Equity Valuation: Models from Leading Investment Banks

13

From Economics to Valuation – Part II

13.1 GENERAL RULES

Before discussing valuation, it is useful to highlight the general rules for using CFROI or EP when assessing potential paths for future value creation.

When EP is positive, the firm has created wealth for its equity shareholders in the period measured equal to the EP. Thus, there are two key questions to ask when using EP:

• Does the firm generate positive EP?
• If EP is positive, can the firm grow the business and increase EP? When assessing CFROI there are three key questions to ask:
• What is the CFROI level?
• What is the cost of capital?
• Given the CFROI spread (CFROI less the cost of capital), should the firm grow or contract?

A frequent criticism of both CFROI and EP is that management can trade future CFROIs or EPs for current CFROIs or EPs. The tradeoff requires the rejection of future positive return projects since they would negatively impact current period earnings and potentially both EP and CFROI. In other words, management decides to trade future higher cash flows for current period cash flow and earnings.

13.2 MARKET VALUE ADDED

EP attempts to address this shortcoming by looking at market value added (MVA). MVA is simply the spread between the market value of the firm and its book value. If management is making short-term decisions to increase current period EP to the detriment of long-term decisions, the MVA should drop. However, an accurate assessment of what is implied in the market value can make the judgment ...