The Metric Wars: EVA versus Cashflow measures

1
The Metric Wars EVA versus Cashflow measures

• Ch 9
• Arne Dag Sti

2
Competing value added approaches

• EVA
• promoted by
• Stern Stewart Co

• CFROI
• Cash Flow Rate of Return on Investment
• promoted by
• Holt Value Associates (Chicago)
• BCG Boston Consulting Group

3
CFROI egenskaper side 383

• CFROI beregnes som IRR (internrenten)
• CFROI blir beregnet utelukkende på grunnlag av
  kontantstrømmer
• CFROI blir inflasjonsjustert

• Kan ikke bli fortolket som internrenten
• Fjerner seg fra Accrual accounting, dvs
  regnskapsbaserte tall
• Realrente, ikke nominalrente

4
CFROI and EVA

• Similarity to EVA
• CFROI is normally calculated on an annual basis
  and is compared to an inflation-adjusted cost of
  capital to determine whether the company has
  earned returns superior to its cost of capital
  and thus created shareholder value for its
  shareholders.
• Both methods assume that management creates value
  by earning returns on invested capital greater
  than the cost of capital.

5
Steps in CFROI calculationsFigure 9-2 page 387

• Step 1 Estimate economic life of depreciable
  assets of the company
• Step 2 Estimate the gross cashflows, inflation
  adjusted
• Step 3 Estimate gross cash investment

• Step 4 Calculate the non-depreciating assets
  (such as land and inventories) . Calculate the
  terminal value of such assets at the end of the
  horizon
• Step 5 CFROI as IRR of the real cash flow
  investment project

6
The CFROI Valuation Model

• Value of the firm
• Value of existing assets
• Value of future investments

• Formula page 389
• Formula page 390

7
3 Components of Market Value

• Market value
• Invested capital
• Present value of future EVAs from assets in place
  
• Present value of future EVAs from future
  investments

• EVA terminology
• COV Current Operations Value
• FGV Future Growth Value

8
Rest of Ch 9

• A case study of CFROI (9 pages)
• The CFROI fade (5 pages) The evidence isnt
  convincing

• Harnischfeger Industries (4 pages)
• Does a predictable fade really exist?

9
CFROI and Inflation

• Adjusting for inflation is one of the distinctive
  selling features of CFROI
• illustrated in 4 steps
• page 405-406
• numeric example

• Inflation affects CFROI in three major ways
• 1) Gains/losses from monetary assets/liabilites
• 2) Inflation adjustment for fixed assets
  (gjenanskaffelsesverdier)
• 3) Inventories

10
EVA or CFROI? Authors conclusion from the
example

• EVA has flexibility in deciding which accounting
  adjustments to make (if any).
• .
• EVAs relative simplicity gives it important
  advantages over CFROI as a divisional performance
  measure

• The CFROI metric requires a comprehensive set of
  adjustments, some of which are complex and
  difficult for line managers to understand

11
The Holt/BCG critique of EVA

• EVA is biased against growth
• EVA ignores dividend payments
• EVA is biased by size and difficult to interpret
  or benchmark
• EVA is not adjusted for inflation

• Pga lineær avskrivning This practice results in
  understating EVA in early years
• EVA based on the firm as a separate entity MM
• Dollar measure versus
• Nominal dollar measure

12
Authors conclusionson the Holt Critique

• With proper depreciation (sinking fund!) EVA is
  pro-growth
• EVA does not ignore dividends (Holt confusion)
• EVA is not biased by size (Holt confusion)
• Inflation?

• Implicitly they admit that inflation might be a
  problem
• but ..
• .
• This might be adjusted for if it is important
• by the cost-benefit test

13
Appendix The Cost of Capital under CFROI

• The Holt CFROI approach assumes that
  company-specific risk is a function of financial
  leverage and size, two risk factors that cannot
  be eliminiated through diversification and
  therefore should be reflected in discount rate
  differentials

• Interesting views!
• Why?
• CAPM too simple for practical use?
• Practical integration of insights from Arbitrage
  Pricing Theory