6.3. EXCESS RETURN MODELS

In Chapter 4 on forecasting cash flows, we established that growth has value only when it is accompanied by excess returns—returns on equity (capital) that exceed the cost of equity (capital). Excess return models take this conclusion to the logical next step and compute the value of a firm as a function of expected excess returns. Although there are numerous versions of excess return models, we will focus on one widely used variant, which is economic value added (EVA), a measure popularized by Stern Stewart, a value consulting firm. Economic value added is a measure of the surplus value created by an investment or a portfolio of investments. It is computed as the product of the excess return made on an investment or investments and the capital invested in that investment or investments.

In this section, we begin by looking at the measurement of economic value added and then consider its links to discounted cash flow valuation.

6.3.1. Calculating EVA

The definition of EVA outlines three basic inputs we need for its computation—the return on capital (ROC) earned on investments, the cost of capital for those investments, and the capital invested in them. In measuring each of these, we make many of the same adjustments discussed in the context of discounted cash flow valuation.

How much capital is invested in existing assets? One obvious answer is to use ...

Get Damodaran on Valuation now with O’Reilly online learning.

O’Reilly members experience live online training, plus books, videos, and digital content from 200+ publishers.