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

ECONOMIC VALUE ADDED

Economic value added is a measure of surplus value created by an investment. This approach defines the return on capital as the “true” cash flow return on capital earned on an investment. It also defines the cost of capital as the weighted average of the costs of the different financing instruments used to finance the investment. EVA has three basic inputs—invested capital, return on capital, and cost of capital:

“Capital invested in project” is designed to capture how much capital is invested in assets in place, projects that are already active. How is invested capital measured? Some people might think market value is a potential measure. One of the problems of market value of companies is that market value includes expected future growth (in addition to assets in place). So, market value is out of the question as a potential measure. The next choice is book value. Is the accounting measure of book value really a measure of the market value of assets in place? Not always and not generally. To get from book value to capital investments, four adjustments are typically used: One adjustment is operating leases. For example, the balance sheet of The Gap has only equity—no debt. The problem is that The Gap leases all of its stores and qualifies the leases as operating leases. In accounting terms, operating leases are operating expenses and do not show up on the balance ...