IESE Insight
How To Measure Value Creation
Fernández, Pablo
Publisher: IESE
This article is based on: Three residual income valuation methods and discounted cash flow valuation
Year: 2003
Language: English

How do we measure a firm´s value creation for its shareholders over a given period? In his paper "Three Residual Income Valuation Methods and Discounted Cash Flow Valuation", Professor Pablo Fernández of IESE shows that three of the parameters commonly used for this purpose yield results that make no sense at all.

Fernández focuses on the calculation of value creation by the measurement of Economic Value Added (EVA), Economic Profit (EP) and Cash Value Added (CVA), all three based on the analysis of a company?s residual income. These residual income methods differ from cash flow models, but the author shows that they always yield the same value as discounted cash flow valuation models because they all depend on the input of the same data and all use the same hypotheses. The financial meaning of EP, EVA and CVA, however, is not as clear as that of cash flows. Also, EVA and EP calculations use both accounting input (such as profit) and market parameters (such as the required return on capital or the average cost of capital).

Based on two examples, Fernández points out the shortcomings of the residual income methods as measurers of value creation. The first example is a company funded entirely by equity and with a simple 5-year financing structure. According to EVA calculations, this company would do quite badly in the first year and improve dramatically from then on. This misleadingly suggests an improvement in company performance. The simple structure of the enterprise and the transparency of its financial policy show that nothing of the kind occurs. Using the CVA method, the company in this example would create no value whatsoever in the five years under study.

In the second example, using the same company but this time partly financed with debt, the residual income methods indicate value creation. All three methods suggest that the company improves its performance over time. Yet Fernández points out that the difference between the firm´s book value at the time it is founded and its market value five years later is simply a consequence of the prospect that the company´s return will be higher than the cost of capital employed. It is therefore an effect that materialises even before the company´s activities start, in year "0" so to speak.

These shortcomings have practical implications for the policies that some companies have adopted to measure business unit or management performance. Fernández argues that basing executive compensation schemes on EP, EVA or CVA, for example, may actually have harmful consequences for companies.

In summary, Fernández declares it impossible to quantify value creation over a given period on the basis of accounting data alone. To measure the success of an enterprise (to calculate the value it has created) EP, EVA and CVA are unreliable. Value and shareholder value always depend on a factor that does not come into play in these methods: expectations.

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