.com/abstract=1716209Electronic copy available at: http://ssrn.com/abstract=1716209
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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
feedback on how well the company has achieved its goals; it furnishes the  basis of an adequate bonus plan
that gives incentives to achieve the firm’s goals and rewards the results of proper decisions.

Corporate financial performance measured in terms of accounting‐based metrics has been viewed as
inadequate as firms began focusing on shareholder value as the primary long‐term objective of the
organization: they fail to take into account the factors that drive shareholder value. Subsequently,
financial‐based 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 risk‐return into
performance calculations. The focus of this article is a review of the main value‐based 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
limited and contradictory and seem to be primarily provided by authors with strong commercial interest in
the outcome of any reasearch into the effectiveness of the methodologies. This paper aims at contributing
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
incentives and compensation. It would be a mistake to believe that any single measure is perfectly suited to
all types of financial decision support, meanwhile it could be very useful to compare the different measures
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 accounting‐based measures of
performance; therefore,  we illustrate the economic measures, highlighting their differences in calculation.
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
the strengths and weaknesses of each value‐based metrics will conclude the analysis.

2. CRITICISMS OF THE ACCOUNTING‐BASED  MEASURES OF PERFORMANCE

Value is a function of 1) investments 2) cash flow 3) economic life and 4) capital cost. The mechanism that is
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
plan to make in a company. The objective for doing this is to be able to establish and execute strategies and
investments that increase shareholder value. But in practice something peculiar seems to occur
(Weissenrieder, 1997).  After the investment has been made companies, analysts and media abandon this
thinking  and  enter the world of P/E‐ratios, 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
investments that we have made by using accounting data. Rappaport (2005) call this disease the short‐term
earnings obsession.
Accounting does not handle any of four factors the way a financial framework should handle  them. What
kind of information does the organization need for strategic decision making and for managing the
company's current operations? Choosing something for the only reason that it looks much like what we see
today from our current framework (accounting) would be a mistake.
Compelling evidence indicates that managers are obsessed with earnings. A recent survey of 400 financial
executives shows that the vast majority view earnings as the most important performance measure they
report to outsiders (Graham et al.,  2005). The two key earnings benchmarks are quarterly earnings for the
same quarter last year and the analyst consensus estimate for the current quarter.  Executives believe that
meeting earnings expectations helps maintain or increase the stock price, provides assurance to customers

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and suppliers, and boosts the reputation of the management team. Failure to meet earnings targets is seen
as a sign of managerial weakness and, if repeated, can lead to a career‐threatening dismissal.
Managing for short‐term earnings compromises shareholder value. In the following section some
fundamental shortcomings of the traditional accounting‐based metrics both as value measure and
performance measure  are summarized.

a) inaccuracy and subjectivity of the accounting numbers

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
company’s cash flows and therefore should not affect its economic value. This could produce two
implications:
− comparisons among different firms as well as different years of the same company  are not reliable
− 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 value‐creating spending on research and development, advertising, maintenance, and
hiring in order to meet earnings benchmarks. More than half the executives would delay a new project
even if it entailed sacrificing value. Managers push revenues into the current period and defer expenses
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
their value. As well as Jensen, we could cite  Cirio and Parmalat as similar examples.

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. numbers not expressed in  the same monetary unit. For example,  inflation can increase ROI
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 value‐based
measures of performance it is enough to use homogeneous numbers (real or nominal) of cash flows and
discount rates. Therefore  ROI could depend on the average age  of the fixed assets of the firm.

Despite, International Financial Reporting Standards (IFRS) attempting to reduce the possibility of such
manipulations,  valuation methodologies such as “mark‐to‐market” tend to exacerbate the problem.

b) nonalignment with the organizational goal of maximizing shareholder wealth

Accounting‐based measures of return omit  to consider the cost of invested capital, both in  terms of risk‐
free rate and risk premium. Therefore, maximizing earnings or return does no imply to maximize
shareholder value.
Maximizing earnings omit to account for the amount of capital invested to produce earnings. It could result
convenient any investment that produce earnings, no matter what return it earns or what risk it bears.  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 firm’s dividends to increase investment will
raise the stock price if, and only if, the new investment earns a rate of return on new investments greater
than its cost of capital, i.e. the rate investors can expect to earn by investing in alternative, equally risky,
securities.
When we use accounting rates of return like ROI or ROA, we risk to incur in the same problem. To illustrate,
a manager that uses ROI in its investment decisions will be encouraged only to select projects that equal or
exceed his/her  SBU’s or division’s current ROI regardless  of the value creation of that investment in the
longer term: projects of  the same SBU or division can differ in risk and cost of capital from the average risk

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and cost of capital of the mix of assets in place. Obviously these measures encourage managers much more
to act in ways that are incongruent with the corporate objective of  maximizing shareholder wealth when
managers  are measured and rewarded on maximizing them.

In marketing terms, it is imperative for businesses to allocate capital to endeavours that would be classified
as “stars” in the Boston Consulting Group (BCG) matrix, and put to sleep those that would be classified as
“dogs”. Traditional accounting performance measures may not enable management to identify between
these and in fact may encourage dogs to be fed more.

In order to avoid these misleading behaviors, hurdle rates or minimum acceptable rates for ROI are often
based on an estimate of the business unit’s (or division’s) 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
which is an economic return demanded by investors.

We can  demonstrate that accounting return of investment differs from economic return of investment as
well as apples differ from oranges (the case of a single project can be extended easily to many projects):

ACCOUNTING ONE‐YEAR RETURN: (cash flow – depreciation – other non cash charges + capital
expenditures + incremental investments in working capital)/ average (over the year) net book value
(i.e. book value minus accumulated depreciation);

ECONOMIC ONE‐YEAR 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. The economic return (r) can be derived as follows (CFt  and VAt  are  cash flow and present
value in year t , respectively):

1 1

1

∆

Note that unlike economic income that depends strictly on cash flows, book income (the numerator of the
accounting return) departs from cash flow since it does not incorporate  current year’s investment outlays
for working capital or fixed capital. In addition, non cash items such as depreciation and provisions for
deferred costs or losses are deducted to arrive at book income.  Furthermore, depreciation represents the
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
book income will not be an accurate measure of economic income.
Therefore,  ROI is not an accurate or reliable estimate of the DCF return. Solomon (1967) demonstrates
that the extent to which ROI overstates the economic or DCF return is a complex function of the following
factors (in parentheses the sign of the effect on the overstatement):
length of project life (+)
capitalization policy (−)
the speed of depreciation policy (+)
the time lag between outlays and the recoupment of these outlays from cash inflows (+)
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 steady‐state one, investments’ economic returns being equal.
When growth rate and economic rate of return are equal, ROI is equal too. ROI differs  from economic
return when the growth rate is  greater or smaller than the economic return.

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He found also that there is no systematic pattern in the error that allows a correction to be  made.

The following example (Tables  1 and 2), referring to an investment in a new restaurant, shows that while
the restaurant investment is expected to yield an economic return of 15%, the ROI results are substantially
different. ROI progresses from a negative figure in the first year to 200% in the fifth year when the
restaurant facilities are almost fully depreciated. Thus, ROI understates the economic rate of return  in the
first two years and significantly overstates it for the last three years. The five‐year average ROI is
approximately  23%,  almost twice the 15% DCF rate of return. As the above example illustrates, accounting
ROI typically understates rates of return during the early stage of an investment and overstates rates in
later stages as the asset base continues to decrease. Some might oppose that these errors offset one other
over time as the firm moves toward a balanced mix of old and new investments. Unfortunately, the errors
are not offsetting. Table 3 illustrates this problem. One restaurant (identical to the investment discusses
earlier) per year is opened during the first five years. Thus, beginning in the fifth year the firm will find itself
in a steady‐state situation.  The steady‐state  ROI is  23%, which significantly overstates the 15% economic
rate of return.

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
accounting data are inadequate in reliably capturing a firm’s true economic performance.
Empirical data from many countries demonstrates the following evidence:

non apparent relationship between  EPS growth and total shareholder returns
weak correlation between  EPS growth and price/earnings ratio (P/Es)
robust correlation  between market value  and present value of expected cash flows
statistically significant abnormal returns are observed when firms change accounting approach to
valuing inventories and computing cost of sales: positive in shift from FIFO to LIFO and negative in the
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
FIFO to LIFO, in fact, if inflation rate is positive, lessen the accounting income and, all being equal, cash
flows increase by means of  smaller tax‐payments
greater correlation with market value added (market value of a company minus book value of its
equity and debt)  of  DCF performance measures than accounting measures
greater correlation with market value added of residual income measures of performance, i.e.
measures that account for the cost of capital invested.

Table 1 – The economic return of investing  in  a new restaurant

      source: Rappaport (1986)

YEARS  (data   in ‘000€)

1   2 3 4 5
Cash flows    176,23   250 350 400 400
Present value (15%)
(at beginning of year)
(1)

1000   973,76 869,8 650,28 347,84
Present value  (15%)
(at end of year)
973,76   869,8 650,28 347,84 0
Change in  value during year
(economic depreciation)
‐  26,24 ‐103,95 ‐219,52 ‐302,44 ‐347,84

Economic income    150   146 130,5 97,6 52,2
Economic rate of return    (%) (2)
   15   15   15 15 15
(1) The present value at the beginning of the year is calculated by discounting the
remaining cash flows at 15%  (2) Economic rate of return corresponds to IRR

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Table 2 – The ROI of investing in a new restaurant

       source: Rappaport (1986)

Table 3 –ROI in the steady‐state

c) short term‐ism of managerial decision‐making

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
will be encouraged only to select projects that equal or exceed their current ROI regardless of the potential
value of investments in the longer term. Thus, the objective of maximizing ROI may result in projects that
will create wealth for shareholder not to be approved. Managers can maximize current profits  by reducing
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).  These investments  are characterized by taking a long time to translate initial outflows into financial
results,   and as is stated in most strategy textbooks, long term survival of a firm is dependent indeed on
this kind of investments.
In addition, ROI does not account for the post‐planning period residual value of the business unit or
company. Normally, only a small  portion of a firm’s  market value depends on profits generated in a five‐
year span;  conversely,  the larger portion depends on cash flows generated beyond that point.  A business
1   2 3 4 5 (steady‐state)

)

Accounting income       (per restaurant)
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
Accounting income  (total)   ‐ 23,77   26,23 176,23 376,23 576,23 576,23
Net book value (per restaurant)
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
Net book  value  (total) 900   1600

2100 2400 2500 2500

ROI for all restaurants  (%) ‐ 2,6 ‐1,6 8,4 15,7 23,0 23,0

YEARS  (data in ‘000 €)
1   2 3 4 5
Cash flows    176,23 250 350 400 400
Depreciation
(stright‐line)
200 200 200 200 200
Accounting income   ‐ 23,77    50 150 200 200
Net book value
(at beginning of year)
1000 800 600 400 200

Net book value
(at end of year)
800 600 400 200

0
Average book value
ROI (%)
900
‐2,6
700
7,1
500
30
300
66,7
100
200

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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
strategic position and increase market value, ROI is likely decline over the next several years.  Conversely, a
harvesting strategy  allows erosion in market share and will generate better planning‐period ROIs, but the
residual value is likely to be very small.

3. COMPETING FINANCIAL PERFORMANCE MEASURES

3.1 Trends in performance measurement

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
achievement of organizational objectives and compensating managers.
Many managers feel that traditional accounting‐based measurement systems no longer adequately fulfil
these functions.
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
percent were less than adequate or poor.
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
major overhaul or planning to replace their performance measurement systems.
The perceived inadequacies in traditional accounting‐based 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
(Ittner and Larcker, 1998). Most economic theories analyzing the choice of performance measures indicate
that performance measurement and reward systems should incorporate any financial or nonfinancial
measure that provides incremental information on managerial effort (subject to its cost).
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 –
(Lingle and Schiemann, 1996)

source: Ittner and Larcker (1998)

Schiemann and Associates surveyed 203 executives in 1996 on the quality, uses and perceived importance
of various financial and nonfinancial performance measures (Lingle and Schiemann, 1996). Their results are
presented in Table 4. While 82 percent of the respondents valued financial information highly, more than

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90 percent clearly defined financial measures in each performance area, included these measures in regular
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
customer satisfaction. Similar disparities exist for measures of operating efficiency, employee performance,
community and environment, and innovation and change.
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’
confidence in financial performance have led many organizations to place greater emphasis on "improved"
financial measures that are claimed to overcome some of the limitations of traditional financial
performance. We review this trend in the following section.

3.2 Economic value  measures

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
capital and for being unduly influenced by external reporting rules.

Meanwhile the traditional discounted cash flow  (DCF) model provides for a thorough analysis of all of the
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,  since many of the inputs need to be estimated and can be manipulated to yield the results that one
wants.
Instead of explicit DCF model a simplified formula‐based DCF approach can be used by making simplifying
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 (Table 5), while simple, is an example that  is particularly useful for demonstrating
the sources of a company’s value.   The MM formula values a company as the sum of the value of the cash
flow of its assets currently in place plus the value of its growth opportunities;  because the formula is based
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, although it is likely to be too simple for real problem solving,  unfortunately.

In addition, it was stated that NPV concept is useless unless we can discount the investment’s complete
cash flow over its completed economic life: in other words, it is only when it is considered over the life of
the business, and not in any given year,  that cash flow approach becomes significant.  Thus, it could be a
measure of performance only if it could be periodized into years, quarters, months or the time period of
the user’s choice. Moreover, this is what some “new economic measures” (which will be analyzed below)
try to do.

If we assume that markets are efficient, we can replace the unobservable value from the discounted cash
flow model with the observed market price, and reward or punish managers based upon the performance
of the stock. Thus, a firm whose stock price has gone up is viewed as having created value, while one whose
stock price goes down has destroyed value. Compensation systems based upon the stock price, including
stock grants and warrants, have become a standard component of most management compensation
packages. While market prices have the advantage of being updated and observable, they are also noisy.
Even if markets are efficient, stock prices tend to fluctuate around the true value, and markets sometimes

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do make big mistakes. Further, a firm’s stock performance seems to be much more reliable when evaluated
over several years. Thus, a firm may see its stock price go up, and its top management rewarded, even as it
destroys value. Conversely, the managers of a firm may be penalized as its stock price drops, even though
the managers may have taken actions that increase firm value. In addition, market measures of
performance reflect factors beyond managers’ control (such as declining inflation and lower interest rates,
for example) as well as  tend  to aggregate relevant information inefficiently  for compensation purposes
(their forward‐looking character may result in compensating for promises and not for actual achievements);
finally, they cannot be disaggregated beyond the firm level. Thus, they cannot be used to analyze the
managers of individual divisions of a firm, and their relative performance.

Consulting firms promoted  a variety of "economic value" measures to overcome limitations of accounting‐
based and market measures.  We illustrate in this section the most known metrics.

           Table 5 – The Miller‐Modigliani DCF formula (Miller‐Modigliani, 1961)

               value of entity = value of assets in place + value of growth

                                 value of assets in place =

                     value of growth =

           where:
           E(NOPAT)= expected net operating profit after taxes
           (assumed as proxy of expected cash flows after taxes)
           WACC = weighted average cost of capital after taxes
           K = investment rate (percentage of cash flows invested in new projects)
           r = rate of return on invested capital
           N = interval of competitive advantage

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, “the gross earnings of management which a man is getting can only be found after making up a
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) “as the difference between two quantities, net earnings and the cost of capital”.  As early
as the 1920’s General Motors applied this concept and in the 1950’s General Electric labelled it “residual
income”  and applied it as a performance measure to their decentralized divisions. It is defined in terms of
after‐tax operating profits less a charge for invested capital, which reflects the firm’s weighted average cost
of capital. Close parallels are thereby found in the related (non‐trademarked) 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 equity’s book
value (at the beginning of the considered period) multiplied by the required return to equity. As ROE is the
ratio of profit after taxes to book value of equity, we can also express the economic profit as
, where is the beginning book value of equity and is the cost of equity.  It is
obvious that for the equity market value to be higher than its book value, ROE must be greater than , if
ROE and are constant (Fernandez,  2003).

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Economic value added (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
capital to economic income and economic capital. Thus, the significance of the difference between EVA and
residual income is dependent upon the impact of these accounting adjustments.
EVA is determined  as adjusted operating income minus a capital charge, and assumes that a manager's
actions only add economic value when the resulting profits exceed the cost of capital.
Economic Value Added = NOPAT – cost of capital x capital invested
= (ROC– cost of capital) x (capital invested)
where
NOPAT = net operating profit after taxes
ROC = NOPAT/capital  invested = return on capital (invested).

There are three basic inputs that we need for EVA computation: the return on capital earned on an
investment, the cost of capital for that investment and the capital invested in it.

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, we ignore the tax benefit of interest expenses since it is already incorporated into the cost of
capital (by an after‐tax cost of debt).  Alternatively, we can arrive at NOPAT by starting with net income as
follows: NOPAT = net income + interest expenses (1‐ tax rate) – non‐operating income (1‐tax rate). Adding
back the after‐tax portion of interest expenses ensures that the tax benefit from debt does not get double
counted.

It is more difficult to estimate the capital invested at the level of the firm than of a single project, because
in a firm  projects tend to be aggregated and expenses are allocated across them. One obvious solution may
be to use the market value of the firm, but market value includes capital invested not just in assets in place
but in expected future growth. If we want to evaluate the quality of assets in place, we need a measure of
the market value of just these assets. Given the difficulty of estimating market value of assets in place,
many analysts turn to the book value of capital as a proxy for the market value of capital invested in assets
in place (Damodaran, 2000).
We can use a double approach to measure invested capital. The capital‐based approach considers the book
values of equity and interest bearing debt (netted against cash balances). The asset‐based approach
could arrive at a similar result using the book values of the assets of the firm as follows:

invested capital = net fixed asset + current asset ‐ current liabilities ‐ cash  = net fixed asset + non‐cash
working capital.

The two approaches could give non‐equivalent results when the firm has long‐term liabilities that are not
interest bearing debt (for example provisions and similar): they will be excluded from the invested capital
computation when we use the capital approach.
The reason we net out cash is consistent with the use of operating income as our measure of earnings. 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
NOPAT could discourages managers to use cash balances efficiently.

The book value, however, is a number that reflects not just the accounting choices made in the current
period, but also accounting decisions made over time on how to depreciate assets, value inventory and
deal with acquisitions (Damodaran, 2000). It is also influenced by the accounting classification of expenses

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into operating and capital expenditures, with only the latter showing up as part of capital. The limitations of
book value as a measure of capital invested has led analysts who use EVA to adjust the book value of
capital to get a better measure of capital invested.
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
measured as earnings before interest and taxes in an income statement, may not be a good measure of this
figure, for the same reasons that has led to adjust the book value of capital invested.
The practitioners who use EVA claim to make many adjustments to the accounting measures of both
operating income and invested capital. Stern Stewart makes as many as 164 adjustments to arrive at EVA.
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 (Fernandez 2002).

Table 6 – Adjustments suggested by Stern Stewart  for calculating the EVA

Some of these adjustments include (Damodaran,  2000):

− capitalizing any operating expense that is intended  to create income not in the current period , but in
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
expenses must be yearly deducted from NOPAT. Making this adjustment for high‐technology firms will
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,
reducing it. The rate at which the R&D is amortized will be sector‐specific and reflect the rate at which
the benefits of new R&D decay in the sector;

− 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
compute the present value of lease obligations and treat it as debt. From a financial standpoint, there is
little difference between operating and capital leases. Therefore, it does make sense to compute the
present value of operating lease commitments and treat them as debt, thus increasing capital invested.
A similar adjustment regards pension provisions: they should be included in computing capital
invested as if  they were equivalent to debt and their financial costs (for example, in Italy TFR costs per
year are equal to 1,5% + 75% of inflation rate) should be added back to NOPAT;

− eliminating any items that may cause  the book value of capital to drop without really impacting capital
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
referred to asset in place –  measured as difference between the acquisition price and the market value
prior to acquisition – should be included in invested capital); earnings prior to the amortization of
goodwill should be considered, correspondingly.
Similar adjustments  regard allowances for bad debts, stock obsolescence and similar ones; they should
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
utilizations in the current year) should be added back to NOPAT (in this way NOPAT is affected only by
cash utilizations of this allowances, i.e. when the losses or the minor inflows occur).
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. In the typical inflationary environment, the value of a FIFO inventory is higher than the value
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
income taxes, the LIFO reserve essentially represents the amount by which an entity's taxable income
has been deferred by using the LIFO method. Reserve should be added to invested capital and year‐to‐
year increase to be added back to NOPAT.

Similar examples are the one‐time 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
capital when market value is well in excess of book value: in fact the book value of equity is reduced by
the market value of the buyback; if the price to book ratio is for example of 10, a buyback of 5%
reduces the book value of equity by 50%;

− 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
remains in the balance sheet – the balance sheet thus looks smaller –  and the goodwill is ignored, 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. It should be noted that the proportion of premium paid for expected future growth potential in
the acquired firm should not added on to arrive at capital invested.

13

It should be noted the impact on tax charge of making the adjustments above. For example, if we add back
to NOPAT  the R&D costs previously expensed, we implicitly include the tax shield of these expenses in the
NOPAT calculations; conversely, if we add back the R&D expenses after taxes (i.e. the gross amount
multiplied by (1‐ tax rate) ), then we ignore it. Moreover, if we add back to NOPAT the R&D expenses minus
the year amortization of the capitalized R&D expenses, both after taxes, therefore we are only considering
the tax shield associated  with the amortization.

The above  are only some of the suggested  adjustments. Young and O’Byrne (2001) admit  that “....even
the most ardent EVA advocate would concede that no company should make more than, say, 15
adjustments”.  They  further state that  10‐12 accounting adjustments were most common but that number
has now declined to five or fewer and in some case no adjustments are made. The explanation they give for
this reduction is: a) managers are reluctant to deviate from GAAP‐based numbers; b) companies have
found that most of the suggested adjustments have little impact on profit and capital.
Moreover, external analysts who choose to use EVA have to accept the reality that their estimates of
operating income can adjust only for the variables on which there is public information.
Anderson et al. (2005) found that, in a sample of 317 USA firms over a ten year time period, five accounting
adjustments yielded on average an EVA only 7,1 % less than the EVA reported by Stern‐Stewart for the
same firms and time period. The two accounting 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‐
Stewart’s EVA and Anderson et al.’s adjusted EVA does not support for the need for a large number of
accounting adjustments. In addition, evidence shows a strong instability of EVA adjustments over time  and
a very strong relationship between adjusted and unadjusted EVA. Therefore, accounting adjustments for
EVA seem to be much to do about nothing.

The third and final component needed to estimate the economic value added is the cost of capital. A school
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, it is clear that using a book value cost of capital essentially is equivalent to assuming that all debt
is attributable to assets in place, and that all future growth comes from equity. Put another way, if we
adopted this rationale in valuation, we would discount cash flows from assets in place at the book cost of
capital, and all cash flows from expected future growth at the cost of equity.
Second, using a book value cost of capital for all economic value added estimates, including the portion
that comes from future growth, will destroy the basis of the approach, which is that maximizing the present
value of economic value added over time is equivalent to maximizing firm value.
Third, if changing capital structure is one tool that can be used to increase EVA, the mechanics work far
better if market value cost of capital is used rather than book value. From a practical standpoint, using the
book value cost of capital will tend to understate cost of capital for most firms, and will understate it more
for more highly levered firms than for lightly levered firms. Understating the cost of capital will lead to
overstating the EVA. Thus, rankings based on book value cost of capital are biased against firms with less
leverage, and biased towards firms with high leverage.

Cash flow return on investment (CFROI)

A second economic value measure that has received considerable attention is "Cash Flow Return on
Investment" (CFROI) and its variants (proposed by the Boston Consulting Group).
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
company’s investments are good, neutral or poor investments. To enhance its value then a firm should
increase the spread between its CFROI and its cost of capital.

14

The CFROI is calculated using four inputs (Damodaran,  2000). The first input is the gross investment (GI)
that the firm has in its assets in place. This is computed by adding back depreciation to the net asset value
to arrive at an estimate of the original investment in the asset. In addition, non‐debt liabilities (allowances)
and intangibles such as goodwill are netted out. Finally, the gross investment is converted into a current
dollar value to reflect inflation that has occurred since the asset was purchased.
The second input is the gross cash flow (GCF) earned in the current year on that asset. This is usually
defined as the sum of the after‐tax operating income of a firm and the non‐charges against earnings, such
as depreciation and amortization. The operating income should be adjusted for operating leases and any
accounting effects, much the same way that it was adjusted for to compute EVA (as well as GI).
The third input is the expected life of  the assets (n) in place, at the time of the original investment, which
varies from sector to sector but reflects the earning life of the investments in question. The expected value
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,
adjusted to current dollar terms (practitioners include also inflation‐adjusted current assets).
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 firm’s 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.

1

An alternative formulation of the CFROI allows for setting aside an annuity to cover the expected
replacement cost of the asset at the end of the project life. This annuity is called the economic depreciation
and is computed as follows:

1 1 ⁄

where n is the expected life of the asset and the expected replacement cost of the asset is defined in
current dollar terms to be the difference between the gross investment and the salvage value. The CFROI
for a firm or a division can then be written as follows:

CFROI Gross Cash Flow ‐ Economic Depreciation /Gross Investment

Appendix shows the equivalence between two formulas, when we assume in deriving the economic
depreciation a discount rate kc CFROI. The differences in discount rate assumptions account for the
difference in CFROI estimated using the two methods. In the first formula the intermediate cash flows are
discounted  at the CFROI, while in the second, at least the portion of the cash flows that are set aside for
replacement,  get reinvested at the cost of capital.

If net present value provides for the genesis for the EVA  approach, the internal rate of return (IRR) is the
basis for the CFROI approach. In investment analysis, the IRR  on a project is computed using the initial
investment on the project and all cash flows over the project’s life. The IRR calculation  can be done entirely
in nominal terms, in which case the internal rate of return is a nominal IRR and is compared to the nominal
cost of capital, or in real terms, in which case it is a real IRR and is compared to the real cost of capital.
At first sight, the CFROI seems to do the same thing. It uses the gross investment (in current dollars) in the
project as the equivalent of the initial investment, assumes that the gross current‐dollar cash flow is
maintained over the project life and computes a real internal rate of return. There are, however, some
significant differences (Damodaran,  2000):

15

• the IRR does not require the after‐tax cash flows to be constant over a  project’s life, even in real terms,
meanwhile the CFROI approach assumes that real cash flows on assets do not increase over time. It
should be noted, however, that the CFROI formula  can be modified to allow for real growth
• the second difference is that the IRR on a project or asset is based upon incremental cash flows in the
future. It does not consider cash flows that have occurred already, that are viewed as “sunk”. The CFROI,
on the other hand, tries to reconstruct a project or asset, using both cash flows that have occurred
already and cash flows that are yet to occur. More specifically, IRR is always forward looking while CFROI
is not. The implications are relevant: a CFROI that exceeds the cost of capital is usually considered a sign
that a firm is using  its assets well, but that might not be true. If the IRR is less than the cost of capital,
that interpretation is false.

From the CFROI we can derive the cash value added (CVA) by multiplying  the spread between CFROI and
WACC by the  inflation‐adjusted cash investment.

Shareholder value added (SVA)

The third economic measure is the shareholder value added (SVA)  elaborated  by  Rappaport (1986) and
Alcar Consulting Group. The key‐factors in determining SVA are the following:
− growth rate of sales
− rate of operating profit margin (netted against  depreciation)
− (cash) tax rate
− rate of incremental  fixed capital investment, in terms of rate of capital intensity of sales, netted against
depreciation (depreciation is implicitly considered equal to replacement investment of fixed capital)
− rate of incremental working capital investment (in terms of rate of working capital intensity of sales)
− cost of capital, expressed in terms of weighted average cost of capital (WACC)
− value growth duration (planning period or competitive advantage period). It corresponds to the length
of time that the firm is expected  to earn returns in excess of  its cost of capital. It  depends on how
company’s strategies are more or less quickly emulated by potential competitors.
These variables are combined in the following model (consistent with DCF  approach) in order to measure
the value creation of a strategy (valid both in backward and forward looking valuation):

value created by strategy change of shareholder value generated by strategy
with respect to non‐strategy scenario

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

gross corporate value present value of operating cash flows during the forecast period terminal
value at the end of the forecast period cash & cash equivalents and non‐operating assets whose
returns are excluded from operating CF

operating cash flowt salest‐1 x 1 growth rate of sales x rate of operating profit margin x 1‐ tax
rate – salest – salest‐1 x rate of incremental investment in fixed assets and working capital.

Cash flows and terminal value are discounted by the cost of capital.
The terminal value at the end of the forecast period can account for a great part of a company’s (or
business unit’s) 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
operating cash flow at the horizon, assuming a steady‐state beyond this term or a constant rate of growth
continuing indefinitely. Sometimes multiple approach could be used. We observe that assuming a constant
operating cash flow beyond the end of the forecast period does not imply a non‐growth state of the

16

business, but that future new investments’ rate of return is equal to their cost of capital; thus, incremental
cash flows can be ignored in calculating the value of business.

4. THE METRICS WAR

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'
measures have flaws that compromise their predictive ability.
A number of impressive claims have been made for each of the economic value measures. Stern Stewart,
for example, cites in‐house research indicating that "EVA stands well out from the crowd as the single best
measure of wealth creation on a contemporaneous basis" (Stewart, 1991), while Dixon and Hedley (1993) of
Braxton Associates cite an internal study showing their CFROI measure explains 91 percent of the variation
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 long‐term track records, whereas a Stern Stewart‐type EVA is in
millions of dollars, heavily influenced by asset size, and unadjusted for inflation‐induced biases" (Myers,
1996). Responded Stern Stewart co‐founder G. Bennet Stewart III "CFROI is literally a consultant's
concoction. It was quite an imaginative development by a consulting firm, but it is not well grounded in the
basic elements of corporate finance theory. CFROI attempts to measure shareholder wealth—which is not
clearly related to maximizing shareholder wealth" (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
of the respondents used EVA or similar measures (up from 18 percent in 1995) and 45 percent expected to
use them in the future (up from 27 percent in 1995).
Yet, despite the increasing emphasis on these measures, research on the extent to which they are superior
to traditional accounting measures is limited and mixed.
In the next paragraphs we will analyze the different perspectives to whose respect the various metrics’
effectiveness could be evaluated.

4.1 The association between economic value measures and stock returns

Many empirical studies have investigated the correlation of the most known economic measures with
excess returns, back‐testing them against the underlying companies’ actual wealth creation, as evidenced
by subsequent stock price increases, or comparing  them  to market value added. Most studies to date have
examined claims made by the proponents of each of these value‐based measures that their own measures
were better predictors of stock returns than traditional accounting measures or rival firms’ measures.
Since the avowed goal of the new performance measures is to increase shareholder wealth, the correlation
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
other measures. However, as argued above, stock returns can be a noisy and even a misleading measure of
managers' value added. Therefore, the rationale is that any financial measure used in assessing firm’s
performance must be highly correlated with shareholders wealth and on the other hand should not be
subjected to randomness inherent in it.
This research domain includes studies that empirically investigate the degree of correlation between
different performance measures (accounting‐ and value‐based) and stock market returns and/or MVA and
its changes. R2
and panel data regression model have been used to measure value relevance: in these
regression models MVA (level or  year‐to‐year 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 (Easton and Harris, 1991) or of forecast errors, as the difference between the realized value
of a performance measure and the market’s expectation (Biddle et al., 1997). It is assumed that market
expectations are formed according to a discrete linear stochastic process in function of lagged observations
of the performance measure. In some studies the incremental information content of the economic
measures is explored by introducing in the regression model  the components in which the measure can be
decomposed as explanatory variables; for example in  Biddle et al. (1997) the EVA is decomposed in 5 parts:
cash flow from operations, operating accruals, after‐tax interest expense, capital charge, and accounting
adjustments.
Researchers have employed two approaches, relative vs. incremental information content, to compare
information usefulness of different measures.  Relative information content compares which performance
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
content types have different practical implications. With knowledge of relative information usefulness, one
will be able to choose a single best performance measure among competing ones. On the other hand,
incremental information usefulness will help one decide whether to employ multiple measures in financial
reporting. Evidently, both are important considerations in the choice of performance measures. Frequently
incremental approach is used adding economic measures to accounting measures in the regression model.

The empirical evidence about the association between the economic metrics and market‐based
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
are better predictors  of stock returns than the former.
In addition, some studies are concentrated on a specific economic measure (mostly EVA) compared to
more traditional metrics; others compare the relative explanatory content  of a larger set of  metrics.

Many studies to date have examined claims that EVA is a better predictor of stock returns than traditional
accounting measures.

a) Milunovich and Tseui's (1996) examination of the computer server industry found market‐value added
between 1990 and 1995 more highly correlated with EVA than with earnings per share, earnings per
share growth, return on equity, free cash flow, or free cash growth.
b) Lehn and Makhija (1997) also found that stock returns over a ten‐year period were more highly
correlated with average EVA over the period than with average ROA, ROS, or ROE. In addition, EVA
performed somewhat better than accounting profits in predicting CEO turnover.
c) O'Byrne (1996) examined the association between market value and two performance measures: 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
model had greater explanatory power when indicator variables for 57 industries and the log of capital
for each firm were included as additional explanatory variables. However, O'Byrne (1996) did not make
similar adjustments to the NOPAT model, making it impossible to compare results using the different
measures.

Other studies suggest that EVA is predictive of stock returns, but is not the only performance measure that
ties directly to a stock's intrinsic value, one of the primary claims of EVA advocates (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 EVA‐related measures. They found that EVA measures
outperformed accounting earnings in explaining stock returns, but the associations were not as strong
as suggested by EVA proponents (maximum R2
= 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
completely with EVA. Finally, residual income provided nearly identical results to EVA, without the need
for the accounting adjustments advocated by Stern Stewart.
b) Biddle et al. (1997) provide the most comprehensive study of EVA's value relevance to date. Their
analyses examined the power of accounting measures (earnings and operating profits) to explain stock
market returns relative to EVA and five components of EVA (cash flow from operations, operating
accruals, after‐tax 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
explanatory power over traditional accounting measures, the contribution from these variables was not
economically significant. Sensitivity analyses indicated that these results were robust to Stern Stewart's
grouping of firms into five "types" based on their past operating returns and growth rates, the time
period examined, and the dependent variable used in the tests (i.e., stock returns or levels or the time
frame used to compute the market measures).
c) Fernandez (2003) analyzed 582 American companies using EVA, MVA, NOPAT and WACC data provided
by Stern Stewart. For each of the 582 companies, he calculated the 10‐year correlations between the
increase in the MVA each year and each year’s EVA, NOPAT and WACC. For 296 (of the 582) companies,
the correlation between the increase in the MVA each year and the NOPAT was greater than the
correlation between the increase in the MVA each year and the EVA. The NOPAT is a purely accounting
parameter, while the EVA seeks to be a more precise indicator of the increase in the MVA.   There are
210 companies for which the correlation with the EVA has been negative. The average correlation
between the increase in the MVA and EVA, NOPAT and WACC was 16%, 21% and –21.4%., respectively.
The average correlation between the increase in the MVA and the increases of EVA, NOPAT and WACC
was 18%, 22.5% and –4.1%. He also found that the correlation between the shareholder return in 1994‐
1998 and the increase in the CVA (according to the Boston Consulting Group) of the world’s 100 most
profitable companies was 1.7%.

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
findings are mixed. Only 6 out of the total 10 studies examined (chosen by giving preference to differences
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
methodology and impact of inflation. In fact, recent studies (Das et al., 2007) conclude that a non‐linear S
shaped function better characterizes return‐earnings relationship; hence, the linear assumption can lead to
the distortion of the findings in the researches conducted. In addition, discrepancy between accounting
profits and true profits along with inflation distorts EVA (which is based on accounting profits).

Clinton and Chen (1998) study followed a more  comprehensive approach. They analyzed and evaluated
EVA, CFROI and Residual Cash Flow (RCF = operating cash flow – cost of capital x beginning capital)  in order
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 &
Poor’s 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 residual‐based measures have been heavily
promoted as better choices than ROI‐based measures, all three residual‐based 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 best‐performing 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

correlations and therefore indistinguishable in their relative lack of contribution to assessing firm value. The
authors then suggest RCF as the best choice to use in linking profit to capital and ultimately to market
value. RCF maintains the advantages of using a cash‐based and a residual‐based measure. The residual cash
flow measure is consistent with capital asset investment planning and is already stated in terms of cash so
adjustment to remove accounting distortions is not necessary.

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 cross‐sectional differences in
the predictive ability of alternative economic value measures. Structural and environmental variables such
as firm strategy, competitive environment, and product or industry life cycle, for example, are likely to be
important determinants of the relative explanatory power of different economic value measures, as well as
the explanatory power of traditional accounting measures (Ittner and Larcker, 1998).

In addition, as Damodaran (2000) observed, we would not expect there to be any correlation between the
magnitude of EVA and stock returns, or even between the change in EVA and stock returns.  This is because
the market value has built into it expectations of future EVAs. Whether a firm’s market value increases or
decreases on the announcement of higher EVA will depend in large part on what the expected change in
EVA was. For mature firms, where the market might have expected no increase or even a decrease in EVA,
the announcement of an increase will be good news and cause the market value to increase. For firms that
are perceived to have good growth opportunities and were expected to report an increase in 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
earnings announcements of firms are judged against expectations, and the earnings surprise is what drives
prices. The same apparent paradox can be noted about CFROI. There is a relationship between CFROI and
market value, with firms with high CFROI generally having high market value. This is not surprising, and
mirrors what we noted about 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
excess returns is more intriguing. To the extent that any increase in CFROI is viewed as a positive surprise,
firms with the biggest increases in CFROI should earn excess returns. In reality, however, the actual change
in CFROI has to be measured against expectations; if CFROI increases, but less than expected, the market
value should drop; if CFROI drops but less than expected, the market value should increase
4.2 The association between economic value measures and DCF approach

Fernandez (2002) shows that EP, EVA and CVA, if used for valuation purposes, are consistent with DCF
approach. Analytically he shows that:
• the present value of the EP discounted at the required return to equity, plus the equity book value
equals the value of equity (the present value of the equity cash flow discounted at the required return
to equity);
• the present value of the EVA discounted at the WACC plus the enterprise book value (equity plus debt)
equals the enterprise market value (the present value of the free cash flow discounted at the WACC);
• the present value of the CVA discounted at the WACC plus the enterprise book value (equity plus debt)
equals  the enterprise market value (the present value of the free cash flow discounted at the WACC).
Therefore,  through the present value of EP, EVA and CVA we get the same equity value as the discounting
the equity cash flow or the free cash flow. Therefore, it is possible to value firms by discounting EVA, EP or
CVA, although these parameters are not cash flows and their financial meaning is much less clear than that
of cash flows.   Therefore, we can conclude that maximizing the present value of the EP, EVA or CVA is
equivalent to maximizing the value of the firm’s shares.

20

However, Fernandez (2002) also remarks that maximizing a particular year’s EP, EVA or CVA is meaningless:
it may be the opposite to maximizing the value of the firm’s shares. The claim that the EP, EVA or CVA
measures the firm’s “value creation” in each period is a tremendous error: it makes no sense to give the EP,
EVA or CVA the meaning of value creation in each period. As the present value of the EVA corresponds to
the MVA, it is common for the EVA to be interpreted incorrectly as each period’s MVA. In fact, he shows
that it may happen that the EVA grows from negative to positive in a considered period but it depends on
the fact that shares’ book value decreases as the fixed assets are depreciated. Furthermore, it may happen
that the EVA and the EP in one year have been positive, and even higher than expected, but that the value
of the firm or business unit has fallen because the business’s expectations have deteriorated. The EVA, EP
and CVA do not measure value creation during each period. It is not possible to quantify value creation
during a period on the basis of accounting data. Value always depends on expectations (Fernandez, 2002).
EVA and DCF model

EVA is a throwback to the net present value rule. Damodaran (2000) demonstrates  that the present value
of the EVAs  by a project over its life is the NPV of the project.
The NPV  of a project can be written as follows:
1
1 1
where
= depreciation and amortization
= salvage value
= cost of capital
= initial investment
n = expected life of the investment
Now consider an alternative investment that requires an initial investment of I, earns exactly the cost of
capital and allows for the entire investment to be salvaged at the end of the project life of n years. The net
present value of this project will be zero. Solving for I in this case, we get:

1 1
Substituting this into the first equation,  we get the net present value of the original project to be the
following:
1
1 1 1 1
Now we assume that the project has a salvage value of zero, and that the present value of depreciation is
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
we can assume that the CFs from depreciation payback I ‐ SVn).

Then, the net present value of this project can be written as:
1
1 1
By noting that ROC=EBIT(1‐t)/I, then we get

21

1 1

Thus, the NPV  of the project is the present value of the EVAs  by that project over its life. Note, however,
that this relation is true only when the assumptions above are verified.

The linkage between EVA  and NPV allows us to link the value of a firm to the economic value added by it
(Damodaran, 2000). Firm value can be expressed in terms of the value of assets in place and expected
future growth as follows:
Firm Value Value of Assets in Place Value of Expected Future Growth

Note that in a DCF model, the values of both assets in place and expected future growth can be written in
terms of the net present value created by each:

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

Substituting the EVA version of NPV back into this equation, we get:

Firm Value Capital Invested Assets in Place +∑ ,
∑ ,
.

Thus, the value of a firm can be written as the sum of three components, the capital invested in assets in
place, the present value of the EVAs  by these assets, and the expected present value of the economic value
that will be added by future investments.
A simplified EVA valuation model (easier to be used in boardrooms) can be derived as follows (Fabozzi and
Grant, 2000)
1
1

The formula means that a firm will:
• earn its NOPAT on its existing assets forever
• earn positive EVA for ever on new investments made over period T
• earn zero EVA on any new investments made after period T.

It is useful to note that the basic EVA model above assumes that competition has no effect on the existing
assets or the new investments made through period T, but competition does effect investments made
after T.  In other words, if Wal‐Mart has 1000 existing stores, these stores will generate their existing
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, this is a very unrealistic model of how business works. Competition reduces the
earning power of all assets, existing and future. And we can add that the basic EVA model does not
provide guidance regarding T.

Another way of presenting these results is in terms of MVA (Damodaran, 2000). The MVA is the difference
between the firm value and the capital invested.  Clearly, this value will be positive only if  the return on
capital is greater than the cost of capital, and will be an increasing function of the spread  between the two
numbers. Conversely, the number will be negative if the return on capital is less than the cost of capital.
Note that the while the firm continues to grow in operating income terms and take new investments after
the n‐th  year, these marginal investments create no additional value if  they earn the cost of capital. A

22

direct implication is that it is not growth that creates value, but growth in conjunction with excess returns.
This provides a new perspective on the quality of growth. A firm can be growing its operating income at a
healthy rate, but if it is doing so by investing large amounts at or below the cost of capital, it will not be
creating value and may actually be destroying it.
Finally, we can derive several implications from the fact that the value of a firm can be written in terms of
the present value of the EVA by both projects in place and expected future projects. First, a policy of
maximizing the present value of EVA over time is equivalent to a policy of maximizing firm value. 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
discount rate to arrive at a value. The EVA approach requires these inputs and an additional one: the capital
invested in the firm. It uses this measure to break firm value up into capital invested and EVA components.
Note that changing the capital invested number has no impact on overall value.  Finally, it is often claimed
that the EVA valuations provide us with fresh insights on value enhancement because of its focus on excess
returns, defined in terms of return and cost of capital. A DCF model where growth is linked to the
reinvestment rate and the return on investments accomplishes the same objectives and arrives at the
same results.

CFROI and DCF model

Damodaran (2000) shows the link between CFROI and  firm value, by  beginning with a simple discounted
cash flow model for a firm in stable growth:

Firm Value FCFF1/ kc ‐gn

This can be rewritten, approximately, in terms of the CFROI as follows:

Firm Value CFROI*GI‐DA 1 ‐ t ‐ CX‐DA ‐ ΔWC / kc ‐gn
where
FCFF = free cash flow to firm = EBIT 1‐t ‐ Capital Expenditures‐ Depreciation ‐ Change in Working
Capital
CFROI = cash flow return on investment
GI = gross investment
CFROI*GI = economic income
DA = depreciation and amortization
CX = capital expenditures
ΔWC = change in working capital
kc = cost of capital
gn = stable growth rate.
More important than the mechanics, however, is the fact that firm value, while a function of the CFROI is
also a function of the other variables in the equation – the gross investment, the tax rate, the growth rate,
the cost of capital and the firm’s reinvestment needs.
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, where the current CFROI fades towards the real cost of capital over time.
A company’s current value depends on competitive life‐cycle patterns that reflect expected future
economic returns and reinvestment rates (Madden, 2007).  The idea of competitive life‐cycles is based on
the premise that competition and capital flows operate over the longer term to force companies’ economic
returns toward the cost of capital. During the high innovation stage, returns are above their cost of capital
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 sector’s economic returns (which approximates the
corporate sector’s long term cost of capital). Thus, corporate reinvestment rates fall back toward the lower,
long term average growth rate of the overall economy. To maintain well‐above‐average economic returns
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
them over time. Thus, a firm that has a current CFROI of 20% and real cost of capital of 8% will be projected
to have lower CFROI over time.
Figure 1 displayed the life‐cycle model (panel A) and the life‐cycle track records of Kmart and Wal‐Mart in
the 1960‐2005 period (panel B and C respectively), where the two companies’ CFROIs can be observed as
well as a benchmark long‐term corporate average CFROI of 6% real to approximate the cost of capital
(Madden, 2007). Wal‐Mart has been able to postpone the downward competitive fade of its superior
CFROIs while still reinvesting at very high rates. This occurred because Wal‐Mart’s founder was skilled in
hiring talented people, motivating employees and developing strategies that were extraordinarily effective
as well as a step ahead of his competitors. His original strategy was to locate stores away from large cities
and to saturate regions so the stores could be efficiently serviced by a centrally located distribution center.

Figure 1  ‐ Life‐Cycle model and Kmart and Wal‐Mart life‐cycle performance

     panel A  ‐ life‐cycle model

     panel B – Kmart life cycle track

      panel C – Wal‐Mart life cycle track

        source: Madden (2007)

24

His strategy proved correct as population expanded to where his stores were located. The remarkable
achievement of creating the world’s largest retailer, along with over 1.7 million jobs, and huge shareholder
value, had the additional social benefit of increasing the purchasing power of millions of customers through
its discount pricing (Madden, 2007).

The value of the firm, in this more complex format, can then be written as a sum of the following:
− the present value of the cash flows from assets in place over their remaining life, which can be written
as ∑ where CFROIaip is the CFROI on assets in place, GIaip is the gross investment
in assets in place and kc is the real cost of capital
− the present value of the excess cash flows from future investments, which can be written in real terms
as ∑
, ∆
  ‐ ∆GIt, where CFROIt,NI  is the CFROI on new investments made in year t
and ΔGIt is the new investment made in year t. Note that if CFROIt,NI = kc, this present value is equal to
zero.
The key to avoiding perpetuity hypothesis is to determine when a company’s return on capital is equal to
its  cost of capital (i.e. discount rate). Afterward, no matter how much a firm grows, the net present value
of future investments is zero.
Thus, a firm's value will depend upon the CFROI it earns on assets in place and both the abruptness and the
speed with which this CFROI fades towards the cost of capital. Thus, a firm can potentially increase its value
by doing any of the following:
− increasing the CFROI from assets in place, for a given gross investment
− reducing the speed at which the CFROI fades towards the real cost of capital
− reduce the abruptness with which CFROI fades towards the cost of capital.

Note that this is no different from an analysis of firm value in the discounted cash flow format in terms of
cash flows from assets in place (increase current CFROI), the length of the high growth period (reduce fade
speed) and the growth rate during the growth period (keep excess returns from falling as steeply).

4.3 Managerial implications of economic value measures

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 decision‐making, performance measurement, and compensation
purposes improves organizational performance (Ittner and Larcker, 1998).

Before debating whether the companies have in fact gained value by adopting the economic value
measures, it is worth  noting the way in which these measures  have been put in practice.
Since EVA is the most popular measure of performance and has widespread application across industries
and continents, in the last decade we have seen a number of converts among corporations to EVA  . Most
firms that have adopted EVA as their value enhancement measure have also tied management
compensation to it. Some firms have made it the sole basis for compensation, while others continue to use
it in association with other compensation schemes (i.e. stock grants and stock options). The adopters of
EVA still measure it looking at year to year changes rather than in terms of the present value of EVAs  over
time. The reward may be  simply based upon achieving an EVA next year that is greater than this year's
number. In other firms, managers are rewarded only if they beat the expected EVA. In almost no case is the
reward based upon the present value of EVAs over time. This practice does create a significant potential for
abuse, as we will see below.  Firms that have converted to EVA  have done so not just at the firm level, but
also at the level of individual divisions or sub‐units within the firm. Thus, the success or failure of an
employee is often measured by the EVA by the unit to which this employee is most closely connected. This
practice makes the estimation problems about EVA much greater (Damodaran,  2000).
Similar practices could be supposed about  CFROI.

25

As regard SVA, Rappaport (1999) explains  the superior SVA approach for an incentive pay plan of operating
managers at business units level (neither for CEO and corporate level executives nor for frontline
managers). SVA puts value on changes in the future cash flows of a company or business unit. According to
SVA approach, business units managers should be rewarded when they create superior SVA in their units.
Calculating superior SVA requires six steps (Rappaport, 1999):
− first, develop expectations for the standard drivers of value‐sales 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 cash‐flow estimates and discount
them at the business unit's cost of capital in order to obtain the value of each operating unit;
− third, aggregate the values of each operating unit to verify that the sum is approximately equal to the
company's market value;
− fourth, from the cash flows used to value the operating unit, establish the annual expected SVA over
the performance period‐typically three years;
− fifth, use year‐end results to compute the actual SVA at the end of each year. The calculation will he the
same as in the previous step, with actual numbers replacing the estimates;
− sixth, calculate the difference between actual and expected SVA. When the difference is positive, you
have superior SVA.
Since value creation prospects can vary greatly from one business unit to another, an approach based on
expectations establishes a level playing field by accounting for differences in business prospects. Managers
who perform extraordinarily well in low return businesses will be rewarded, while those who do poorly in
high‐return businesses will be penalized. Setting the SVA threshold targets at 80% of a designated target
would be appropriate.
In addition, when setting performance pay, it is important to note that value creation is a long‐term
phenomenon. Annual performance measures do not account for the longer‐term 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
superior SVA beyond the current period, the performance evaluation period should be extended to, say, a
rolling three‐year cycle.
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 day‐to‐day guidance to them). For more specific
measures, companies can develop leading indicators of value, which are quantifiable, easily communicated
current  accomplishments that frontline employees can influence directly and that significantly affect the
long‐term value of the business in a positive way. Examples might include time to market for new product
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
leading‐indicator performance is the foundation for achieving superior SVA, which in turn serves to increase
long‐term shareholder returns (Rappaport, 1999).

A 1995 survey by Sibson & Co.  supports claims that many users of economic value measures do not base
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
respondents used economic value measures  only in annual incentive plans and not in long‐term plans, and
relatively few used them at all organizational levels.

Now we can analyze what is the potential for abuse in adopting the economic measures in managerial
compensation, as illustrated above.

26

Table 7 – Uses of economic value measures

  source: Ittner and Larcker (1998)

Assume that a firm adopts EVA and decides to judge managers based upon their capacity to generate
greater‐than‐expected EVA (Damodaran, 2000).
To answer this question, let us go back to the following equation,  where firm value is  decomposed into
capital invested, the present value of EVA by assets in place and the present value of EVA by future growth.

+ ∑
,
+ ∑
,

The first two terms in the equation (the capital invested and the present value of EVA by these
investments), are both sensitive to how capital invested is measured. If capital invested is reduced, keeping
the operating income constant, the first term in the equation will drop but the present value of EVAs  will
increase proportionately.
When managers are judged based upon the EVA, there will be strong incentives to keep the capital
invested down. Thus, if the reduction in capital invested came from closing down a plant that was not (and
does not expect to) generate any operating income, the cash flow generated by liquidating the plant’s
assets will increase value. However, if the reduction is purely cosmetic in terms of its effects on capital
invested, thus does not create and may even destroy value. Some examples are: a) accounting changes that
reduce the book value of capital, but do not generate tax benefits or higher operating income in future
periods (for example, large one‐time restructuring charges); b) game playing once the rules for EVA
measure  have been defined (the incentive to lease rather than to buy assets);  c)  when EVA is estimated
for divisions, the allocation of invested capital to the divisions will be based upon rules devised by the firm:
while expected  objective and unbiased, they could be subjective and over allocate capital to some divisions
or  under allocate capital to others. This misallocation is likely to reflect the power of individual divisions to
influence the process: the EVA will result  over estimated for the last and  under estimated for the former.

Furthermore, the value of a firm is the value of its assets in place and the value of its future growth
prospects. When managers are judged on the basis of EVA in the current year, or on year‐to‐year changes,

27

the EVA  that is being measured is just that from assets in place. Thus, managers may trade off the EVA
from future growth for higher EVA from assets in place. In addition, the present value of the EVA is not just
a function of the dollar EVA but also of the cost of capital. A firm can take actions that increase its EVA, 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 year‐to‐year EVA changes, there will be a tendency to shift investments
into riskier investments. This tendency will be exaggerated if the cost of capital does not reflect the changes
in risk or lags it (beta estimates that are based upon historical returns will lag changes in risk).
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
level of a firm, the higher growth divisions end up with the lowest EVA (in some cases with negative EVA).
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,
since it will make the firm’s overall EVA look much better (Damodaran, 2000).

Although  the relationship between CFROI and firm value is less intuitive than the relationship between EVA
and firm value, partly because it is a percentage return, the games that managers can play, when their
performance is judged on the basis of the CFROI,  are similar to those noted in discussion of EVA.

The first is the capital game, where the CFROI is increased while the gross investment is reduced. Since it is
the product of the two that drives value, it is possible for a firm to increase CFROI and end up with a lower
value. Thus, managers of firms judged on the basis of CFROI will do everything in their power to keep the
gross investment as small as possible.

CFROI, even more than EVA, is focused on assets in place and does not look at future growth. To the extent
that managers increase CFROI at the expense of future growth, the value can decrease while CFROI goes
up. This is because the effects of the growth sacrifice are likely to be observed in the fade factor, and unless
this can be precisely estimated and compared to what it should have been, the growth game will continue
to be paid (Damodaran, 2000).

While the CFROI is compared to the cost of capital to pass judgment on whether a firm is creating or
destroying value, it represents only a partial correction for risk. The value of a firm is still the present value
of expected future cash flows. Thus, a firm can increase its spread between the CFROI and cost of capital,
but still end up losing value if the present value effect of having a higher cost of capital dominates the
higher CFROI.
In general, then, an increase in CFROI, by itself, does not indicate that the firm value has increases, since it
might have come at the expense of lower growth and/or higher risk.

Since the focus of SVA is future performance, it is difficult to apply when measuring historic performance.
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
increasing value, avoiding the short‐term performance obsession.

We will examine now empirical evidence about effects on managerial behaviour induced by the adoption of
the economic value measures.
Wallace (1997) examined relative performance changes in 40 adopters of residual income‐based measures
such as EVA, EP and CVA and a matched sample of non‐users supports claims that these measures change
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% more assets and utilized assets more intensively, leading to significantly greater change in
residual income. These actions result to be consistent with the strong rate of return discipline associated
with the explicit capital charge in residual income‐based measures.

28

Wallace also found weak evidence that stock market participants responded favourably to the adoption of
residual income‐based compensation plans.
Kleiman (1999) compared the performance of 71 companies that adopted EVA between 1987 and 1996
with that of its most direct competitors that did not adopt the EVA. He demonstrated that adoption of EVA‐
based performance evaluation system resulted in substantial improvements in EBITDA and operating
margins, faster asset turns and stronger cash flow generation, which are in turn the drivers of the superior
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
shareholder returns than their immediate competitors: 2.6% in the year of introduction, and 5.7%, ‐1% and
11.1% during the following years.

No empirical evidence is available on effectiveness  of SVA in managerial compensation systems.

A related issue is whether the performance implications of economic value measures depend upon how
the measures are used within the organization. Stern Stewart argues that effective implementation of EVA
requires firms to make this measure the cornerstone of a total financial management system that focuses
on EVA for capital budgeting, goal setting, investor communication, and compensation (Stern et al.,  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
not made a way of life; 2) EVA is implemented too fast; 3) lack of conviction by the CEO or division head;  4)
inadequate training (Stewart, 1995).

As reported in a Stern Stewart study (www.EVA.com) companies that implemented EVA in the 1990’s
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
companies concentrating on the period since the peak of the stock market on march 2000 through midyear
2002 showed that the portfolio of Stern Stewart’s EVA clients earned a total return of 36,5% and beat the
S&P 500 by a total of 69,8%. The performance differential was even more significant for companies that
have reinforced EVA as a performance measure and decision tool by tying management incentives to EVA.
Those firms earned a 64.5% whereas companies that used EVA only for performance measurement earned
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
and directly aligns the interests of managers and employees with those of the owners. But tests  and data
are provided by Stern Stewart, which is strongly interested to support the most pervasive use of EVA.

Biddle et al. (1998) provide some evidence that the use of economic value measures in compensation plans
is associated with the measures’ effectiveness. The only subsample in which EVA outperformed traditional
accounting measures in predicting stock returns was firms using EVA in compensation plans. Similarly, the
Sibson & Co. survey  indicates that 26.3 percent of firms using economic value measures in incentive plans
reported that these measures were "very successful" and 36.8 percent reported they were "marginally
successful." None of the respondents  stated that the measures were "not successful." The 31.5 percent of
respondents who were "not sure" of the measures' effectiveness were all recent adopters.

Wallace (1997) also identified a group of 36 firms that used  a residual income measure to some extent in
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. These results support the contention that residual income‐based performance measures only
work if they are used in compensation plans.

29

Wallace's (1998) survey of EVA users found that firms including EVA in their incentive compensation plans
also implemented the measure to a significantly greater degree for capital budgeting and dividend
decisions, but not for asset disposal, working capital management, share repurchase, or financing decisions.
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
two EVA user groups.

5. A COMPARISON:  STRENGTHS AND WEAKNESSES OF THE ECONOMIC  VALUE MEASURES

The following table (Fernandez,  2003) proposes a comparison between EVA and CFROI (through CVA).

Cwynar (2009) define EVA, CVA and RI as  accounting‐based variants of residual income approach because
they utilize book values of both operating income and  invested capital, although more or less adjusted
(unadjusted for RI) in order to eliminate or limit the distortions of accounting numbers. Conversely, SVA is
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
opening market value (rather than book value)  of the firm's equity plus debt.

Table 8 – A comparison between EVA and CVA



source: adapted from Fernandez (2003).

If all value‐based metrics have similar goals, then why are there different metrics? A cynic might answer
that it gives all the consultants something to argue about. Although this hypothesis definitely has merit, the
reality is that different metrics are likely to serve different purposes (Fabozzi and Grant, 2000).
The principal users of value‐based 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 management’s skill by looking at
management’s historic and forecasted track record relative to peers, and then determine whether the firm
is over or undervalued based on their expectations. Contrast this to corporate executives who have almost
limitless information on a single firm. The firm, however, is made up of several business units, hundreds of
projects and thousands of employees. Corporate executives must not only make strategic decisions to help
EVA
economic value added
CVA
cash value added

measure of
shareholder
value
creation

EVA=NOPAT – (Ebv + D) WACC
CVA = NOPAT + DEP  – EDEP –
(DO+EbvO) WACC
(DEP = accounting depreciation;
EDEP = economic depreciation)
EVA= (ROC‐WACC)(D+Ebv)

CVA = (CFROI‐WACC) x (DO+EbvO)
measure of
shareholder
return
ROC = ROA = NOPAT/ (D+Ebv)
(NOPAT= net operating profit
after taxes and after
adjustments)
CFROI = (NOPAT + DEP  –
EDEP)/(DO+EbvO)
assets in
place
D+Ebv = adjusted book value
of debt and equity
(D= debt , Ebv = book value of
equity)
(DO+EbvO) = working capital
requirements + fixed assets +
cumulated depreciation + inflation
adjustment

30

the firm create shareholder value, they must also promote and instill value‐based management principles
throughout the organization down to the lowest levels. In addition, they must design and maintain internal
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 executive’s
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
and a valuation system that objectively sets target values. Corporate executives want the same properties,
but are much more interested in a simple measure that is easy to communicate and administer throughout
the firm. Can one framework meet the needs of both parties?

As discussed earlier, a primary goal of value‐based metrics is to eliminate the numerous distortions in
accounting data to provide comparability across time, firms and industries.  Once we have cleaned up the
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
computation DCF approach directly and does not introduce accounting distortions.
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
many difficulties for a manager who is trying to compare firms across time and industries to determine
the best investment opportunity. For example, how does a manager compare EVA for two firms when
one firm uses accelerated depreciation and the other straight‐line? Or what about firms having similar
fixed assets that were purchased at different times? In addition, the manager must determine if the
net asset base adequately accounts for the money the firm has invested to generate its cash flows (e.g.
the firm may have fully depreciated, but not retired fixed plant) and whether depreciation expense is
sufficient to replace the existing fixed assets. These issues have additional implications for the
corporate executive. The EVA calculation’s reliance on “net plant” can lead corporations 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 project’s 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
manager know whether to accept or reject the project?  This calculation issue has serious implications
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
investments are expressed at current prices).  EVA can deal with the “old plant trap” by replacing the
accounting depreciation with the annuity (economic) depreciation. Obviously, such a solution is not as
easy, further for external analysts.
Unlike EVA, CFROI is an internal rate of return and not a measure of economic profit. It provides a
consistent basis from which to evaluate companies regardless of their size. This characteristic of CFROI has
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
does not eliminate the hurdle rate problem, in which companies set an acceptable rate of return (the cost
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
employed assets, even if it exceeds the hurdle rate.  It would result in a greater positive cash flow for the
company, but lower total rate on the portfolio of investments.  Because it lowers the overall performance
evaluation criterion, it discourages approval of the project even though it would be beneficial to the whole
company. In addition,  as well as IRR, CFROI is a rate‐based measure and can provide a moving target based
on assumptions regarding reinvestment that may or may not be true (given two projects with equal NPV
but differing timing and amounts for cash flows, IRR will often produce different answers). Finally, CFROI is

31

a non‐linear measure: therefore, it is not easy for a manager to link how much he needs to improve cash
flow to obtain a target increase in CFROI.
Unlike EVA and CFROI, 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 company’s value. The SVA
includes strategy‐specific forecasts and therefore the strategic implications of the SVA model  are more
clear and intuitive. Moreover,  it focuses on the standard drivers of value (sales growth, operating margins,
investments, cost of capital).  However, since the focus of SVA is future performance, it is difficult to apply
when measuring historic performance and then it could be considered less adequate in compensation
systems. However, as discussed  above, since the focus of SVA is future performance should orient correctly
the operating managers to find strategies with the highest potential for increasing value.

We will sum up as follows the strengths and weaknesses of the three value‐based measures analyzed.

EVA

Fundamentally EVA has two sound features:
− by focusing  attention on “surplus” value, it does stress that it is not how much  income a firm makes
that marks its success, but how much it makes in excess of its cost of capital
− 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
smaller  spread –  than do existing projects) can be value destroying.

EVA, on the other hand,  shows various shortcomings.

− it is distorted by the  effect of “the old plant trap” and this calculation issue has serious implications
on management incentive mechanism
− 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,
not less (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
unadjusted EVA (Anderson et al., 2005)
− it could be inconsistent with value creation. The value of a firm’s assets is the present value of the EVAs
generated by them. Thus, a firm could be generating a positive EVA in the current year from assets, but
the expected EVA in future years may be negative, making these assets poor investments. Conversely,
you can have a firm generating negative EVA  in the current year, but the assets could still be value
creating if the present value of expected future EVAs is positive. Similarly, if a firm increases its EVA this
year relative to last year’s EVA or even relative to expectations, it could not stated that it has increased
its value, but it might have done so by trading off against future growth or increasing its riskiness
− neither  strong nor univocal evidence exists  on a higher correlation between EVA or EVA’s increases
and market value increases than other traditional metrics as well as rival economic value measures
− EVA  has been criticized for being too complex for front‐line managers to use, for motivating managers
to reduce beneficial capital expenditures to improve short‐term EVA, and for ignoring the firm's "core
competencies" and providing little actionable information on the long‐term 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 EVA for decision‐making and compensation purposes, and implemented an EVA‐based bonus
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
accounting measures.  Three primary reasons for the measure's demise in AT&T were identified:
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
training in the computation and use of EVA, employees outside of corporate headquarters did not
understand how their actions affected EVA results, and felt they had limited ability to impact
corporate or business unit EVA targets
the company came to recognize that EVA was an historical measure that provided incomplete
information on key drivers of future performance, such as employees and customers
although internal EVA results were positive, total shareholder return between December 1992 and
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
performance measures they believe to be more closely aligned with analysts' forecast models and
shareholder value.

CFROI

There are some firms with significant capital rationing constraints, where it is critical that investments be
directed to those projects where they earn the highest possible returns for the firm. For these firms, it can
be argued that value added measures that focus on 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
percentage rate of return allows these firms to get the maximum return from limited capital.
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, cost of capital and forecast periods for each company.
It is not clear, however, that CFROI is a significant advance over even traditional accounting measures such
as ROI or ROC.
Unlike accounting return measures and even EVA, CFROI focuses on cash flows. This is partially true, since
non‐cash charges are added back to arrive at the gross cash flow, but the cash flow used in CFROI
calculations is not the cash flow available for claimholders in the firm because it is prior to capital
expenditures and it is stated in real terms. In addition, CFROI avoids accounting distortions by excluding
depreciation, but accounting depreciation affect calculation of asset life (as average depreciation period).
The traditional accounting measures of return tend to be overstated because they look at the remaining
book value of assets. Thus, as assets are depreciated, the return on equity and capital tend to increase. By
focusing on the gross investment, rather than the net, and adjusting for current dollars, it is argued that
CFROI provides a superior measure of return on an investment. This argument, however,  tends to work
better for manufacturing firms but does not really hold up for firms that are not capital intensive.
Furthermore, it is argued that by assuming a fixed life for an asset and computing an internal rate of return,
the CFROI provides a better measure of return than traditional accounting measures which often divide
current earnings by book value of investment. This, again, is a far better argument with capital intensive
firms that invest in plant and equipment than it is for firms that invest in short term and intangible assets.
Furthermore, if we assume that assets have infinite lives and that capital maintenance expenditures offset
depreciation, the CFROI measure converges on the return on capital.
Moreover, CFROI does not eliminate the hurdle rate problem, in which companies set an acceptable rate of
return 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
employed assets, even if it exceeds the hurdle rate (the cost of capital).  As well as IRR, CFROI is a rate‐

33

based measure and can provide a moving target based on assumptions regarding reinvestment that may or
may not be true.
While it is a useful tool for  picking stocks, it is less useful for corporate planning. Corporate planners want
to understand how change in strategy will affect their company’s value. Based on a series of average
assumptions (cash flows determined by a 40 year CFROI fading to country‐wide averages, constant cost of
capital, etc.) in order to avoid explicit forecasts, CFROI will miss the distinctions (it was defined a sort of
"Procrustean Bed" approach to corporate valuation).
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
level of systematic risk and your strategy is not going to change, then CFROI approach will model your firm
effectively. For any company that is not average on all these accounts, the BCG model will miss the
distinctions. For example, would a natural resources company really want to "fade" to the same CFROI and
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 value‐based system using CFROI will be
unsuccessful without a value driver analysis that unbundles CFROI into discrete, controllable financial and
operational variables (Snyder,  1995).

Therefore, it appears as a too complex measure for managers to understand and act upon, even if it is
conceptually superior to traditional accounting measures and EVA. It would be difficult to explain CFROI to
the average operating manager, much less his/her specific role in making it happen.

SVA

The shareholder value approach has gained popularity mainly because of the following reasons:

− it accounts for risk, free from accounting distortions and measures the change in value
− the approach uses complete information. It incorporates historical, current and forecast information in
determining the amount and timing of future cash flows, the value growth duration and systematic and
specific risk in its analysis
− 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
highest value for other stakeholders like employees, other investors in the company and customers
− in the literature many surveys state the high correlation between cash outflow, downside stock price
movements and decreasing shareholder value. From this research and experience, the discounted cash
flow approach to understand investor expectations has established its position as a pre‐eminent, but
not exclusive, analytical tool for value based management
− 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 company’s value. The SVA includes
strategy‐specific forecasts and therefore the strategic implications of the SVA model are more clear and
intuitive.  Operating managers need to identify and focus on leading indicators to deliver superior value
to shareholders.

Common criticisms  on   the SVA approach are the subjectivity, the high sensitivity of the residual value to
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
judgement and strategic thinking, subjectivity is also necessarily added. Certain other approaches avoid
this subjectivity only at the cost of relying on historical data and applying restrictive assumptions about
the future

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 non‐recurrent events and normalizes the cash flow used as the basis for residual value. That
residual value should be highly sensitive to the growth in perpetuity assumption. A firm that can create
value indefinitely into the future (i.e. one with a perpetuity growth greater than zero) should be much
more valuable than one that does not. It should be stressed that the perpetuity with growth
assumption for residual value is only applicable to the very few firms that have an economic advantage
that cannot be reduced by competition.
− 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, APT or any other approach.
− shortcomings in the area of compensation. Compared to the EVA, the SVA approach is likely to pose
the most important question in performance measurement – whether a company earns a better return
on its investment than its cost of capital – less directly. A direct result of asking this question is that the
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
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 increasing SVA,
unlike EVA and CFROI that can induce distorting behaviours.

Appendix – Formulas of CFROI

From the following formula
1

we can demonstrate how the following alternative formulation  of the CFROI can be derived, if we assume
in deriving the economic depreciation  a discount rate of kc CFROI k

CFROI Gross Cash Flow ‐ Economic Depreciation /Gross Investment.

Stating that:
ED = economic depreciation = GI – SV * , where = 1 1 ⁄ is the final value of an n‐
period  annuity with interest rate k
multiplying each member of the above equation by 1 k n and therefore subtracting by each member GI,
we can rewrite the relationship  as follows:

GI 1 k n ‐1 GCF * – ED * .
Being   1 k n ‐1 k * and * 1 k n , we can get

k*GI GCF – ED therefore  k GCF – ED /GI (quod erat demonstrandum).

35

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www.valueanalitix.com – Comparison of methodologies

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