What’s Wrong with the Value Based Measures?

Abstract:     
Purpose – The purpose of this paper is to investigate the approaches to calculate measures of value creation incorporating capital charge, to reveal inconsistencies in combining market and book values in a single measure and to suggest necessary corrections.

Design/methodology/approach – The paper uses stylized counterexamples, simple formalization and thought experiments to find out inconsistencies in value creation measures’ construction and performance.

Findings – The paper finds that the resulting figures of conventional EVA and some other measures such as ROIC-WACC spread, CFROI, CVA and the like are incorrect because of mixing book and market values and might encourage wrong decisions. Now the financial profession calculates the Capital Charge using market values as weights for WACC, but uses book value for Invested Capital. The paper reveals that there may be at least two measures for capital charge, based either on market or book values of invested capital, which stand for current or historical opportunity costs of investors correspondently, but mixing market and book values produces something meaningless. It suggests using accounting values of equity and debt to calculate WACC for tracking cost of capital. The market values based WACC was invented as a discount rate for Free Cash Flow to Firm and should be used strictly with this designation. The EVA-based valuation models are also of great interest for practical applications. It is shown that the EVA-based valuation can be linked to both DDM and FCFM frameworks, using the “excess cash” within the invested capital as a switch. The paper also finds that market values based cost of capital represents the genuine opportunity costs of investors and it may be used for constructing measures of wealth creation, which is somewhat different from value creation.

Originality/value – This is the first study revealing inconsistencies in a set of heavily used measures of financial performance. It refines understanding of the capital charge and suggests proper ways of linking it to accounting or market measures and thus may be valuable for both researchers and practitioners.

Keywords: Economic Value Added (EVA), Residual Income (RI), Performance Measurement, Capital Charge, Weighted Average Cost of Capital (WACC), Accounting WACC, Market WACC, Accounting EVA, Market-based EVA, Cross-Bred EVA, Residual Market Profit, Firm Evaluation, Project Evaluation, Corporate Finance

JEL Classification: G30, G31, G32, H43, M41, M46

working papers series