Economic Value Added

Economic Value AddedFrom Wikipedia, the free encyclopedia

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In corporate finance, Economic Value Added or EVA, is an estimate of a firm's economic profit – being the

value created in excess of the required return of thecompany's investors (being shareholders and debt

holders). Quite simply, EVA is the profit earned by the firm less the cost of financing the firm's capital. The

idea is that value is created when the return on the firm's economic capital employed is greater than the

cost of that capital; see Corporate finance: working capital management. This amount can be determined by

making adjustments to GAAP accounting. There are potentially over 160 adjustments that could be made

but in practice only five or seven key ones are made, depending on the company and the industry it

competes in.

Contents

  [hide]

1 Calculating EVA

2 Comparison with other approaches

3 Relationship to market value added

4 Integrating EVA and PBC

5 See also

6 References

7 External links

[edit]Calculating EVA

EVA is net operating profit after taxes (or NOPAT) less a capital charge, the latter being the product of the

cost of capital and the economic capital. The basic formula is:

where:

, is the Return on Invested Capital (ROIC);

 is the weighted average cost of capital (WACC);

 is the economic capital employed;

NOPAT  is the net operating profit after tax, with adjustments and translations, generally for the

amortization of goodwill, the capitalization of brand advertising and others non-cash items.

EVA Calculation:

EVA = net operating profit after taxes – a capital charge [the residual income method]

therefore EVA = NOPAT – (c × capital), or alternatively

EVA = (r x capital) – (c × capital) so that

EVA = (r-c) × capital [the spread method, or excess return method]

where:

r = rate of return, and

c = cost of capital, or the Weighted Average Cost of

Capital (WACC).

NOPAT is profits derived from a company’s operations after cash taxes but before financing costs and

non-cash bookkeeping entries. It is the total pool of profits available to provide a cash return to those

who provide capital to the firm.

Capital is the amount of cash invested in the business, net of depreciation. It can be calculated as the

sum of interest-bearing debt and equity or as the sum of net assets less non-interest-bearing current

liabilities (NIBCLs).

The capital charge is the cash flow required to compensate investors for the riskiness of the business

given the amount of economic capital invested.

The cost of capital is the minimum rate of return on capital required to compensate investors (debt and

equity) for bearing risk, their opportunity cost.

Another perspective on EVA can be gained by looking at a firm’s return on net assets (RONA). RONA

is a ratio that is calculated by dividing a firm’s NOPAT by the amount of capital it employs (RONA =

NOPAT/Capital) after making the necessary adjustments of the data reported by a conventional

financial accounting system.

EVA = (RONA – required minimum return) × net investments

If RONA is above the threshold rate, EVA is positive.

[edit]Comparison with other approaches

Other approaches along similar lines include Residual Income Valuation (RI) and residual cash flow.

Although EVA is similar to residual income, under some definitions there may be minor technical

differences between EVA and RI (for example, adjustments that might be made to NOPAT before it is

suitable for the formula below). Residual cash flow is another, much older term for economic profit. In

all three cases, money cost of capital refers to the amount of money rather than the proportional cost

(% cost of capital); at the same time, the adjustments to NOPAT are unique to EVA.

Although in concept, these approaches are in a sense nothing more than the traditional, commonsense

idea of "profit", the utility of having a separate and more precisely defined term such as EVA is that it

makes a clear separation from dubious accounting adjustments that have enabled businesses such

as Enron to report profits while actually approaching insolvency.

Other measures of shareholder value include:

Added value

Market value added

Total shareholder return .

[edit]Relationship to market value added

The firm's market value added, or MVA, is the discounted sum (present value) of all future expected

economic value added:

Note that MVA = PV of EVA.

More enlightening is that since MVA = NPV of Free cash flow (FCF) it follows therefore that the

NPV of FCF = PV of EVA;

since after all, EVA is simply the re-arrangement of the FCF formula.

[edit]Integrating EVA and PBC

Recently, Mocciaro Li Destri, Picone & Minà (2012)[1] proposed a performance and cost

measurement system that integrates the EVA criteria with Process Based Costing (PBC). The

EVA-PBC methodology allows us to implement the EVA management logic non only at the firm

level, but also at lower levels of the organization. EVA-PBC methodology plays an interesting role

in bringing strategy back into financial performance measures.

Business valuationFrom Wikipedia, the free encyclopedia

Business valuation is a process and a set of procedures used to estimate the economic value of an

owner’s interest in a business. Valuation is used by financial market participants to determine the price they

are willing to pay or receive to perfect a sale of a business. In addition to estimating the selling price of a

business, the same valuation tools are often used by business appraisers to resolve disputes related to

estate and gift taxation, divorce litigation, allocate business purchase price among business assets,

establish a formula for estimating the value of partners' ownership interest for buy-sell agreements, and

many other business and legal purposes.

Contents

  [hide]

1     Standard and premise of value   

2     There are two premises of Value   

3     Elements of business valuation   

o 3.1      Economic conditions   

o 3.2      Financial analysis   

o 3.3      Normalization of financial statements   

o 3.4      Income, asset and market approaches   

4     Income approaches   

o 4.1      Discount or capitalization rates   

4.1.1      Capital Asset Pricing Model (CAPM)   

4.1.2      Modified Capital Asset Pricing Model   

4.1.3      Weighted average cost of capital ("WACC")   

4.1.4      Build-Up Method   

5     Asset-based approaches   

6     Market approaches   

o 6.1      Guideline Public Company method   

o 6.2      Guideline Transaction Method or Direct Market Data Method   

7     Option pricing approaches   

8     Discounts and premiums   

o 8.1      Discount for lack of control   

o 8.2      Discount for lack of marketability   

8.2.1      Restricted stock studies   

8.2.2      Option pricing   

8.2.3      Pre-IPO studies   

o 8.3      Applying the studies   

9     Estimates of business value   

10      See also   

11      References   

12      Further reading   

[edit]Standard and premise of value

Before the value of a business can be measured, the valuation assignment must specify the reason for and

circumstances surrounding the business valuation. These are formally known as the business value

standard and premise of value.[1] The standard of value is the hypothetical conditions under which the

business will be valued. The premise of value relates to the assumptions, such as assuming that the

business will continue forever in its current form (going concern), or that the value of the business lies in the

proceeds from the sale of all of its assets minus the related debt (sum of the parts or assemblage of

business assets).

[edit]There are two premises of Value

Going Concern - Value as an ongoing operating business enterprise.[2] Liquidation – Value when business is

terminated.

Premise of value for fair value Calculation

•In use – If the asset would provide maximum value to the market participants principally through its use in

combination with other assets as a group. •In Exchange – If the asset would provide maximum value to the

market participants principally on a stand alone basis. Business valuation results can vary considerably

depending upon the choice of both the standard and premise of value. In an actual business sale, it would

be expected that the buyer and seller, each with an incentive to achieve an optimal outcome, would

determine the fair market value of a business asset that would compete in the market for such an

acquisition. If the synergies are specific to the company being valued, they may not be considered. Fair

value also does not incorporate discounts for lack of control or marketability.

Note, however, that it is possible to achieve the fair market value for a business asset that is being

liquidated in its secondary market. This underscores the difference between the standard and premise of

value.

These assumptions might not, and probably do not, reflect the actual conditions of the market in which the

subject business might be sold. However, these conditions are assumed because they yield a uniform

standard of value, after applying generally accepted valuation techniques, which allows meaningful

comparison between businesses which are similarly situated.

[edit]Elements of business valuation

[edit]Economic conditions

The examples and perspective in this article deal primarily with the United States and do not represent a worldwide view of the subject.Please improve this article and discuss the issue on the talk page. (March 2011)

A business valuation report generally begins with a description of national, regional and local economic

conditions existing as of the valuation date, as well as the conditions of the industry in which the subject

business operates. A common source of economic information for the first section of the business valuation

report is the Federal Reserve Board’s Beige Book, published eight times a year by theFederal Reserve

Bank. State governments and industry associations also publish useful statistics describing regional and

industry conditions.

[edit]Financial analysis

The financial statement analysis generally involves common size analysis, ratio analysis (liquidity, turnover,

profitability, etc.), trend analysis and industry comparative analysis. This permits the valuation analyst to

compare the subject company to other businesses in the same or similar industry, and to discover trends

affecting the company and/or the industry over time. By comparing a company’sfinancial statements in

different time periods, the valuation expert can view growth or decline in revenues or expenses, changes in

capital structure, or other financial trends. How the subject company compares to the industry will help with

the risk assessment and ultimately help determine the discount rate and the selection of market multiples.

[edit]Normalization of financial statements

The most common normalization adjustments fall into the following four categories:

Comparability Adjustments. The valuer may adjust the subject company’s financial statements to

facilitate a comparison between the subject company and other businesses in the same industry or

geographic location. These adjustments are intended to eliminate differences between the way that

published industry data is presented and the way that the subject company’s data is presented in

its financial statements.

Non-operating Adjustments. It is reasonable to assume that if a business were sold in a hypothetical

sales transaction (which is the underlying premise of the fair market value standard), the seller would

retain any assets which were not related to the production of earnings or price those non-operating

assets separately. For this reason, non-operating assets (such as excess cash) are usually eliminated

from the balance sheet.

Non-recurring Adjustments. The subject company’s financial statements may be affected by events that

are not expected to recur, such as the purchase or sale of assets, a lawsuit, or an unusually large

revenue or expense. These non-recurring items are adjusted so that the financial statements will better

reflect the management’s expectations of future performance.

Discretionary Adjustments. The owners of private companies may be paid at variance from the market

level of compensation that similar executives in the industry might command. In order to determine fair

market value, the owner’s compensation, benefits, perquisites and distributions must be adjusted to

industry standards. Similarly, the rent paid by the subject business for the use of property owned by the

company’s owners individually may be scrutinized.

[edit]Income, asset and market approaches

Three different approaches are commonly used in business valuation: the income approach, the asset-

based approach, and the market approach.[3] Within each of these approaches, there are various

techniques for determining the value of a business using the definition of value appropriate for the appraisal

assignment. Generally, the income approaches determine value by calculating the net present value of the

benefit stream generated by the business (discounted cash flow); the asset-based approaches determine

value by adding the sum of the parts of the business (net asset value); and the market approaches

determine value by comparing the subject company to other companies in the same industry, of the same

size, and/or within the same region. A number of business valuation models can be constructed that utilize

various methods under the three business valuation approaches. Venture Capitalists and Private Equity

professionals have long used the First chicago method which essentially combines the income approach

with the market approach.

In certain cases equity may also be valued by applying the techniques and frameworks developed

for financial options, via a real options framework,[4] as discussed below.

In determining which of these approaches to use, the valuation professional must exercise discretion. Each

technique has advantages and drawbacks, which must be considered when applying those techniques to a

particular subject company. Most treatises and court decisions encourage the valuator to consider more

than one technique, which must be reconciled with each other to arrive at a value conclusion. A measure of

common sense and a good grasp of mathematics is helpful.

[edit]Income approaches

The income approaches determine fair market value by multiplying the benefit stream generated by the

subject or target company times a discount or capitalization rate. The discount or capitalization rate

converts the stream of benefits into present value. There are several different income approaches, including

capitalization of earnings or cash flows, discounted future cash flows ("DCF"), and the excess earnings

method (which is a hybrid of asset and income apprope of benefit stream to which it is applied). The result

of a value calculation under the income approach is generally the fair market value of a controlling,

marketable interest in the subject company, since the entire benefit stream of the subject company is most

often valued, and the capitalization and discount rates are derived from statistics concerning public

companies. IRS Revenue Ruling 59-60 states that earnings are preeminent for the valuation of closely held

operating companies.

[edit]Discount or capitalization rates

A discount rate or capitalization rate is used to determine the present value of the expected returns of a

business. The discount rate and capitalization rate are closely related to each other, but distinguishable.

Generally speaking, the discount rate or capitalization rate may be defined as the yield necessary to attract

investors to a particular investment, given the risks associated with that investment.

In DCF valuations, the discount rate, often an estimate of the cost of capital for the business is used to

calculate the net present value of a series of projected cash flows.

On the other hand, a capitalization rate is applied in methods of business valuation that are based on

business data for a single period of time. For example, in real estate valuations for properties that

generate cash flows, a capitalization rate may be applied to the net operating income (NOI) (i.e.,

income before depreciation and interest expenses) of the property for the trailing twelve months.

There are several different methods of determining the appropriate discount rates. The discount rate is

composed of two elements: (1) the risk-free rate, which is the return that an investor would expect from a

secure, practically risk-free investment, such as a high quality government bond; plus (2) a risk

premium that compensates an investor for the relative level of risk associated with a particular investment in

excess of the risk-free rate. Most importantly, the selected discount or capitalization rate must be consistent

with stream of benefits to which it is to be applied.

[edit]Capital Asset Pricing Model (CAPM)

The Capital Asset Pricing Model (CAPM) is one method of determining the appropriate discount rate in

business valuations. The CAPM method originated from the Nobel Prize winning studies of Harry

Markowitz, James Tobin and William Sharpe. The CAPM method derives the discount rate by adding a risk

premium to the risk-free rate. In this instance, however, the risk premium is derived by multiplying the equity

risk premium times "beta," which is a measure of stock price volatility. Beta is published by various sources

for particular industries and companies. Beta is associated with the systematic risks of an investment.

One of the criticisms of the CAPM Method is that beta is derived from the volatility of prices of publicly

traded companies, which are likely to differ from private companies in their capital structures, diversification

of products and markets, access to credit markets, size, management depth, and many other respects.

Where private companies can be shown to be sufficiently similar to public companies, however,

the CAPM method may be appropriate.

[edit]Modified Capital Asset Pricing Model

The Cost of Equity (Ke) is computed by using the Modified Capital Asset Pricing Model (Mod. CAPM)

Mod. CAPM Model ke = Rf + B ( Rm-Rf) + SCRP + CSRP Where: Rf = Risk free rate of return (Generally

taken as 10-year Government Bond Yield) B = Beta Value (Sensitivity of the stock returns to market returns)

Ke = Cost of Equity Rm= Market Rate of Return SCRP = Small Company Risk Premium, CSRP= Company

specific Risk premium [5]

[edit]Weighted average cost of capital ("WACC")

The weighted average cost of capital is an approach to determining a discount rate. The WACC method

determines the subject company’s actual cost of capital by calculating the weighted average of the

company’s cost of debt and cost of equity. The WACC must be applied to the subject company’s net cash

flow to total invested capital.

One of the problems with this method is that the valuator may elect to calculate WACC according to the

subject company’s existing capital structure, the average industry capital structure, or the optimal capital

structure. Such discretion detracts from the objectivity of this approach, in the minds of some critics.

Indeed, since the WACC captures the risk of the subject business itself, the existing or contemplated capital

structures, rather than industry averages, are the appropriate choices for business valuation.

Once the capitalization rate or discount rate is determined, it must be applied to an appropriate economic

income stream: pretax cash flow, aftertax cash flow, pretax net income, after tax net income, excess

earnings, projected cash flow, etc. The result of this formula is the indicated value before discounts. Before

moving on to calculate discounts, however, the valuation professional must consider the indicated value

under the asset and market approaches.

Careful matching of the discount rate to the appropriate measure of economic income is critical to the

accuracy of the business valuation results. Net cash flow is a frequent choice in professionally conducted

business appraisals. The rationale behind this choice is that this earnings basis corresponds to the equity

discount rate derived from the Build-Up or CAPM models: the returns obtained from investments in publicly

traded companies can easily be represented in terms of net cash flows. At the same time, the discount

rates are generally also derived from the public capital markets data.

[edit]Build-Up Method

The Build-Up Method is a widely recognized method of determining the after-tax net cash flow discount

rate, which in turn yields the capitalization rate. The figures used in the Build-Up Method are derived from

various sources. This method is called a "build-up" method because it is the sum of risks associated with

various classes of assets. It is based on the principle that investors would require a greater return on

classes of assets that are more risky. The first element of a Build-Up capitalization rate is the risk-free rate,

which is the rate of return for long-term government bonds. Investors who buy large-cap equity stocks,

which are inherently more risky than long-term government bonds, require a greater return, so the next

element of the Build-Up method is the equity risk premium. In determining a company’s value, the long-

horizon equity risk premium is used because the Company’s life is assumed to be infinite. The sum of the

risk-free rate and the equity risk premium yields the long-term average market rate of return on large public

company stocks.

Similarly, investors who invest in small cap stocks, which are riskier than blue-chip stocks, require a greater

return, called the "size premium." Size premium data is generally available from two sources:Morningstar's

(formerly Ibbotson & Associates') Stocks, Bonds, Bills & Inflation and Duff & Phelps' Risk Premium Report.

By adding the first three elements of a Build-Up discount rate, we can determine the rate of return that

investors would require on their investments in small public company stocks. These three elements of the

Build-Up discount rate are known collectively as the "systematic risks."

In addition to systematic risks, the discount rate must include "unsystematic risks," which fall into two

categories. One of those categories is the "industry risk premium." Morningstar’s yearbooks contain

empirical data to quantify the risks associated with various industries, grouped by SIC industry code.

The other category of unsystematic risk is referred to as "specific company risk." Historically, no published

data has been available to quantify specific company risks. However as of late 2006, new research has

been able to quantify, or isolate, this risk for publicly traded stocks through the use of Total Beta

calculations. P. Butler and K. Pinkerton have outlined a procedure which sets the following two equations

together:

Total Cost of Equity (TCOE) = risk-free rate + total beta*equity risk premium TCOE = risk-free rate +

beta*equity risk premium + size premium + company-specific risk premium

The only unknown in the two equations is the company specific risk premium.

While it is possible to isolate the company-specific risk premium as shown above, many appraisers just key

in on the total cost of equity (TCOE) provided by the following equation: TCOE = risk-free rate + Total

beta*equity risk premium.

It is similar to using the market approach in the income approach instead of adding separate (and

potentially redundant) measures of risk in the build-up approach. The use of total beta (developed by

Aswath Damodaran) is a relatively new concept. It is, however, gaining acceptance in the business

valuation community since it is based on modern portfolio theory. Total beta can help appraisers develop a

cost of capital who were content to use their intuition alone when previously adding a purely subjective

company-specific risk premium in the build-up approach.

It is important to understand why this capitalization rate for small, privately held companies is significantly

higher than the return that an investor might expect to receive from other common types of investments,

such as money market accounts, mutual funds, or even real estate. Those investments involve substantially

lower levels of risk than an investment in a closely held company. Depository accounts are insured by the

federal government (up to certain limits); mutual funds are composed of publicly traded stocks, for which

risk can be substantially minimized through portfolio diversification.

Closely held companies, on the other hand, frequently fail for a variety of reasons too numerous to name.

Examples of the risk can be witnessed in the storefronts on every Main Street in America. There are no

federal guarantees. The risk of investing in a private company cannot be reduced through diversification,

and most businesses do not own the type of hard assets that can ensure capital appreciation over time.

This is why investors demand a much higher return on their investment in closely held businesses; such

investments are inherently much more risky. (This paragraph is biased, presuming that by the mere fact that

a company is closely held, it is prone towards failure.)

[edit]Asset-based approaches

The value of asset-based analysis of a business is equal to the sum of its parts. That is the theory

underlying the asset-based approaches to business valuation. The asset approach to business valuation is

based on the principle of substitution: no rational investor will pay more for the business assets than the

cost of procuring assets of similar economic utility. In contrast to the income-based approaches, which

require the valuation professional to make subjective judgments about capitalization or discount rates, the

adjusted net book value method is relatively objective. Pursuant to accounting convention, most assets are

reported on the books of the subject company at their acquisition value, net of depreciation where

applicable. These values must be adjusted to fair market value wherever possible. The value of a

company’s intangible assets, such as goodwill, is generally impossible to determine apart from the

company’s overall enterprise value. For this reason, the asset-based approach is not the most probative

method of determining the value of going business concerns. In these cases, the asset-based approach

yields a result that is probably lesser than the fair market value of the business. In considering an asset-

based approach, the valuation professional must consider whether the shareholder whose interest is being

valued would have any authority to access the value of the assets directly. Shareholders own shares in a

corporation, but not its assets, which are owned by the corporation. A controlling shareholder may have the

authority to direct the corporation to sell all or part of the assets it owns and to distribute the proceeds to the

shareholder(s). The non-controlling shareholder, however, lacks this authority and cannot access the value

of the assets. As a result, the value of a corporation's assets is not the true indicator of value to a

shareholder who cannot avail himself of that value. The asset based approach is the entry barrier value and

should preferably to be used in businesses having mature or declaining growth cycle and is more suitable

for capital intensive industry.[6]

Adjusted net book value may be the most relevant standard of value where liquidation is imminent or

ongoing; where a company earnings or cash flow are nominal, negative or worth less than its assets; or

where net book value is standard in the industry in which the company operates. The adjusted net book

value may also be used as a "sanity check" when compared to other methods of valuation, such as the

income and market approaches...

[edit]Market approaches

Main article: Valuation using multiples

The market approach to business valuation is rooted in the economic principle of competition: that in a free

market the supply and demand forces will drive the price of business assets to a certain equilibrium. Buyers

would not pay more for the business, and the sellers will not accept less, than the price of a comparable

business enterprise. It is similar in many respects to the "comparable sales" method that is commonly used

in real estate appraisal. The market price of the stocks of publicly traded companies engaged in the same

or a similar line of business, whose shares are actively traded in a free and open market, can be a valid

indicator of value when the transactions in which stocks are traded are sufficiently similar to permit

meaningful comparison.

The difficulty lies in identifying public companies that are sufficiently comparable to the subject company for

this purpose. Also, as for a private company, the equity is less liquid (in other words its stocks are less easy

to buy or sell) than for a public company, its value is considered to be slightly lower than such a market-

based valuation would give.

When there is a lack of comparison with direct competition, a meaningful alternative could be a vertical

value-chain approach where the subject company is compared with, for example, a known downstream

industry to have a good feel of its value by building useful correlations with its downstream companies.

Such comparison often reveals useful insights which help business analysts better understand performance

relationship between the subject company and its downstream industry. For example, if a growing subject

company is in an industry more concentrated than its downstream industry with a high degree of

interdependence, one should logically expect the subject company performs better than the downstream

industry in terms of growth, margins and risk.

[edit]Guideline Public Company method

Guideline Public Company method entails a comparison of the subject company to publicly traded

companies. The comparison is generally based on published data regarding the public companies’ stock

price and earnings, sales, or revenues, which is expressed as a fraction known as a "multiple." If the

guideline public companies are sufficiently similar to each other and the subject company to permit a

meaningful comparison, then their multiples should be similar. The public companies identified for

comparison purposes should be similar to the subject company in terms of industry, product lines, market,

growth, margins and risk.

[edit]Guideline Transaction Method or Direct Market Data Method

Using this method, the valuation analyst may determine market multiples by reviewing published data

regarding actual transactions involving either minority or controlling interests in either publicly traded or

closely held companies. In judging whether a reasonable basis for comparison exists, the valuation analysis

must consider: (1) the similarity of qualitative and quantitative investment and investor characteristics; (2)

the extent to which reliable data is known about the transactions in which interests in the guideline

companies were bought and sold; and (3) whether or not the price paid for the guideline companies was in

an arms-length transaction, or a forced or distressed sale. In regards to data reliability and both the

guideline transaction method and the direct market data method, unlike real estate sales data, sales of

privately held companies are neither actively traded or regularly reported to city or county recording offices,

nor verified by these same local government offices. Sales of privately held companies are voluntarily

reported by business brokers to data re-sellers or unscientifically accumulated by these same private, for

profit data re-sellers. Consequently the data is considered, by the very nature of the data collection process,

to be corrupted by sampling bias and nonsampling error, and of questionable reliability.

[edit]Option pricing approaches

As above, in certain cases equity may be valued by applying the techniques and frameworks developed

for financial options, via a real options framework.[4] For general discussion as to context seeValuing

flexibility under Corporate finance; for detail as to applicability and other considerations

see further under Real options valuation.

In general, equity may be viewed as a call option on the firm,[7] and this allows for the valuation of troubled

firms which may otherwise be difficult to analyse; see Distressed securities. Here, since the principle

of limited liability protects equity investors, shareholders would choose not to repay the firm’s debt where

the value of the firm (as perceived) is less than the value of the outstanding debt; seebond valuation. Of

course, where firm value is greater than debt value, the shareholders would choose to repay (i.e. exercise

their option) and not to liquidate. Thus analogous to out the money options which nevertheless have value,

equity will (may) have value even if the value of the firm falls (well) below the face value of the outstanding

debt - and this value can (should) be determined using the appropriate option valuation technique. (A

further application of this principle is the analysis of agency problems;[4] see Contract

design under Principal–agent problem.)

Certain business situations, and the parent firms in those cases, are also logically analysed under an

options framework; see "Applications" under the Real options valuation references. Just as a financial

option gives its owner the right, but not the obligation, to buy or sell a security at a given price, companies

that make strategic investments have the right, but not the obligation, to exploit opportunities in the future.

Thus, for companies facing uncertainty of this type, the stock price may (should) be seen as the sum of the

value of existing businesses (i.e. the discounted cash flow value) plus any real option value.[8] Equity

valuations here, may (should) thus proceed likewise. Compare PVGO.

A common application is to natural resource investments.[9] Here, the underlying asset is the resource itself;

the value of the asset is a function of both quantity of resource available, and the price of the commodity in

question. The value of the resource is then the difference between the value of the asset and the cost

associated with developing the resource. Where positive ("in the money") management will undertake the

development, and will not do so otherwise, and a resource project is thus effectively a call option.

A resource firm may (should) therefore also be analysed using the options approach. Specifically, the value

of the firm comprises the value of already active projects determined via DCF valuation (or other standard

techniques) and undeveloped reserves as analysed using the real optionsframework.

Product patents may also be valued as options, and the value of firms holding these patents - typically firms

in the bio-science, technology, and pharmaceutical sectors – can (should) similarly be viewed as the sum of

the value of products in place and the portfolio of patents yet to be deployed.[10] As regards the option

analysis, since the patent provides the firm with the right to develop the product, it will do so only if

the present value of the expected cash flows from the product, exceeds the cost of development, and the

patent rights thus correspond to a call option. See Patent valuation underEconomics and patents. Similar

analysis may be applied to options on films (or other works of intellectual property) and the valuation of Film

studios.

[edit]Discounts and premiums

The valuation approaches yield the fair market value of the Company as a whole. In valuing a minority, non-

controlling interest in a business, however, the valuation professional must consider the applicability of

discounts that affect such interests. Discussions of discounts and premiums frequently begin with a review

of the "levels of value." There are three common levels of value: controlling interest, marketable minority,

and non-marketable minority. The intermediate level, marketable minority interest, is less than the

controlling interest level and higher than the non-marketable minority interest level. The marketable minority

interest level represents the perceived value of equity interests that are freely traded without any

restrictions. These interests are generally traded on the New York Stock Exchange, AMEX, NASDAQ, and

other exchanges where there is a ready market for equity securities. These values represent a minority

interest in the subject companies – small blocks of stock that represent less than 50% of the company’s

equity, and usually much less than 50%. Controlling interest level is the value that an investor would be

willing to pay to acquire more than 50% of a company’s stock, thereby gaining the attendant prerogatives of

control. Some of the prerogatives of control include: electing directors, hiring and firing the company’s

management and determining their compensation; declaring dividends and distributions, determining the

company’s strategy and line of business, and acquiring, selling or liquidating the business. This level of

value generally contains acontrol premium over the intermediate level of value, which typically ranges from

25% to 50%. An additional premium may be paid by strategic investors who are motivated by synergistic

motives. Non-marketable, minority level is the lowest level on the chart, representing the level at which non-

controlling equity interests in private companies are generally valued or traded. This level of value is

discounted because no ready market exists in which to purchase or sell interests. Private companies are

less "liquid" than publicly traded companies, and transactions in private companies take longer and are

more uncertain. Between the intermediate and lowest levels of the chart, there are restricted shares of

publicly traded companies. Despite a growing inclination of the IRS and Tax Courts to challenge valuation

discounts, Shannon Pratt suggested in a scholarly presentation recently that valuation discounts are

actually increasing as the differences between public and private companies is widening . Publicly traded

stocks have grown more liquid in the past decade due to rapid electronic trading, reduced commissions,

and governmental deregulation. These developments have not improved the liquidity of interests in private

companies, however. Valuation discounts are multiplicative, so they must be considered in order. Control

premiums and their inverse, minority interest discounts, are considered before marketability discounts are

applied.

[edit]Discount for lack of control

The first discount that must be considered is the discount for lack of control, which in this instance is also a

minority interest discount. Minority interest discounts are the inverse of control premiums, to which the

following mathematical relationship exists: MID = 1 – [1 / (1 + CP)] The most common source of data

regarding control premiums is the Control Premium Study, published annually by Mergerstat since 1972.

Mergerstat compiles data regarding publicly announced mergers, acquisitions and divestitures involving

10% or more of the equity interests in public companies, where the purchase price is $1 million or more and

at least one of the parties to the transaction is a U.S. entity. Mergerstat defines the "control premium" as the

percentage difference between the acquisition price and the share price of the freely traded public shares

five days prior to the announcement of the M&A transaction. While it is not without valid criticism,

Mergerstat control premium data (and the minority interest discount derived therefrom) is widely accepted

within the valuation profession.

[edit]Discount for lack of marketability

Another factor to be considered in valuing closely held companies is the marketability of an interest in such

businesses. Marketability is defined as the ability to convert the business interest into cash quickly, with

minimum transaction and administrative costs, and with a high degree of certainty as to the amount of net

proceeds. There is usually a cost and a time lag associated with locating interested and capable buyers of

interests in privately held companies, because there is no established market of readily available buyers

and sellers. All other factors being equal, an interest in a publicly traded company is worth more because it

is readily marketable. Conversely, an interest in a private-held company is worth less because no

established market exists. The IRS Valuation Guide for Income, Estate and Gift Taxes, Valuation Training

for Appeals Officers acknowledges the relationship between value and marketability, stating: "Investors

prefer an asset which is easy to sell, that is, liquid." The discount for lack of control is separate and

distinguishable from the discount for lack of marketability. It is the valuation professional’s task to quantify

the lack of marketability of an interest in a privately held company. Because, in this case, the subject

interest is not a controlling interest in the Company, and the owner of that interest cannot compel liquidation

to convert the subject interest to cash quickly, and no established market exists on which that interest could

be sold, the discount for lack of marketability is appropriate. Several empirical studies have been published

that attempt to quantify the discount for lack of marketability. These studies include the restricted stock

studies and the pre-IPO studies. The aggregate of these studies indicate average discounts of 35% and

50%, respectively. Some experts believe the Lack of Control and Marketability discounts can aggregate

discounts for as much as ninety percent of a Company's fair market value, specifically with family-owned

companies.

[edit]Restricted stock studies

Restricted stocks are equity securities of public companies that are similar in all respects to the freely

traded stocks of those companies except that they carry a restriction that prevents them from being traded

on the open market for a certain period of time, which is usually one year (two years prior to 1990). This

restriction from active trading, which amounts to a lack of marketability, is the only distinction between the

restricted stock and its freely traded counterpart. Restricted stock can be traded in private transactions and

usually do so at a discount. The restricted stock studies attempt to verify the difference in price at which the

restricted shares trade versus the price at which the same unrestricted securities trade in the open market

as of the same date. The underlying data by which these studies arrived at their conclusions has not been

made public. Consequently, it is not possible when valuing a particular company to compare the

characteristics of that company to the study data. Still, the existence of a marketability discount has been

recognized by valuation professionals and the Courts, and the restricted stock studies are frequently cited

as empirical evidence. Notably, the lowest average discount reported by these studies was 26% and the

highest average discount was 40%.

[edit]Option pricing

In addition to the restricted stock studies, U.S. publicly traded companies are able to sell stock to offshore

investors (SEC Regulation S, enacted in 1990) without registering the shares with theSecurities and

Exchange Commission. The offshore buyers may resell these shares in the United States, still without

having to register the shares, after holding them for just 40 days. Typically, these shares are sold for 20% to

30% below the publicly traded share price. Some of these transactions have been reported with discounts

of more than 30%, resulting from the lack of marketability. These discounts are similar to the marketability

discounts inferred from the restricted and pre-IPO studies, despite the holding period being just 40 days.

Studies based on the prices paid for options have also confirmed similar discounts. If one holds restricted

stock and purchases an option to sell that stock at the market price (a put), the holder has, in effect,

purchased marketability for the shares. The price of the put is equal to the marketability discount. The range

of marketability discounts derived by this study was 32% to 49%. However, ascribing the entire value of a

put option to marketability is misleading, because the primary source of put value comes from the downside

price protection. A correct economic analysis would use deeply in-the-money puts or Single-stock futures,

demonstrating that marketability of restricted stock is of low value because it is easy to hedge using

unrestricted stock or futures trades.

[edit]Pre-IPO studies

Another approach to measure the marketability discount is to compare the prices of stock offered in initial

public offerings (IPOs) to transactions in the same company’s stocks prior to the IPO. Companies that are

going public are required to disclose all transactions in their stocks for a period of three years prior to the

IPO. The pre-IPO studies are the leading alternative to the restricted stock stocks in quantifying

the marketability discount. The pre-IPO studies are sometimes criticized because the sample size is

relatively small, the pre-IPO transactions may not be arm’s length, and the financial structure and product

lines of the studied companies may have changed during the three year pre-IPO window.

[edit]Applying the studies

The studies confirm what the marketplace knows intuitively: Investors covet liquidity and loathe obstacles

that impair liquidity. Prudent investors buy illiquid investments only when there is a sufficient discount in the

price to increase the rate of return to a level which brings risk-reward back into balance. The referenced

studies establish a reasonable range of valuation discounts from the mid-30%s to the low 50%s. The more

recent studies appeared to yield a more conservative range of discounts than older studies, which may

have suffered from smaller sample sizes. Another method of quantifying the lack of marketability discount is

the Quantifying Marketability Discounts Model (QMDM).

[edit]Estimates of business value

The evidence on the market value of specific businesses varies widely, largely depending on reported

market transactions in the equity of the firm. A fraction of businesses are "publicly traded," meaning that

their equity can be purchased and sold by investors in stock markets available to the general public.

Publicly traded companies on major stock markets have an easily calculated "market capitalization" that is a

direct estimate of the market value of the firm's equity. Some publicly traded firms have relatively few

recorded trades (including many firms traded "over the counter" or in "pink sheets"). A far larger number of

firms are privately held. Normally, equity interests in these firms (which include corporations, partnerships,

limited-liability companies, and some other organizational forms) are traded privately, and often irregularly.

A number of stock market indicators in the United States and other countries provide an indication of the

market value of publicly traded firms. The Survey of Consumer Finance in the US also includes an estimate

of household ownership of stocks, including indirect ownership through mutual funds.[11] The 2004 and 2007

SCF indicate a growing trend in stock ownership, with 51% of households indicating a direct or indirect

ownership of stocks, with the majority of those respondents indicating indirect ownership through mutual

funds. Few indications are available on the value of privately held firms. Anderson (2009) recently estimated

the market value of U.S. privately held and publicly traded firms, using Internal Revenue Service and SCF

data.[12] He estimates that privately held firms produced more income for investors, and had more value than

publicly held firms, in 2004.

Free cash flowFrom Wikipedia, the free encyclopedia

In corporate finance, free cash flow (FCF) is cash flow available for distribution among all

the securities holders of an organization. They include equity holders, debt holders, preferred

stock holders,convertible security holders, and so on.

Element Data Source

EBIT x (1-Tax rate) Current Income Statement

+ Depreciation & Amortization

Current Income Statement

- Changes in Working Capital Prior & Current Balance Sheets: Current Assets and Liability accounts

- Capital expenditure Prior & Current Balance Sheets: Property, Plant and Equipment accounts

= Free Cash Flow

Note that the first three lines above are calculated for you on the standard Statement of Cash Flows.

When Net profit and Tax rate applicable are given, you can also calculate it by taking:

Element Data Source

Net Profit Current Income Statement

+ Interest expense Current Income Statement

- Net Capital Expenditure(CAPEX) Current Income Statement

- Net changes in Working Capital Prior & Current Balance Sheets: Current Assets and Liability accounts

- Tax shield on Interest Expense Current Income Statement

= Free Cash Flow

where,

Net Capital Expenditure(CAPEX) = Capex - Depreciation & Amortization

Tax Shield = Net Interest Expense X Effective Tax Rate

When PAT and Debit/Equity ratio is available:

Element Data Source

Profit after Tax (PAT) Current Income Statement

- Changes in Capital expenditure X (1-d)

Balance Sheets, Cash Flow Statements

+ Depreciation & Amortization X (1-d) Prior & Current Balance Sheets: Current Assets and Liability accounts

- Changes in Working Capital X (1-d) Balance Sheets, Cash Flow Statements

= Free Cash Flow

where d - is the debt/equity ratio. e.g.: For a 3:4 mix it will be 3/7.

Element Data Source

Earning Before Interest and Tax x (1-Tax)

Current Income Statement

+ Depreciation & Amortization Current Income Statement

- Changes in Working CapitalPrior & Current Balance Sheets: Current Assets and Liability accounts

= Cash Flows from Operations same as Statement of Cash Flows: section 1, from Operations

Therefore,

Element Data Source

Cash Flows from Operations Statement of Cash Flows: section 1, from Operations

- Capital Expenditure Statement of Cash Flows: section 2, from Investment

= Free Cash Flow

There are two differences between Net Income and Free Cash Flow: The first is the accounting for the

consumption of capital goods. The Net Income measure uses depreciation, while the Free Cash Flow

measure uses last period's net capital purchases.

Measurement Type

Component Advantage Disadvantage

Free Cash Flow

Prior period net investment spending

Spending is in current dollars

Capital investments are at the discretion of management, so spending may be sporadic.

Net Income Depreciation charge

Charges are smoothed, related to cumulative prior purchases

Allowing for typical 2% inflation per year, equipment purchased 10 years ago for $100 would now cost about $122. With 10 year straight line depreciation the old machine would have an annual depreciation of $10, but the new, identical machine would have depreciation of

$12.2, or 22% more.

The second difference is that the Free Cash Flow measurement deducts increases in net working capital,

where the net income approach does not. Typically, in a growing company with a 30 day collection period

for receivables, a 30 day payment period for purchases, and a weekly payroll, it will require more and more

working capital to finance the labor and profit components embedded in the growing receivables balance.

The net income measure essentially says, "You can take that cash home" because you would still have the

same productive capacity as you started with. The Free Cash Flow measurement however would say, "You

can't take that home" because you would cramp the enterprise from operating itself forward from there.

Likewise when a company has negative sales growth it's likely to diminish its capital spending dramatically.

Receivables, provided they are being timely collected, will also ratchet down. All this "deceleration" will

show up as additions to Free Cash Flow. However, over the longer term, decelerating sales trends will

eventually catch up.

Net Free Cash Flow definition should also allow for cash available to pay off the company's short term debt.

It should also take into account any dividends that the company means to pay.

Net Free Cash Flow = Operation Cash flow – Capital Expenses to keep current level of operation –

dividends – Current Portion of long term debt – Depreciation

Here Capex Definition should not include additional investment on new equipment. However maintenance

cost can be added.

Dividends - This will be base dividend that the company intends to distribute to its share holders.

Current portion of LTD - This will be minimum Debt that the company needs to pay in order to not create

defaults.

Depreciation - This should be taken out since this will account for future investment for replacing the current

PPE.

If the Net Income category includes the income from Discontinued operation and extraordinary income

make sure it is not be part of Free Cash Flow.

Net of all the above give Free Cash available to be reinvested on operation without having to take more

debt.

Contents

  [hide]

1 Alternative Mathematical formula

2 Uses of the metric

3 Problems with capital expenditures

4 Agency costs of free cash flow

5 See also

6 References

7 External links

[edit]Alternative Mathematical formula

FCF measures

operating cash flow (OCF)

less expenditures necessary to maintain assets (capital expenditures or "capex")but this does not

include increase in working capital.

less interest charges

In symbols:

where

OCBt is the firm's net operating profit after taxes (Also known as NOPAT) during period t

It is the firm's investment during period t including variation of working capital

Investment is simply the net increase (decrease) in the firm's capital, from the end of one period to the

end of the next period:

where Kt represents the firm's invested capital at the end of period t. Increases in non-cash current

assets may, or may not be deducted, depending on whether they are considered to be maintaining

the status quo, or to be investments for growth.

Unlevered Free Cash Flow (i.e., cash flows before interest payments) is defined as EBITDA -

capex - changes in net working capital - taxes. This is the generally accepted definition. If there are

mandatory repayments of debt, then some analysts utilize levered free cash flow, which is the

same formula above, but less interest and mandatory principal repayments.

Investment bankers compute Free Cash Flow using the following formula:

FCFF = After tax operating income + Noncash charges (such as D&A) - Capex - Working capital

expenditures + Interest*(1-t)= Free Cash Flows to the Firm (FCFF)

FCFE = Net income + Noncash charges (such as D&A) - Capex - Change in Non Cash Working

Capital + Net Borrowing = Free Cash Flows to the equity (FCFE)

Or simply:

FCFE = FCFF + Net borrowing - Interest*(1-t)

[edit]Uses of the metric

Free cash flow measures the ease with which businesses can grow and pay dividends to

shareholders. Even profitable businesses may have negative cash flows. Their requirement for

increased financing will result in increased financing cost reducing future income.

According to the discounted cash flow valuation model, the intrinsic value of a company is

the present value of all future free cash flows, plus the cash proceeds from its eventual sale. The

presumption is that the cash flows are used to pay dividends to the shareholders. Bear in mind the

lumpiness discussed below.

Some investors prefer using free cash flow instead of net income to measure a company's

financial performance, because free cash flow is more difficult to manipulate than net income. The

problems with this presumption are itemized at cash flow and return of capital.

The payout ratio is a metric used to evaluate the sustainability of distributions from REITs, Oil and

Gas Royalty Trusts, and Income Trust. The distributions are divided by the free cash flow.

Distributions may include any of income, flowed-through capital gains or return of capital.

[edit]Problems with capital expenditures

The expenditures for maintenances of assets is only part of the capex reported on the Statement

of Cash Flows. It must be separated from the expenditures for growth purposes. This split is not a

requirement under GAAP, and is not audited. Management is free to disclose maintenance capex

or not. Therefore this input to the calculation of free cash flow may be subject to manipulation, or

require estimation. Since it may be a large number, maintenance capex's uncertainty is the basis

for some people's dismissal of 'free cash flow'.

A second problem with the maintenance capex measurement is its intrinsic 'lumpiness'. By their

nature, expenditures for capital assets that will last decades may be infrequent, but costly when

they occur. 'Free cash flow', in turn, will be very different from year to year. No particular year will

be a 'norm' that can be expected to be repeated. For companies that have stable capital

expenditures, free cash flow will (over the long term) be roughly equal to earnings

[edit]Agency costs of free cash flow

In a 1986 paper in the American Economic Review, Michael Jensen noted that free cash flows

allowed firms' managers to finance projects earning low returns which therefore might not be

funded by the equity or bond markets. Examining the US oil industry, which had earned substantial

free cash flows in the 1970s and the early 1980s, he wrote that

[the] 1984 cash flows of the ten largest oil companies were $48.5 billion, 28 percent of the

total cash flows of the top 200 firms in Dun's Business Month survey. Consistent with the

agency costs of free cash flow, management did not pay out the excess resources to

shareholders. Instead, the industry continued to spend heavily on [exploration and

development] activity even though average returns were below the cost of capital.

Jensen also noted a negative correlation between exploration announcements and the market

valuation of these firms - the opposite effect to research announcements in other industries.

[edit]See also

Weighted average cost of capitalFrom Wikipedia, the free encyclopedia

The weighted average cost of capital (WACC) is the rate that a company is expected to pay on average

to all its security holders to finance its assets.

The WACC is the minimum return that a company must earn on an existing asset base to satisfy its

creditors, owners, and other providers of capital, or they will invest elsewhere. Companies raise money from

a number of sources: common equity, preferred equity, straight debt, convertible debt, exchangeable

debt, warrants, options, pension liabilities, executive stock options, governmental subsidies, and so on.

Different securities, which represent different sources of finance, are expected to generate different returns.

The WACC is calculated taking into account the relative weights of each component of the capital structure.

The more complex the company's capital structure, the more laborious it is to calculate the WACC.

Companies can use WACC to see if the investment projects available to them are worthwhile to undertake.

[1]

Contents

  [hide]

1 Calculation

2 See also

3 References

4 External links

[edit]Calculation

In general, the WACC can be calculated with the following formula:[2]

where   is the number of sources of capital (securities, types of liabilities);   is the required rate of return

for security  ;   is the market value of all outstanding securities  .

Tax effects can be incorporated into this formula. For example, the WACC for a company financed by one

type of shares with the total market value of   and cost of equity   and one type of bonds with the

total market value of   and cost of debt  , in a country with corporate tax rate   is calculated as:

Actually carrying out this calculation has a problem. There are many plausible proxies for each element. As

a result, a fairly wide range of values for the WACC for a given firm in a given year, may appear defensible,

see Frank and Shen (2012).[3]

Beta (finance)From Wikipedia, the free encyclopedia

  (Redirected from Beta coefficient)

For other uses, see Beta (disambiguation).

In finance, the Beta (β) of a stock or portfolio is a number describing the correlated volatility of an asset in

relation to the volatility of the benchmark that said asset is being compared to. This benchmark is generally

the overall financial market and is often estimated via the use of representative indices, such as the S&P

500.[1]

An asset has a beta of zero if its moves are not correlated with the benchmark's moves. A positive beta

means that the asset generally follows the benchmark, in the sense that the asset tends to move up when

the benchmark moves up, and the asset tends to move down when the benchmark moves down. A

negative beta means that the asset generally moves opposite the benchmark: the asset tends to move up

when the benchmark moves down, and the asset tends to move down when the benchmark moves up.[2]

It measures the part of the asset's statistical variance that cannot be removed by the diversification provided

by the portfolio of many risky assets, because of the correlation of its returns with the returns of the other

assets that are in the portfolio. Beta can be estimated for individual companies using regression

analysis against a stock market index.

Contents

  [hide]

1     Definition   

o 1.1      Security market line   

2     Choice of benchmark   

3     Investing   

4     Academic theory   

5     Multiple beta model   

6     Estimation of beta   

7     Extreme and interesting cases   

8     Criticism   

9     See also   

10      Notes   

11      External links   

[edit]Definition

The formula for the beta of an asset within a portfolio is

where ra measures the rate of return of the asset, rp measures the rate of return of the portfolio, and

cov(ra,rp) is the covariance between the rates of return. The portfolio of interest in the CAPM formulation

is the market portfolio that contains all risky assets, and so the rp terms in the formula are replaced

by rm, the rate of return of the market.

Beta is also referred to as financial elasticity or correlated relative volatility, and can be referred to as

a measure of the sensitivity of the asset's returns to market returns, its non-diversifiable risk,

itssystematic risk, or market risk. On an individual asset level, measuring beta can give clues

to volatility and liquidity in the marketplace. In fund management, measuring beta is thought to

separate a manager's skill from his or her willingness to take risk.

The beta coefficient was born out of linear regression analysis. It is linked to a regression analysis of

the returns of a portfolio (such as a stock index) (x-axis) in a specific period versus the returns of an

individual asset (y-axis) in a specific year. The regression line is then called the Security characteristic

Line (SCL).

 is called the asset's alpha and   is called the asset's beta coefficient. Both coefficients

have an important role in Modern portfolio theory.

For example, in a year where the broad market or benchmark index returns 25% above the risk

free rate, suppose two managers gain 50% above the risk free rate. Because this higher return is

theoretically possible merely by taking a leveraged position in the broad market to double the beta

so it is exactly 2.0, we would expect a skilled portfolio manager to have built the outperforming

portfolio with a beta somewhat less than 2, such that the excess return not explained by the beta is

positive. If one of the managers' portfolios has an average beta of 3.0, and the other's has a beta

of only 1.5, then the CAPM simply states that the extra return of the first manager is not sufficient

to compensate us for that manager's risk, whereas the second manager has done more than

expected given the risk. Whether investors can expect the second manager to duplicate that

performance in future periods is of course a different question.

[edit]Security market line

Main article: Security market line

The Security Market Line

The SML graphs the results from the capital asset pricing model (CAPM) formula. The x-axis

represents the risk (beta), and the y-axis represents the expected return. The market risk premium

is determined from the slope of the SML.

The relationship between β and required return is plotted on the security market line (SML) which

shows expected return as a function of β. The intercept is the nominal risk-free rate available for

the market, while the slope is E(Rm)− Rf. The security market line can be regarded as representing

a single-factor model of the asset price, where Beta is exposure to changes in value of the Market.

The equation of the SML is thus:

It is a useful tool in determining if an asset being considered for a portfolio offers a reasonable

expected return for risk. Individual securities are plotted on the SML graph. If the security's

risk versus expected return is plotted above the SML, it is undervalued because the investor

can expect a greater return for the inherent risk. A security plotted below the SML is

overvalued because the investor would be accepting a lower return for the amount of risk

assumed.

[edit]Choice of benchmark

In the US, published betas typically use a stock market index such as S&P 500 as a

benchmark. Other choices may be an international index such as the MSCI EAFE. The

benchmark should be chosen to be similar to the other assets chosen by the investor. The

ideal index would match the portfolio; for example, for a person who owns S&P 500 index

funds and gold bars, the index would combine the S&P 500 and the price of gold. In practice a

standard index is used. The choice of the index need not reflect the portfolio under question;

e.g., beta for gold bars compared to the S&P 500 may be low or negative carrying the

information that gold does not track stocks and may provide a mechanism for reducing risk.

The restriction to stocks as a benchmark is somewhat arbitrary. A model portfolio may be

stocks plus bonds. Sometimes the market is defined as "all investable assets" (see Roll's

critique); unfortunately, this includes lots of things for which returns may be hard to measure.

[edit]Investing

By definition, the market itself has a beta of 1.0, and individual stocks are ranked according to

how much they deviate from the macro market (for simplicity purposes, the S&P 500 is

sometimes used as a proxy for the market as a whole). A stock whose returns vary more than

the market's returns over time can have a beta whose absolute value is greater than 1.0

(whether it is, in fact, greater than 0 will depend on the correlation of the stock's returns and

the market's returns). A stock whose returns vary less than the market's returns has a beta

with an absolute value less than 1.0.

A stock with a beta of 2 has returns that change, on average, by twice the magnitude of the

overall market's returns; when the market's return falls or rises by 3%, the stock's return will

fall or rise (respectively) by 6% on average. (However, because beta also depends on the

correlation of returns, there can be considerable variance about that average; the higher the

correlation, the less variance; the lower the correlation, the higher the variance.) Beta can also

be negative, meaning the stock's returns tend to move in the opposite direction of the market's

returns. A stock with a beta of -3 would see its return decline 9% (on average) when the

market's return goes up 3%, and would see its return climb 9% (on average) if the market's

return falls by 3%.

Higher-beta stocks tend to be more volatile and therefore riskier, but provide the potential for

higher returns. Lower-beta stocks pose less risk but generally offer lower returns. Some have

challenged this idea, claiming that the data show little relation between beta and potential

reward, or even that lower-beta stocks are both less risky and more profitable (contradicting

CAPM).[3] In the same way a stock's beta shows its relation to market shifts, it is also an

indicator for required returns on investment (ROI). Given a risk-free rate of 2%, for example, if

the market (with a beta of 1) has an expected return of 8%, a stock with a beta of 1.5 should

return 11% (= 2% + 1.5(8% - 2%)).

[edit]Academic theory

Academic theory claims that higher-risk investments should have higher returns over the long-

term. Wall Street has a saying that "higher return requires higher risk", not that a risky

investment will automatically do better. Some things may just be poor investments (e.g.,

playing roulette). Further, highly rational investors should consider correlated volatility (beta)

instead of simple volatility (sigma). Theoretically, a negative beta equity is possible; for

example, an inverse ETF should have negative beta to the relevant index. Also,

a short position should have opposite beta.

This expected return on equity, or equivalently, a firm's cost of equity, can be estimated using

the Capital Asset Pricing Model (CAPM). According to the model, the expected return on

equity is a function of a firm's equity beta (βE) which, in turn, is a function of both leverage and

asset risk (βA):

where:

KE = firm's cost of equity

RF = risk-free rate (the rate of return on a "risk free investment"; e.g., U.S. Treasury

Bonds)

RM = return on the market portfolio

because:

and

Firm Value (V) + Cash and Risk-Free Securities = Debt Value (D) + Equity Value (E)

An indication of the systematic riskiness attaching to the returns on ordinary

shares. It equates to the asset Beta for an ungeared firm, or is adjusted upwards

to reflect the extra riskiness of shares in a geared firm., i.e. the Geared Beta.[4]

[edit]Multiple beta model

The arbitrage pricing theory (APT) has multiple betas in its model. In contrast to

the CAPM that has only one risk factor, namely the overall market, APT has

multiple risk factors. Each risk factor has a corresponding beta indicating the

responsiveness of the asset being priced to that risk factor.

Multiple-factor models contradict CAPM by claiming that some other factors can

return, therefore one may find two stocks (or funds) with equal beta, but one

may be a better investment.

[edit]Estimation of beta

To estimate beta, one needs a list of returns for the asset and returns for the

index; these returns can be daily, weekly or any period. Then one uses standard

formulas from linear regression. The slope of the fitted line from the linear least-

squares calculation is the estimated Beta. The y-intercept is the alpha.

Myron Scholes and Joseph Williams (1977) provided a model for estimating

betas from nonsynchronous data.[5]

Beta specifically gives the volatility ratio multiplied by the correlation of the

plotted data. To take an extreme example, something may have a beta of zero

even though it is highly volatile, provided it is uncorrelated with the market.

Tofallis (2008) provides a discussion of this,[6] together with a real example

involving AT&T. The graph showing monthly returns from AT&T is visibly more

volatile than the index and yet the standard estimate of beta for this is less than

one.

The relative volatility ratio described above is actually known as Total Beta (at

least by appraisers who practice business valuation). Total Beta is equal to the

identity: Beta/R or the standard deviation of the stock/standard deviation of the

market (note: the relative volatility). Total Beta captures the security's risk as a

stand-alone asset (because the correlation coefficient, R, has been removed

from Beta), rather than part of a well-diversified portfolio. Because appraisers

frequently value closely held companies as stand-alone assets, Total Beta is

gaining acceptance in the business valuation industry. Appraisers can now use

Total Beta in the following equation: Total Cost of Equity (TCOE) = risk-free rate

+ Total Beta*Equity Risk Premium. Once appraisers have a number of TCOE

benchmarks, they can compare/contrast the risk factors present in these publicly

traded benchmarks and the risks in their closely held company to better

defend/support their valuations.

[edit]Extreme and interesting cases

Beta has no upper or lower bound, and betas as large as 3 or 4 will occur

with highly volatile stocks.

Beta can be zero. Some zero-beta assets are risk-free, such as treasury

bonds and cash. However, simply because a beta is zero does not mean

that it is risk-free. A beta can be zero simply because the correlation

between that item's returns and the market's returns is zero. An example

would be betting on horse racing. The correlation with the market will be

zero, but it is certainly not a risk-free endeavor.

A negative beta simply means that the stock is inversely correlated with the

market.

A negative beta might occur even when both the benchmark index and the

stock under consideration have positive returns. It is possible that lower

positive returns of the index coincide with higher positive returns of the

stock, or vice versa. The slope of the regression line in such a case will be

negative.

If it were possible to invest in an asset with positive returns and beta −1 as

well as in the market portfolio (which by definition has beta 1), it would be

possible to achieve a risk-free profit. With the use of leverage, this profit

would be unlimited. Of course, in practice it is impossible to find an asset

with beta −1 that does not introduce additional costs or risks.

Using beta as a measure of relative risk has its own limitations. Most

analyses consider only the magnitude of beta. Beta is a statistical variable

and should be considered with its statistical significance (R square value of

the regression line). Higher R square value implies higher correlation and a

stronger relationship between returns of the asset and benchmark index.

If beta is a result of regression of one stock against the market where it is

quoted, betas from different countries are not comparable.

Staple stocks are thought to be less affected by cycles and usually have

lower beta. Procter & Gamble, which makes soap, is a classic example.

Other similar ones are Philip Morris (tobacco) andJohnson &

Johnson (Health & Consumer Goods). Utility stocks are thought to be less

cyclical and have lower beta as well, for similar reasons.

'Tech' stocks typically have higher beta. An example is the dot-com bubble.

Although tech did very well in the late 1990s, it also fell sharply in the early

2000s, much worse than the decline of the overall market.

Foreign stocks may provide some diversification. World benchmarks such

as S&P Global 100 have slightly lower betas than comparable US-only

benchmarks such as S&P 100. However, this effect is not as good as it

used to be; the various markets are now fairly correlated, especially the US

and Western Europe.[citation needed]

Derivatives and other non-linear assets. Beta relies on a linear model. An

out of the money option may have a distinctly non-linear payoff. The change

in price of an option relative to the change in the price of the underlying

asset (for example a stock) is not constant. For example, if one purchased

a put option on the S&P 500, the beta would vary as the price of the

underlying index (and indeed as volatility, time to expiration and other

factors) changed. (see options pricing, and Black Scholes).

[edit]Criticism

Seth Klarman of the Baupost group wrote in Margin of Safety: "I find it

preposterous that a single number reflecting past price fluctuations could be

thought to completely describe the risk in a security. Beta views risk solely from

the perspective of market prices, failing to take into consideration specific

business fundamentals or economic developments. The price level is also

ignored, as if IBM selling at 50 dollars per share would not be a lower-risk

investment than the same IBM at 100 dollars per share. Beta fails to allow for

the influence that investors themselves can exert on the riskiness of their

holdings through such efforts as proxy contests, shareholder resolutions,

communications with management, or the ultimate purchase of sufficient stock

to gain corporate control and with it direct access to underlying value. Beta also

assumes that the upside potential and downside risk of any investment are

essentially equal, being simply a function of that investment's volatility compared

with that of the market as a whole. This too is inconsistent with the world as we

know it. The reality is that past security price volatility does not reliably predict

future investment performance (or even future volatility) and therefore is a poor

measure of risk."[7]

Cost of capitalFrom Wikipedia, the free encyclopedia

Capital is a term used in the field of financial investment to refer to the cost of a company's funds

(both debt and equity), or, from an investor's point of view "the shareholder's required return on a portfolio

company's existing securities".[1] It is used to evaluate new projects of a company as it is the minimum

return that investors expect for providing capital to the company, thus setting a benchmark that a new

project has to meet.

Contents

  [hide]

1     Summary   

2     Cost of debt   

3     Cost of equity   

o 3.1      Expected return   

o 3.2      Comments   

3.2.1      Cost of retained earnings/cost of internal equity   

4     Weighted average cost of capital   

5     Capital structure   

6     Modigliani-Miller theorem   

7     See also   

8     References   

9     Further reading   

[edit]Summary

For an investment to be worthwhile, the expected return on capital must be greater than the cost of capital.

The cost of capital is the rate of return that capital could be expected to earn in an alternative investment of

equivalent risk. If a project is of similar risk to a company's average business activities it is reasonable to

use the company's average cost of capital as a basis for the evaluation. A company's securities typically

include both debt and equity, one must therefore calculate both the cost of debt and the cost of equity to

determine a company's cost of capital. However, a rate of return larger than the cost of capital is usually

required.

The cost of debt is relatively simple to calculate, as it is composed of the rate of interest paid. In practice,

the interest-rate paid by the company can be modelled as the risk-free rate plus a risk component (risk

premium), which itself incorporates a probable rate of default (and amount of recovery given default). For

companies with similar risk or credit ratings, the interest rate is largely exogenous(not linked to the

company's activities).

The cost of equity is more challenging to calculate as equity does not pay a set return to its investors.

Similar to the cost of debt, the cost of equity is broadly defined as the risk-weighted projected return

required by investors, where the return is largely unknown. The cost of equity is therefore inferred by

comparing the investment to other investments (comparable) with similar risk profiles to determine the

"market" cost of equity. It is commonly equated using the CAPM formula (below), although articles such as

Stulz 1995 question the validity of using a local CAPM versus an international CAPM- also considering

whether markets are fully integrated or segmented (if fully integrated, there would be no need for a local

Once cost of debt and cost of equity have been determined, their blend, the weighted-average cost of

capital (WACC), can be calculated. This WACC can then be used as a discount rate for a project's

projected cash flows.

[edit]Cost of debt

The cost of debt is computed by taking the rate on a risk free bond whose duration matches the term

structure of the corporate debt, then adding a default premium. This default premium will rise as the amount

of debt increases (since, all other things being equal, the risk rises as the amount of debt rises). Since in

most cases debt expense is a deductible expense, the cost of debt is computed as an after tax cost to make

it comparable with the cost of equity (earnings are after-tax as well). Thus, for profitable firms, debt

is discounted by the tax rate. The formula can be written as (Rf + credit risk rate)(1-T), where T is the

corporate tax rate and Rf is the risk free rate.

The yield to maturity can be used as an approximation of the cost of debt.

[edit]Cost of equity

Cost of equity = Risk free rate of return + Premium expected for risk

Cost of equity = Risk free rate of return + Beta x (market rate of return- risk free rate of return) where Beta=

sensitivity to movements in the relevant market

Where:

Es

The expected return for a security

Rf

The expected risk-free return in that market (government bond yield)

βs

The sensitivity to market risk for the security

RM

The historical return of the stock market/ equity market

(RM-Rf)

The risk premium of market assets over risk free assets.

The risk free rate is taken from the lowest yielding bonds in the particular market,

such as government bonds.

An alternative to the estimation of the required return by the CAPM as above, is the

use of the Fama–French three-factor model.

[edit]Expected return

The expected return (or required rate of return for investors) can be calculated with

the "dividend capitalization model", which

is 

[edit]Comments

The models state that investors will expect a return that is the risk-free return plus

the security's sensitivity to market risk times the market risk premium.

The risk premium varies over time and place, but in some developed

countries during the twentieth century it has averaged around 5%. The equity market

real capital gain return has been about the same as annual real GDP growth.

The capital gains on the Dow Jones Industrial Average have been 1.6% per year

over the period 1910-2005. [2] The dividends have increased the total "real" return on

average equity to the double, about 3.2%.

The sensitivity to market risk (β) is unique for each firm and depends on everything

from management to its business and capital structure. This value cannot be known

"ex ante" (beforehand), but can be estimated from ex post (past) returns and past

experience with similar firms.

[edit]Cost of retained earnings/cost of internal equity

Note that retained earnings are a component of equity, and therefore the cost of

retained earnings (internal equity) is equal to the cost of equity as explained above.

Dividends (earnings that are paid to investors and not retained) are a component of

the return on capital to equity holders, and influence the cost of capital through that

mechanism.

[edit]Weighted average cost of capital

Main article: Weighted average cost of capital

The Weighted Average Cost of Capital (WACC) is used in finance to measure a

firm's cost of capital.

The total capital for a firm is the value of its equity (for a firm without

outstanding warrants and options, this is the same as the company's market

capitalization) plus the cost of its debt (the cost of debt should be continually updated

as the cost of debt changes as a result of interest rate changes). Notice that the

"equity" in the debt to equity ratio is the market value of all equity, not

the shareholders' equity on the balance sheet.To calculate the firm’s weighted cost

of capital, we must first calculate the costs of the individual financing sources: Cost

of Debt, Cost of Preference Capital and Cost of Equity Cap..

Calculation of WACC is an iterative procedure which requires estimation of the fair

market value of equity capital.[3]

[edit]Capital structure

Main article: Capital structure

Because of tax advantages on debt issuance, it will be cheaper to issue debt rather

than new equity (this is only true for profitable firms, tax breaks are available only to

profitable firms). At some point, however, the cost of issuing new debt will be greater

than the cost of issuing new equity. This is because adding debt increases

the default risk - and thus the interest rate that the company must pay in order to

borrow money. By utilizing too much debt in its capital structure, this increased

default risk can also drive up the costs for other sources (such as retained earnings

and preferred stock) as well. Management must identify the "optimal mix" of

financing – the capital structure where the cost of capital is minimized so that the

firm's value can be maximized.

The Thomson Financial league tables show that global debt issuance exceeds equity

issuance with a 90 to 10 margin.weighted average cost of capital

[edit]Modigliani-Miller theorem

Main article: Modigliani-Miller theorem

If there were no tax advantages for issuing debt, and equity could be freely

issued, Miller and Modigliani showed that, under certain assumptions, the value of a

leveraged firm and the value of an unleveraged firm should be the same.

[edit]See also

Preference share

Ordinary share

[edit]References

1. ̂  Brealy &al. "Principles of Corporate Finance", Chapter 10

2. ̂  Fred's Intelligent Bear Site

3. ̂  Business Valuation Glossary - WACC Calculation using an Iterative

Procedure

What’s Really Wrong with Using RONA, and What’s Better?

By Bennett Stewart

Chairman and Chief Executive, EVA Dimensions LLC

In this paper I explain why rate-of-return measures like RONA and ROI inevitably mislead 

managers into making serious mistakes in allocating capital and in even basic management 

decisions.  CFO’s should stop using RONA and ROI, and should instead make capital a cost, a 

charge to profit, like any other cost, and then get everyone to focus on maximizing the growth 

rate in the residual economic profit.

RONA, ROI, ROE, IRR, take your pick.  Each is a way to measure the productivity of capital, to relate 

profit to invested capital, or cash flow to spending, and quantify the rate of return earned after getting 

the money back.  Returns matter.  Earning a return over the cost of capital is a prerequisite for adding 

value and enriching the owners.   The higher the return, the more value is being created with the capital.  

A CFO may also logically assume that a business line earning a higher return may be a better candidate 

than another for further investment and growth – assuming past results can be replicated.   A higher 

projected return also provides assurance that a given decision or plan is more secure.  Key assumptions 

can slip, yet value can still be added or at least preserved when the expected return is higher going in.  

And as an analytical tool, RONA can be traced to operating margins and asset turns, in accord with the 

classic DuPont formula, and used to give line teams a rounded view of operating performance and 

balance-sheet asset management.  For many reasons, return measures like RONA have earned a 

prominent role in financial management over the years.  But I come not to praise RONA.  I come to bury 

it.

RONA and its variants actually are highly misleading and incomplete performance indicators, for reasons 

I will explain.  And the deficiencies are far from academic.  As you will see, companies that have aimed 

to increase RONA or maintain a high one have committed major blunders in strategy and resource 

allocation.  And when RONA is judged from the bird’s eye view of how well it performs as an element in 

a firm’s overall financial system, it fails, or at least, it is far inferior to another approach which is based 

on using economic profit, or EVA as I like to call it (for economic value added), as I shall also elaborate.

RONA fundamentally fails because it is inconsistent with what is – or should be – the main mission of 

every firm, which is to maximize the wealth of its owners by maximizing the net present value of all 

existing and projected investments.  The goal, in short, is to maximize the difference between the capital 

that investors have put or left in the business and the present value of the cash flow that can be taken 

out of it, a difference I call MVA, standing for market value added.    

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Take an example.  A company that trades for a total market value or “enterprise value” of $1 billion, and 

where $600 million of capital has been invested in its net business assets, has created an MVA of $400 

million, the difference.  That measures how much wealth the firm has created for the owners by 

comparing what they have put in with what they can get out.  Put another way, it is “franchise value,” 

the value of the business above just putting the assets in a pile.  It is also, mathematically, the market’s 

assessment of the net present value, or NPV, of all investments, those already in place plus those 

expected to materialize down the road.  Increasing MVA – or maximizing corporate NPV, if you will – is 

therefore every company’s most important financial goal, as any corporate finance text will remind us, 

for it not only maximizes the owner’s wealth but at a macro level it generally leads to an optimal 

allocation of scarce resources and the greatest possible growth in the standard of living. 

Here’s the problem in a nutshell.  RONA tells us about the ratio of market value-to-invested capital, but 

that is not the same thing as maximizing the spread between market value and invested capital, which is 

the real goal.   A company that aims to maximize RONA will always tend to hold back and underinvest, 

under-innovate, under-scale, and under grow.  It will leave value and growth on the table, and become 

vulnerable to a hostile takeover or a toppling by upstart rivals, as I will demonstrate. 

The glaring deficiency of RONA first became apparent to me in the early 1980s, when I had the privilege 

of advising The Coca-Cola Company.  The company at the time was fabulously profitable, earning about 

a 25% return on its capital, but the company was reluctant to put the Coke name on growth products –

Cherry Coke, Diet Coke, Caffeine-Free Coke – because those products were reckoned to earn only a 20% 

return, not 25%, and would dilute the rate of return on the Coke brand.  Worse, the company had made 

a mistake 100 years before.  The founders had granted perpetual franchise licenses to bottlers that by 

1980 were in economically undersized territories, and in many cases run by lackadaisical third 

generation owners.  Coke needed to buy them up, consolidate contiguous regions, install hungry 

operators, and revise its pricing formula.  But again, the capital to be invested in that vital strategy could 

not approach the phenomenal return from one of the world’s most valuable brands.  So Coke was stuck, 

because management was stuck on maintaining its high RONA.  

The solution for Coke, as it is for every other company, was to let go of RONA and instead to define 

success as growth in economic profit or EVA.  EVA replaces RONA’s percent ratio with a money measure 

of total value added.   EVA is equal to the percent spread of RONA less the cost of capital, multiplied by 

the amount of capital invested in the business, which means that EVA is the dollar spread of the return 

versus the cost of capital.   Put another way, EVA is the dollar economic profit after deducting all costs, 

including the cost of capital.  The distinction may appear subtle and effete.  After all, EVA uses the same 

data as RONA – to measure profit less the cost of capital instead of profit divided by the capital.  I’ve 

even had CFO’s tell me they are using EVA when they are actually using RONA or return on capital.  But 

in fact, the two are not the same at all, and the difference is quite profound and incredibly far reaching.    

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Let’s go back to Coke.  At the time that management was confronted with the decision to expand or 

punt, Coke’s weighted average cost of capital was about 10%, so it was earning a RONA return about 

15% above that cost.  Coke was thus earning an EVA profit of $150 for every $1,000 of invested capital.  

Suppose to roll out the new products and acquire bottlers, Coke would double its invested capital, while 

only earning a 20% return on the new money put into the business.  Then its RONA would fall half way, 

from 25% to 22.5%, and its spread over the cost of capital would narrow from 15% to 12.5%.  But the 

spread would be multiplied by twice the amount of capital, by $2,000, for an EVA of $250, an increase of 

$100.  This is a classic example of where RONA goes down and yet EVA and share price go up.

Coke’s managers wisely decided to go for more EVA and let their focus on RONA lapse, which is always 

the right decision, at least in principle.  By setting aside the cost of capital, EVA automatically deducts 

the profit that must be earned to recover the amount of capital that has been or will be invested, and 

so, a projection for EVA always discounts to the exact same net present value you get by discounting the 

projected cash flow.    

I say this with great conviction and emphasis because we have developed a software tool that 

automatically calculates NPV by discounting both cash flow and EVA, and it always gives the same 

valuation answer for a given forecast.   Please understand that the equality is not a theory or something 

you might or might not “believe.”  It is a mathematical truth, just as 2 + 2 = 4.   And so, everything that 

validates cash flow or discounted cash flow as a management tool automatically validates EVA as well.  

Discard EVA, and you might as well discard discounted cash flow, for they come to the same thing.   But 

putting the math aside, which need not trouble us here, consider the implications.

If a company or business line or business project is forecast to just break even on EVA, to just earn the 

cost of capital, then that business or investment is just worth the book value of its invested capital.  

There is no franchise value, there is no owner wealth, and there is no NPV if the profit only but covers 

the cost of capital.  But once EVA turns positive, then the greater it is, the faster it grows, and the longer 

and more surely it endures, the greater is the NPV and MVA.  For this reason, Fortune magazine dubbed 

EVA “the Real Key to Creating Wealth” in a cover story article that first introduced EVA to the business 

world, way back in September 1993.

Recognizing this, Coke decided in the early 1980s to expand its product portfolio and acquire its bottlers 

– which it might not have been done had RONA remained the measure that mattered.  The decision led 

the company to such a phenomenal improvement in its EVA profit that by 1996 Coke was producing the 

most MVA wealth of any American firm, as Fortune chronicled in a story titled “America’s Best and 

Worst Wealth Creators” featuring Coke’s legendary CEO, Roberto Goizueta, on its cover. 

Other companies were not so lucky, Anheuser-Busch among them.   For years the beer behemoth had 

opportunities to invest, acquire and grow globally, but turned all of them down, leaving the firm ring- 

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fenced and vulnerable to a hostile takeover.  On November 18, 2008, the company reluctantly 

succumbed to the Brazilian-Belgian brewing company InBev.  A-B became a target because its CEO, 

August Busch, refused to dilute the RONA the firm was garnering in its U.S. beer business by entering 

more competitive overseas markets.  As one advisor close to the company explained it:

“When you have a business that was as profitable as his [August Busch III, CEO] was, where the 

returns were as strong as his were, I’m not sure anyone would be so smart to say, “We’ve got to 

take over the world,” said one A-B adviser.  “We understand now why he should have, but it 

would have diluted his margins and his returns.”

Dethroning the King

By Julie Macintosh

As a sidebar, InBev, the buyer, grew out of Brahma Beer, the first Brazilian company to adopt EVA.   I 

helped Brahma to adopt EVA in 1996 after I got a call from the CEO, Marcel Telles, who became aware 

of EVA after First Boston published an analyst report on Brahma using EVA.  Marcel was so intrigued he 

asked the analyst, “Where can I learn more about EVA,” which led to me.  We spent about 6 months 

developing a program to measure EVA throughout the company, and it became a key asset and 

capability of the firm that helped it to successfully gobble up many other brewers and eventually

become the world’s largest and most successful.  

Coke and Anheuser-Busch are not isolated examples.  You probably know that Steve Jobs and Intel’s 

Andrew Grove’s favorite business book is The Innovator’s Dilemma by Harvard Professor Clayton 

Christensen.  The book chronicles how established industry leaders almost always cede their top spot to 

upstarts that start small, in the low-margin end of the business, and then over time take over the whole 

business.   It led Andrew Grove to coin the expression, “Only the paranoid survive,” which is perhaps 

one solution.  But Christensen thought there must be another more fundamental reason why this 

happens over and over, and which would lead to a different remedy than paranoia to cure the 

Innovator’s Dilemma.  It is, unsurprisingly, to give up on a “finance orthodoxy” that worships at the 

RONA church:

After puzzling over this mystery for a long time, he finally came up with the answer: it was owing to the 

way the managers had learned to measure success.  Success was not measured in numbers of dollars but 

in ratios.  Whether it was return on net assets, or gross margin percentage, or internal rate of return, all 

these measures had, in the past forty years, been enshrined in a near-religion (he liked to call it the 

Church of New Finance), by partners in hedge funds and venture-capital firms and finance professionals 

in business schools.  People had come to think that the most important thing was not how much profit 

you made in absolute terms but what but what percentage profit you made on each dollar you put in.  

And that belief drove managers to shed high-volume but low margin products from their balance     

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sheets… this is why he called it a church-- it was an encompassing orthodoxy that made it impossible for 

believers to see that it might be wrong.

“When Giants Fail – What Business Has Learned From Clayton Christensen”

By Larissa MacFarquhar

The New Yorker, May 14, 2012

RONA is simply not conducive to corporate health.  The bottom line is this: EVA is additive, but RONA is 

not.  Add something good to something great and EVA is greater still.  Add a low margin business to a 

strong one, and EVA increases so long as the cost of capital is covered.  EVA is a measure to maximize, 

because more is always better than less, because more EVA is more NPV is more owner wealth.  But 

that’s just not true of RONA.  There is literally no way to tell whether a company or division is better off 

reporting a higher or lower RONA, taken by itself.  Of course, you can always bring in other factors like 

growth and combine them with RONA, but all you are really doing is trying to recreate EVA by imperfect 

proxy.  Why not make it simpler and more accurate and just go for the real thing?  Why not focus on a 

single measure that accurately scores the actual total value added by a business, by a plan, or by a 

decision, which is exactly what EVA does?

RONA is not only a misleading and incomplete measure at the corporate or line of business level, as I 

have discussed so far.  It also fails to provide reliable insights concerning the configuration of individual 

projects, particularly when questions of how big, how fast, how many, and how much come into play. 

Most investments, and most strategies for that matter, are characterized by increasing and then 

decreasing returns to scale.   As more money is plowed in, the return initially grows larger and larger as 

unavoidable fixed costs are covered and market traction is gained.  But at some point diseconomies set 

in and the returns begin to tail off as investment spending is stepped up even further.  This dynamic 

causes companies that focus on RONA to almost always undersize their investments and leave profitable 

growth and added value on the table.

As an example of this general phenomenon, consider the decision of how high to build a building.  

Suppose analysis shows a 10-storey building won’t even cover the cost of capital.  Its internal rate of 

return (IRR), or RONA (assuming for simplicity that the returns are even), is only 5% when the cost of 

capital is 10%.  The building is so small that the rental income cannot even cover the full fixed cost of the 

land.  It’s a negative NPV project, and not worth considering except as a stepping stone.

On the next step up the ladder, a 20-storey building costs $20 million, let’s say, and it generates an 18% 

RONA, and an NPV of $16 million.  The return climbs because the additional rental income and higher 

rental rates that management can charge for the higher floors is gravy to cover fixed costs.  This is an 

example of “increasing returns to scale.”    

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But now it gets complicated.  A 30 storey building costs $40 million, or twice as much to construct.  It’s 

more expensive per floor, and generates a RONA of only 15%.  Extra elevator banks must be added, 

which cuts into rentable space on all floors.  The building requires sturdier reinforcement and takes 

significantly longer to construct, which delays the start of revenues.  All these elements conspire to 

reduce the overall RONA of the proposed 30-storey building to less than the rate of return projected on 

the 20-story building.  This is an example of “diseconomies of scale” creeping in.  Nevertheless, the 30-

story building does show a higher NPV.  The NPV is estimated to be $20 million, or $4 million more than 

for the 20-storey building.

The final candidate is a gleaming 40-storey tower, costing a whopping $70 million to construct, and 

generating a RONA of just 10%, and NPV of $0, as even more diseconomies of scale set in.   It is however 

a magnificent structure and it generates gushers of cash flow and EBITDA– after the investment has 

been made – neither of which are important in the question of allocating scarce resources. 

So what’s the correct decision – the 20-storey edifice that maximizes RONA, the 30-story one that 

maximizes NPV, or the 40-story tower that maximizes EBITDA?  True, the 20 and 30 storey projects are 

both acceptable, being that both earn returns more than the cost of capital and generate positive NPV.  

But the 30-storey project is the best project, because it’s the one that maximizes NPV.  It maximizes the 

spread between capital put in and the value gotten out.  It maximizes corporate MVA, owner wealth, 

franchise value, and societal well-being by using scarce resources up to the point where incremental 

value added still exceeds the incremental resource cost.

There are two ways to see this.  Compared to the 20-storey project, the 30-storey project costs another 

$20 million in investment, but generates an extra $4 million in net present value on top of that.  Simply 

put, the incremental project to build from 20 to 30 stories is attractive in its own right.  Why turn that 

down just to maximize RONA?  And the same reasoning applies to why management should NOT build a 

40-storey tower, for that is the same as taking on the 30-storey building, for a positive NPV, and then 

adding another project to build to the 40

th

floor, which is a negative NPV use of the added capital.

The 30-storey project is also distinguished by its larger EVA.  The annual EVA profit of the 20-story 

building is (18% - 10%) x $20 million, or $1.6 million.  The EVA of the 30-storey building is considerably 

higher, actually 25% higher – it is (15% -10%) x $40 million, or $2 million.  True, it’s a lower rate of 

return, but it is earned on more capital.  Size matters, too.  The right answer is always to choose more 

EVA, since that always translates into more NPV, which is why it is so important to use EVA not just to 

judge the performance of whole lines of business but also to use it for judging – and actually helping to 

improve -- the value of individual projects.  And the best way to make sure that happens is to stop using 

discounted cash flow to measure NPV, and instead to get business managers and finance professionals 

to start projecting, analyzing and discounting EVA to measure and improve the NPV of plans, projects 

and acquisitions!  By using EVA to make the decisions and set the plans that will maximize NPV, and also     

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to use it to monitor and analyze actual performance after the fact, the finance process is fundamentally 

simpler and more cohesive – the same measure matters in both directions.  It also makes managers 

more accountable for delivering the value they promised by realizing the EVA they projected.  

Companies that use cash flow and RONA may think they are doing the right thing, and the simple thing, 

but that is just not true.  EVA is easier, and better, once you get there.

But do not just take my word for it.  The pitfalls of IRR and by extension RONA are well recognized in the 

finance literature.  Scholars with no axe to grind join me in recommending that corporate managers stop 

using IRR and RONA.  Consider this excerpt from world’s best-selling corporate finance textbook, 

Principles of Corporate Finance, by Stewart C. Myers (MIT Sloan), Richard A. Brealey (London Business 

School) and Franklin Allen (Wharton): 

Many firms use internal rate of return (IRR) in preference to net present value.  We think that is a 

pity….Financial managers never see all the possible projects.  Most projects are proposed by 

operating managers.  A company that instructs non-financial managers to look first at project 

IRR’s prompts a search for those projects with the highest IRR’s rather than the highest NPVs. It 

also encourages managers to modify projects so their IRR’s are higher.  Where do you typically

find the highest IRR’s?  In short lived projects requiring little up-front investment.  Such projects 

may not add much value to the firm.

The bottom line is this: When there are decisions about how many SKUs to carry, how much advertising 

to do or research to perform, how big to build a warehouse, plant, or building, how many stores to open 

and how much working capital to stock, whenever questions of scaling and growing must be weighed 

against margins and returns, or even, how should a product be configured and priced, or a production 

function fulfilled, then RONA- and IRR-minded managers are always apt to under-scale and under-invest 

and under-innovate compared to managers that are aiming to maximize EVA and NPV.

I was going over all this recently with Mike Archbold, the President and Chief Operating Officer of the 

up-and-coming specialty retailer, Vitamin Shoppe, where he was instrumental in establishing a financial 

focus on EVA.  “Bennett,” Mike said, “your building example resonates with me, but we call it the “S” 

curve.  We see it all the time.  Declining returns, followed by ramping returns, followed by cresting 

returns.  When I was CFO at Autozone, we got EVA so embedded as a financial discipline that even the 

marketing department got quite sophisticated at projecting the “S” curve on marketing campaigns and 

we’d always look for the point to maximize the EVA profit.

“And here at Vitamin Shoppe, we’ve used an outside vendor to help us with automatic inventory 

restocking, which is actually a complicated problem, or at least we think so, because we look for the 

solution that maximizes our EVA, taking account all the tradeoffs.  You’ve got to balance lead times, 

order size, inventory investment, warehouse and shipping costs, and the risk you are stocked-out and 

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lose a sale and disappoint a customer, which means that cost is more than just the lost sales, but a bad 

customer experience.  But we told our vendor, we want to put a price on everything and solve the 

program to maximize the expected net EVA profit, and it worked fabulously for us.

“The vendor, though, was quite surprised by our request, because their clients almost always ask them 

to just maximize the in-store stocking rate, to make sure they have the product on the shelves to never 

miss a sale.  But that uni-dimensional focus is just as wrong as focusing on the return on capital or 

RONA.  I mean, if RONA was the answer, it would really discourage us from ever making labor saving 

capital investments.  Why invest capital, even if it’s cheaper than the labor it replaces, when the capital 

goes into the denominator of the RONA computation and labor doesn’t.  That’s nuts.  And that’s how I 

can tell if a business operator is really business savvy.  If they get EVA, they get value, and I can trust 

them to get the right decisions done.  And if they don’t get EVA, what does that say?”

RONA can also be severely criticized for a number of mundane but very practical deficiencies.  For 

example, RONA critically depends on how management decides to define the “net assets” in the 

denominator.  Should excess cash or retirement “assets” or deferred tax accounts be left included?  How 

about off-balance-sheet-leased assets?  Should assets be measured net of impairment charges or at 

original value?   Should assets be revalued or at historic costs?  Should capital include all debt and equity 

or just equity?  The answers to these questions can profoundly swing a RONA or ROI computation, and 

while EVA is not totally immune from these choices, it is far more resilient because capital is a cost, and 

not a denominator.   For instance, EVA is essentially the same whether leases are capitalized or 

expensed or whether capital is defined as debt plus equity or just equity alone.  You can either pay for 

capital explicitly, by deducting rent expense or interest expense from the profit, or implicitly, as part of 

the weighted average capital charge deducted from EVA, and the resulting EVA is the same either way,

whereas the RONA would be very different.  And besides, the emphasis should always be on the change

in EVA, and not EVA per se, which also makes it even more immune to how the capital base is defined.

RONA is also highly distorted and essentially meaningless for new economy companies that tend to 

employ trivial amounts of capital.  Apple’s RONA, for instance, has been phenomenally high and

extremely volatile and basically useless as a performance indicator over the past decade, because its 

new-economy capital base is so lean and variable.  By contrast, its EVA steadily increased, from 4% of 

sales to 18% of sales, as a clear indication of the increasing productivity and profitability of the firm’s 

business model.  Another example is Blue Nile, the discount internet jeweler, which effectively has 

negative capital.  Cash from sales and trade funding is so prodigious it exceeds the firm’s meager 

investment in inventories and fixed assets.  And with negative capital, its RONA is truly meaningless.  

Under EVA, though, negative capital simply counts as a profit rebate.  EVA is credited with the value of 

investing the capital float at the firm’s cost of capital. As a result, Blue Nile’s EVA has been positive and 

generally increasing, and as a percent of sales typically runs in the range of 3% to 4.5%, which puts Blue     

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Nile’s business model around the 65

th

to 75

th

percentile in terms of how capable it is of driving EVA 

profit to the bottom line per dollar of sales.

The key point once again is that EVA makes capital a cost, an understandable charge to earnings just like 

cost of goods sold, and not into a ratio denominator, so once you’ve computed EVA, and accounted for 

the cost of capital, you are no longer obliged to divide by capital to bring capital into the picture; that 

would be redundant.   You can instead divide EVA by sales, say, to compute an “EVA Margin,” and then 

say that EVA is our EVA Margin multiplied times our sales.  You can make the management and 

maximization of value into a profit-margin and sales-based system, which is a heck of a lot more 

understandable to operating folk than a return on capital times capital approach.

And while we are on the subject, the EVA profit margin turns out to be generally a far better, more 

comparable and more universally applicable summary measure of business model productivity and 

profitability than RONA.  You’ll see this in an outsourcing question I discuss a little later on, for instance.  

Also, when you take the EVA Margin apart and trace it to the underlying performance drivers that 

explain it, to indicators like gross margin, working capital days, plant turns, tax rates and the like, as we 

do on the so-called EVA Margin schedule, you end up with an analytical tool that is way better than the 

Du-Pont ROI formula.   The EVA Margin schedule puts all costs, operating costs and capital costs, on the 

same footing, as a percent of sales charge to the margin.  It uses simple plus and minus math to measure 

the impact of all performance drivers, where DuPont ROI is multiplicative -- you multiply the operating 

margin times the asset turns -- which is fuzzy logic indeed.   The incremental impact of improving the 

margin depends on the asset turns, and vice versa, which confounds all but the mathematicians.  

Understandably, CFO’s are now moving in droves to using custom EVA Margin schedules as their main 

analytical tool to replace DuPont ROI analysis, because it makes it easier for them and their line teams to 

size up the relative significance of individual performance drivers, to make decisions involving tradeoffs, 

to spot notable trends, gaps and opportunities, and to benchmark with peers.  

Another practical problem with RONA is that it is very tricky to apply to internal divisions that must be 

assigned assets.  The knee jerk reaction of line operators is to reject the allocation of assets to their 

business units in order to keep their RONA up.  But when the emphasis is instead placed on increasing

EVA, managers shift gears and want to be assigned all the assets that they can legitimately manage.  An 

initial assignment of assets reduces their division’s initial EVA, but that does not matter.  What matters 

is whether they are able to better manage the assets they are assigned and by so doing to improve their 

EVA going forward.  EVA depoliticizes the management of the assets, and focuses on performance at the 

margin, ignoring irrelevant sunk costs.   RONA by contrast is inherently based on an accumulation of 

irrelevant sunk costs, and it encourages endless arguing over the internal allocation of assets.    

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I must toss one last grenade in the RONA direction before discussing “what’s better” (I did come to bury 

it, after all).  RONA is so inherently biased against integration and generally so in favor of outsourcing it 

pushes activities out that should stay in.   

Let’s take a company that is considering moving computer systems and services from in-house 

management to the cloud.  The company currently has $1000 in capital, and is earning $150, for a 15% 

15% return.  With a  10% cost of capital, its  EVA is $50.  Suppose the company is able to remove $200 in 

computer assets to the cloud for the same total cost, so that the firm’s EVA and the EVA/Sales Margin 

remain the same.  It’s a pure break even exchange.  The outside cost and the inside cost, including the 

cost of capital, are identical, let’s say.

Even so, the firm’s RONA automatically and misleadingly increases to 16.25% (because 16.25% - 10%, 

times $800 in capital, is the firm’s $50 EVA, which has not changed, by definition).  In other words, the 

outsourcing maneuver leads to a higher rate of return, but on less capital, for the same EVA.  It’s truly 

value neutral, but RONA was tricked into paying the decision a compliment it did not deserve.

RONA is so biased in favor of outsourcing that it motivates firms to go bulimic, to become so lean and 

hollowed-out they eventually cut beyond the fat and into muscle, giving up essential long run sources of 

competitive advantage, and really paying more for services they could perform more cheaply in house, 

all costs included.  EVA, by contrast, favors outsourcing only where a third party partner has clear 

advantages that enable it to perform a function at such a truly lower total cost that it overcomes the 

disadvantages of having to contract and deal with an outside vendor.

I’ll give you an example.  One of my EVA clients in the early 1990s was Equifax, the credit reporting 

bureau.  It was then run by Jack Rogers, a former IBM senior officer who was intimately familiar with 

IBM’s computer capabilities, so he thought that outsourcing Equifax’s extensive computer operations to 

IBM could make sense, if properly structured, even though the move would be quite counter-cultural.  

But to his credit, rather than mandating the decision, or asking his team to simply trust his business 

judgment, which was by the way considerable, he said, “we have to run the EVA on it --  It could be 

good, it could be bad, it’s EVA that will tell us.”   As it happened, the facts and figures clearly showed an 

EVA advantage to turning over the company’s computers and operations to IBM, while Equifax retained 

its real franchise value in its hold on personal credit statistics and market presence.  That was the very 

first large outsourcing transaction of its kind (which is why IBM for years used Equifax’s decision to 

showcase the merits of its outsourcing solution, based on the EVA analysis).  As Equifax demonstrates, 

moving assets into the cloud or offshore for that matter can make sense -- if it generates more EVA, but 

never because it increases RONA.   An improved RONA is at best a by-product of making the right 

NPV/EVA decision, but should never be the prime motivator.    

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To say it one last time, only EVA always gives the right answer, to sourcing decisions or any other, 

because it’s the only measure that literally discounts to the net present value of discounted cash flow.  

There is no a priori reason to expect RONA to give the right answer, and it frequently doesn’t, and there 

is every reason to think EVA will give the right, value maximizing answer, and in my experience, it does, 

and it does with more clarity, simplicity and accountability than any other approach.

So then, why do so many CFOs persist in using RONA and related rate-of-return metrics, when they are 

so bad?  I think there are two reasons.  For one, RONA’s a ratio.  It permits performance comparisons 

and investment rankings regardless of size.  Its very defect is an advantage in giving CFOs a way to rate 

performance across divisions that differ in scale and to compare projects that vary in investment 

commitment.  It “common-sizes” the comparisons.   Another reason is that a ratio replacement for 

RONA has not existed.  For all its shortcomings, it was the best ratio kid on the block for ranking 

performance and investments.  What was better?

Until recently, nothing.  But now, a set of new ratio metrics developed by EVA Dimensions offer CFOs all 

the advantages of size-adjusted performance indicators without sacrificing the critical link to maximizing 

the money value of NPV and owner wealth and overall corporate profit performance.  The new ratios 

are, unsurprisingly, all based on EVA.  The very good news is that the new EVA ratios can completely 

replace RONA and IRR and even operating margins with a management framework that is fundamentally 

more accurate, simpler to use and understand, more informative, and considerably more effective as a 

practical framework for value-based corporate planning and decision making.  Accept my premise, and 

there is no longer a reason ever to look at RONA, or ROI, ROE, or IRR, ever again.  

I explain this “second-generation” EVA framework in companion papers, and I’ve already alluded to one 

of them, the EVA Margin, in this discussion.  But the most important new EVA ratio is a real 

breakthrough in the art of value-based corporate financial management, superseding even EVA Margin 

as the key metric that matters.  It is called EVA Momentum.  It is the change in EVA divided by priorperiod sales.  It is the size-adjusted growth rate in EVA, scaled to sales.  It can be measured quarter to 

quarter, year to year, over multiple years as a trend, and even better, over the life of a business plan.  It 

is a statistic.  However viewed, it is the only ratio where bigger is always better, because it gets bigger 

when EVA gets bigger, which means NPV and MVA are getting bigger too.

It is the sole ratio measure that totally and correctly summarizes the performance of any business in all 

ways that add value or that subtract from it.  It solves the innovator’s dilemma, and correctly guides all 

decisions by correctly incorporating all tradeoffs.   Most important, it can serve as every company’s most 

important financial goal, applicable to all lines of business, regardless of their capital intensity and 

inherited performance conditions.    

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For example, it gives managers in turnaround businesses the opportunity to shine by making their 

negative EVA less negative.  At the same time, it does not reward managers in stellar businesses that 

just tread water and maintain a positive EVA profit.  Instead, it puts a Bunsen burner under the behinds 

of managers in those well-endowed businesses to keep scaling, growing and innovating rather than just 

resting on their laurels, and perhaps to even reduce their margins and returns if that is what it takes to 

increase EVA and maximize value.

The point is, unlike all other ratio indicators, managers can legitimately aim to maximize EVA 

Momentum without being misled into making dumb decisions.  It can be used instead of RONA as the

key measure of performance and the arbiter of the quality and value of business plans.  Put simply, a 

business plan is better if it can credibly generate a greater EVA Momentum growth rate over the 3-5 

year plan horizon, for the greater the planned Momentum, the greater the NPV of the plan and 

contribution to the firm’s share price.  CFO’s are now using EVA Momentum to help their line teams 

develop better, more valuable plans, by seeing how they can generate more EVA Momentum.  And they 

are tracing EVA Momentum to underlying metrics and milestones, including the EVA Margin, and Margin 

schedule, to end up with scorecards that are more comprehensive, value-based, and topped with an 

actual score.

When you pull together the complete set of new EVA ratio metrics, and use them as the key 

performance statistics, financial goals, plan targets, and financial analytical tools, and, when you stop 

discounting cash flow and instead forecast, analyze and discount EVA to measure and improve the value 

of plans, projects, acquisitions and decisions, you have the simplest and most effective way to run a 

business for maximum performance and added market value.  And with new software tools, data bases, 

and training and support services from EVA Dimensions, you can get there faster and more effectively, 

and at a lower price point, than ever before possible. 

Bennett Stewart is Chairman and CEO of EVA Dimensions, a financial technology firm that provides EVA -

based software, data -bases and training and support services to its corporate clients, and EVA-based 

equity research services to major institutional investors.  www.evadimensions.com