Chapter 5

Economic Value Added

5.1 MEASURING VALUE CREATION

This chapter examines the economic value added (EVA)1 approach to valuation and discusses the similarities and differences between EVA and free cash flow. EVA is not just a restatement of DCF but an important complement that should have a place in every analyst's toolkit. While the applicability of the EVA concepts is wide-ranging and includes the design of managerial compensation systems, in this book we are interested in the use of EVA for estimating the sources of value creation and valuing strategic and restructuring decisions.2

Firms create value by investing in projects with returns in excess of their cost of capital. The value created by the firm is thus the difference between the present value of its future cash flows and the capital invested. In this context, the term “economic value-added” refers to a periodic measure of the value created by the firm. It is obtained by subtracting from operating income after taxes the cost of capital utilization. This measure has been found useful in evaluating the performance of companies and their business units and in developing incentive compensation schemes for aligning the interest of managers with those of the owners. It also provides a useful interpretation of free cash-flow valuation.

Economic value-added is referred to as “economic profit” in the economics literature, and some of the accounting and control literature has long recognized the cost of the total capital ...

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