Valuation Techniques: Discounted Cash Flow, Earnings Quality, Measures of Value Added, and Real Options

MEASURES OF VALUE ADDED

Measuring whether a firm’s management has increased or decreased a firm’s value during a period is difficult because a firm’s value may be affected by many factors. Currently advocated performance measurement techniques, such as Stern, Stewart & Company’s EVA and MVA approaches, are based on valuation principles, but an important distinction exists between valuation and performance measurement: Valuation relies on forecasts, and performance measurement relies on actual results. In this section we take a close look at value-added measures of performance and discuss an alternative measure of performance, the cash flow return on investment (CFROI).

Economic Profit

Many U.S. corporations, including The Coca-Cola Company, Briggs & Stratton Corporation, CSX Corporation, and AT&T Corporation, are embracing a relatively new method of evaluating and rewarding management performance that is based on the idea of compensating management for economic profit rather than for accounting profit.13 What is economic profit? It is basically the difference between revenues and costs, where the costs include not only expenses but also the cost of capital. And although the application of economic profit is relatively new in the measurement of performance, the concept of economic profit has been around since the late 19th century (Marshall 1890). What this recent emphasis on economic profit has done is focus attention away from accounting profit and toward the cost of capital. ...