Value Creation Recreated

& why EVA is Fundamentally Flawed

Abstract
Economic Value Added (EVA) and competing metrics are a leitmotif for management,
strategy consultants and wall street. Such metrics, the synthesis of M&M proposition III and
the notion of residual income, form the scholarly framework on value creation. However, the
empirical evidence is poor, e.g. EVA appears less associated to stock returns than earnings,
and the available explanations hereof are inconclusive and rather intuitive. A re-examination
is warranted and exposes a fundamental flaw: EVA fails to account for market efficiency. A
framework that distinguishes between value creation through shareholder returns and value
creation through capital budgeting is introduced; resolving the empirical result.

Roger Dayala 2014

Electronic copy available at: http://ssrn.com/abstract=2478399

Value creation and its nemesis value destruction have intrigued scholars and practitioners for
decades. And in the debt-laden world of today where many markets are slowly recovering
from one of the deeper crises in history, forcing companies to restructure, its significance has
anything but diminished. The contemporary framework on value creation for both scholars
and practitioners is Residual Income (RI) based and among competing metrics the Economic
Value Added (EVA) method (Stewart (1991)) is arguably the most dispersed.

When EVA emerged, it was the buzzword in finance, taking strategy consultants, company
executives, and wall street by storm. Since, it has become mainstream in these fields. Other
than the significance of value creation for such parties, arguably the success of the method is
also supported by its multi-functionality. By calculating and discounting the annual RI over
the capital invested, the method simultaneously calculates the fair value of any firm and the
value creative nature of managements actions. Therefore, it equally qualifies as a valuation
tool, an equity selection tool, an internal management performance tool, a management
performance tool for investors and a capital budgeting tool.

Even from the perspective of equity valuation alone it is often favored over and above the
classical firm DCF method - in spite of both methods calculating identical fair values because the former is considered to additionally provide a useful insight in the short and midterm yearly impact of the investment policy, and about the quality of the company and its
management; i.e. about the quality of the investment. In the words of G. Bennet Stewart, III:
The procedure of discounting free cash flow does yield an accurate value, but it fails to
provide any meaningful measures to assess progress in creating value or useful benchmarks
to judge performance. The cash flow performance of one company simply cannot be
meaningfully compared with another. The EVA valuation approach, on the other hand,

Roger Dayala 2014

Electronic copy available at: http://ssrn.com/abstract=2478399

provides a clear basis for reviewing performance after a new capital project has been
accepted or a new strategy has been implemented; namely, has it increased EVA over a
reasonable period of time? (Stewart (1991): 350).

The scholarly reception of EVA instead has been rather lukewarm: the seminal work in this
field is typically credited to Rappaport (1981 & 1986) and Ohlson (1989 & 1995) and
scholars also question the theoretical relevance of such frameworks altogether, given the
roots in both the long known notion of residual income (e.g. Hamilton (1777) and Marshall
(1890)) and the undeniable M&M propositions (Modigliani & Miller (1958)). Yet whether a
reminder or an innovation, it seems fair to say that EVAs underlying principles of linking
residual income to shareholder value, stock returns, management performance and capital
budgeting is the dominant framework for Value Creation among both scholars and
practitioners today.

This is not to say no criticism exists, Ross et al. (2002) have outlined the practical risk - and
error - of applying a generic hurdle rate for all projects for the purpose of capital budgeting.
Also, while the empirical evidence on EVA is mixed1, the bulk of such evidence suggests the
association of EVA (like other accounting measures) with stock returns remains poor and that
the superiority of EVA vis--vis earnings has not been forthcoming. Not least, there is debate
on the level of sophistication required when calculating the historic capital invested, the cash
flow return and the appropriate discount rate.

This latter issue, known as the metric wars (Myers (1996)), is a technical debate among
competing metrics on how the sought after residual income return on the amount of capital

For a review of the empirical evidence see, Worthington and West (2001) and Sharma and Kumar (2010)

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invested is best calculated. The middle issue relates to the use and effectiveness of EVA as a
measure and forecasting tool for value creation in financial markets (read: stock returns) and
the first issue involves the application of EVA as a Capital Budgeting tool. While all issues
are ultimately interrelated, this paper specifically addresses the middle issue: Why does the
EVA method in practice fail as a measure and forecasting tool of value creation in financial
markets?

Explanations have been sought for this phenomenon, yet they are inconclusive and rather
remain on an intuitive level. The answer to the problem, as will be illustrated next, is that the
core of EVA and its competing metrics is flawed. In part I the M&M propositions and the
long known notion of residual income with their specific consequences for Value Creation
and EVA will be discussed. Part II exposes the fundamental flaw in the core of the
methodology, introduces a novel framework for value creation, explains the issues under
investigation and reflects on both the novel framework and the EVA method. Part III
summarizes and concludes.

Roger Dayala 2014

I.

EVA and its Underlying Principles

The notion of residual income, that in order for a firm to create wealth for its owners it must
earn a return on its invested capital in excess of the cost of capital, has been recognized by
economists since the 18th century. This is regarded superior to accounting profits because
unlike the latter, the former adjusts for the total cost of the total capital, because it adjusts for
the time value of money and because it adjusts for risk, i.e. the effective cost of capital should
appropriately reflect the risk of the operations of the firm. The classical Net Present Value
(NPV) rule in capital budgeting is based on identical principles, with standard finance
textbooks analogously illustrating the superiority of such approach over alternative methods
such as the internal rate of return method and the payback method.

In addition to the ancient notion of RI, the undeniable2 Modigliani & Miller (M&M)
propositions (Modigliani & Miller (1958)) apply.
Proposition I:
The market value of any firm is independent of its capital structure and is given by
capitalizing its expected return at the rate k appropriate to its class. (M&M, 1958: 268)
Proposition II:
The expected yield of a share of stock is equal to the appropriate capitalisation rate k for a
pure equity stream in the class, plus a premium related to the financial risk equal to the debtto-equity ratio times the spread between k and r. (M&M, 1958: 268)
And M&M proposition III in particular:

Within the M&M assumption set, through the famous homemade leverage arbitrage opportunity, the
propositions are proven to be true

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If a firm in class k is acting in the best interest of the stockholder at the time of the decision,
it will exploit an investment opportunity if and only if the rate of return on the investment,
say *, is as large as or larger than k. (M&M, 1958: 271)
That is, the cut-off point for investment in the firm will in all cases be k and will be
completely unaffected by the type of security used to finance the investment. (M&M, 1958:
271)

Hence, consistent with M&M proposition III, k is besides the relevant firm discount rate also
the generic hurdle rate to which the return on new investments should be compared for such
investments to be considered acceptable; i.e. to assess whether such investments create value.
And based on Proposition II, in a world without taxes and under the assumption of a constant
debt to equity ratio, k also equates to the weighted average of the cost of debt and the cost of
equity, commonly known as the Weighted Average Cost of Capital3 (WACC). As a
consequence, shareholder value is created by a return on invested capital that is higher than
the firms WACC. Or put differently, an expected return above the WACC creates Residual
Income.

It is from these long known principles that EVA and its competing metrics have been derived,
providing a practical application for the calculation of both the Equity Value and the Value
Creation for any firm. Indeed, shareholder value is created if the return on capital invested
exceeds the WACC and thus, the fair market value of any firm is by definition not just the
net present value of its future unleveraged cash flows (as M&M proposition I illustrates), but
equally it is the sum of the total capital invested plus the NPV of the annual expected value
created or destroyed. In other words, one can measure what the annual expected value
3

In a world with taxes, as a result of the tax shield, the WACC decreases slightly with the use of leverage.
However, since we will also assume a world without taxes going forward, such tax effects (here) are irrelevant

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creation is by calculating the annual RIs through comparing the return on total Capital
Invested to the WACC and subsequently one can value the firm by adding to the total
invested capital the sum of the NPV of those projected annual RIs through discounting
those annual RIs over the relevant discount rate, the WACC.

In its core consequently, an RI based method calculates the book value of the total capital
invested (KB) in t=0. Subsequently the expected yearly RI starting in t=1 is calculated by
multiplying the total capital invested in t-1 with the differential of the Net Operating Profit
After Taxes (NOPAT) return (rN) and the WACC (w) in t. Assuming no accounting
distortions, the NOPAT return is defined as the Free Cash Flow4 (C) in t before net new
Investments (I), divided by the total capital invested in t-1, whereas the total capital invested
in t is calculated as the total capital invested in t-1 plus the net new investments in t. The
expected annual RIs measures of value creation are discounted over the WACC and
added to the value of total capital invested in t=0 to arrive at the fair value of the firm (VF).
The RI value creation method:
NOPAT[t] = C[t] + I[t]

(1)

KB[t] = KB[t-1] + I[t]

(2)

rN[t] = NOPAT[t] / K[t-1]

(3)

VF = KB[0] + [(rN[t] w) KB[t-1] / (1 + w)t

(4)

1-

And, as previously indicated, when consistently applied this fair firm value is equal to the fair
value according to the classical firm DCF calculation, where consistent with M&M I the fair
value of a firm is the NPV of the expected yearly free cash flows discounted with the WACC:
VF = C[t] /(1 + w)t
1-

In a world without taxes the expected return defined by M&M and the Free Cash Flow (C) are identical

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(5)

EVA distinguishes itself from the above general RI based value creation theory by providing
a practical application with a specific sophisticated methodology to correct the book amount
of total capital invested and the annual net new investments and NOPATs for accounting
distortions and anomalies such as goodwill and accruals5. Hence, yearly EVA is the adjusted
NOPAT return minus a proxy for the WACC, the hurdle rate, multiplied by the adjusted
capital invested. A positive EVA forecast indicates expected value creation and a negative
EVA forecast indicates expected value destruction. The adjusted capital invested, which in
the EVA approach intends to reflect the sum of all cash that has been invested in a
companys net assets over its life (Stewart (1991): 86) is referred to as the economic value of
the capital invested (KE).

These EVA adjustments incidentally, do not affect the aforementioned consistency with the
DCF method for calculating fair values. For formula (4) is a mathematical fact: when
consistently applied it holds regardless of whether K is correctly calculated or not.

However, as previously identified, when correctly applying the EVA method (including the
suggested accounting adjustments) its success as a measuring and forecasting tool of stock
returns appears limited. The bulk of empirical evidence suggests the association of EVA (like
other accounting measures) with stock returns remains poor and that the superiority of EVA
vis--vis earnings in this regard has not been forthcoming. Notably, Chen and Dodd (1997)
report that not a single EVA measure is able to account for more than 26 percent of the
variation in stock returns and Biddle et al. (1999) find that empirically EVA appears less
associated to stock returns and firm values than earnings. Biddle et. al themselves provide
possible explanations for this phenomenon:

See Stewart (1991 & 1994) for a description hereof: over 164 possible adjustments to US GAAP exist

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1) Market participants use cost of capital estimates different than EVA

2) EVAs accounting adjustments have the effect of undoing discretionary accruals that
market participants use to infer firms future prospects.
3) The market may make a different set of accounting adjustments
4) Even if the market adjustments are similar to those of the EVA, they may contain
little news. If earnings already conveys essential economic news (e.g., unexpected
revenues and costs) and the market provides its own cost of capital estimate there
may be little left to glean from EVA and RI.
5) It also is possible that, for the time period studied, the market had yet to recognize
valuable incremental information contained in EVA and RI numbers.

These possible explanations can be grouped into three types: 1) perhaps the EVA method is
flawed in terms of accounting adjustments or cost of capital calculations, 2) perhaps RI based
metrics provide little news over earnings or 3) perhaps the market has yet to recognize the
value of EVA and RI numbers. Another explanation, which may also be categorized as type
1, is provided by De Villiers (1997). He claims inflation may be the culprit and subsequently
introduces an adjusted EVA procedure. While all plausible, clearly the suggested
explanations are rather intuitive, inconclusive and to an extent mutually exclusive. What is
otherwise interesting about the first type of explanations, is that it suggests in principle, any
of the competing metrics might resolve the empirical weakness of the EVA. Indeed,
competing metrics, De Villiers adjusted EVA procedure included, are based on identical
principles, but differ in the way they calculate the (economic) value of the amount of capital
invested, in the way they adjust for (such) accounting distortions to calculate the best proxy
for NOPAT and/or in the way they calculate a proxy for the WACC. Regardless, there is no

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academic literature available to support the claim of any of the existing competing metrics
overcoming the empirical flaws identified. Rather, Worthington & Wests extensive review
reveals that the available empirical literature suggests there is no single accounting-based
measure upon which one can rely to explain changes in shareholder wealth (Worthington &
West (2001): 69).

The subsequent analysis explains why in principle all such RI based methods fail to describe
value creation in efficient markets even under the assumption of 1) a correct economic value
for the total amount of capital invested, 2) perfect NOPAT expectations, 3) perfect
adjustments to NOPAT and 4) a perfect proxy for the WACC.

Roger Dayala 2014

II.

Value Creation Recreated

A. Introduction

A modular reconstruction of a residual income based method will expose the fundamental
flaw in the contemporary interpretations of both the RI doctrine and the M&M propositions.
And to allow a seamless crossover between the EVA, RI and M&M doctrines, we will
assume perfect capital markets, no taxes, a constant debt to equity ratio and no accounting
distortions. That is, under such assumptions the Net Operating Profit After Taxes (NOPAT)
and the Free Cash Flow before net new investments (C+I) can be used interchangeably, while
the Free Cash Flow (C) and the WACC (w) are identical respectively to the expected
return6 and the capitalization rate (k) M&M define.

The analysis commences with discussing a hypothetical zero-growth firm with a fixed capital
structure at inception (0i). It is then fair to say the economic value of the total capital invested
(KE[0i]) is equal to the sum of the book values of the total equity capital (SB[0i]) and total
debt capital (DB[0i]) and hence to the book value of the total capital invested (KB[0i]). And
consistent with M&M and the firm DCF method, in a zero-growth model the fair firm value
(VF) is a perpetuity and can be calculated by dividing the Free Cash Flow in year 1 (C[1]) by
the WACC (w).
VF = C[1]/w

(6)

It can now be illustrated easily why it is true that the Free Cash Flow Return (or NOPAT
Return7) on total Capital Invested (rC) must be greater than the WACC, the firm discount rate,
in order for any firm at inception to create firm (/shareholder8) value:
SB[0i] + DB[0i] = KE[0i]
6

(7)

The Expected Return in M&M Proposition I refers not to a ratio, but to the expected free operating cash flow
Note that we assume no growth here (I =0), and hence C = NOPAT
8
Going forward, firm value creation and shareholder value creation will be used interchangeably, because
consistent with M&M shareholder value can only be created as a consequence of firm value creation
7

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C[1] = KE[0i] rC

(8)

If the Free Cash Flow return (rC) is higher than the WACC (w):
rC > w

(9)

It then follows from (6) and (8) that Value is created:

VF > KE[0i]

(10)

Indeed, if the expected return on the total capital invested is higher than the appropriate
required return (i.e. the hurdle rate) the market value of the firm increases over and above the
economic value of the initial total capital invested, hence value creation.

However, this notion of perfect capital markets where value is priced continuously has
significant (other) ramifications that may not have been understood properly. In the next
section I investigate a market perspective on value creation and in the section thereafter I
shall address a cash perspective.
B. Market Value Creation
When next allowing growth and investments to the assumption set, then rather than a
perpetuity, the fair value of any firm (VF), based on M&M, is the value of its future expected
free cash flows (C) discounted over the WACC (w). And given M&M Proposition I, the fair
value of a firm is also equal to the sum of the fair values of its Equity (SF) and its Debt (DF):
VF = SF + DF

(11)

Ergo, from equation (11) in conjunction with equation (10) from the previous section it
follows that even under the assumption of a perfect model with perfect assumptions with
perfect accounting adjustments, the sum of the fair value of the equity and debt is not
necessarily equal to the sum of either the book values or economic values of the equity and
debt. Consequently, in perfect capital markets at any time t the fair (market) value of the total
Roger Dayala 2014

capital of a firm should be distinguished from the economic value and/or book value of the
total amount of capital actually invested. Rather, the fair (market) value of the total capital
(KF) at any time t is the sum of the fair values of the Equity (capital) and the Debt (capital) at
that particular time.
KF = SF + DF

(12)

In other words, as a consequence of formulae (7), (11) & (12) and consistent with M&M, in
perfect capital markets, regardless of the book or economic value of the total capital, the fair
(market) value of the total capital is always identical to the fair value of the firm.
KF = VF

(13)

Market Value Creation (MVC) is subsequently defined as the expected excess market return
on the actual9market value of the capital (KM). It then follows directly, that the expected
Market Value Creation for any investor in year b during any forward period (b,e) is zero for
any firm that is fairly valued in year b. This is true, because the expected market return (rM)
on the fair market value of the capital (KF) is by default the required return, the WACC (w).
And based on the definition of MVC and (implicitly) consistent with the M&M principles,
market value is (expected to be) created for any individual shareholder if the average
(expected) yearly market return on the market value of the capital is higher than the WACC,
the hurdle rate.

That is, in year b the fair value of the firm to expect in year e is by definition, ceteris paribus,
the future value (FV) of the fair value of the firm in year e based on the present value in year
b, calculated with the appropriate firm discount rate, the WACC (w). In formulae:
KF[b] = VF[b] = SF[b] + DF[b]
KF[e] = VF[e] = SF[e] + DF[e]

That is, KF reflects the fair market value and KM the actual market value

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(14)
(15)

VF[e] = FV[e] (VF[b])

(16)

FV[e] (VF[b]) = VF[b] (1+w)(e-b)

(17)

Whereby:
FV[e] (VF[b]) = Future Value of the firm in year e based on its present value in year b.
Now, if rM were the only unknown in the following equation:
VF[b] (1+rM)(e-b) = VF[e]

(18)

rM = w

(19)

=>

Indeed, the mathematical implication of formulae (14) through (18) is that the compound
average expected yearly market return on the fair (market) value of the total capital in year b
(KF[b]) must be the WACC (w) during any b-e period. Therefore, any fairly valued firm is
always expected to return its WACC on average for any holding period from that point
onwards, ceteris paribus; consequently the expected excess return, or expected market value
creation, is zero.

It then follows that if the actual market value of the firm (VM) is at any time (b) below its
present value or fair market value (VF), according to a hypothetical perfect firm DCF model,
there is, ceteris paribus, a reasonable expectation10 of market value creation for new investors
buying a fraction of the shares. Because if one expects the market value to correct to its fair
value over time (during the b,e period), the shareholder is expected to not only be rewarded
via the expected yearly appreciation of the firm by its WACC (which is by definition market
value neutral), but also incrementally by the expected correction towards its fair value, hence
firm/ shareholder market value creation.
In formulae:
10

There is no guarantee that the market value will trade at its fair value in year e, nor that the fair value itself
does not get impaired due to (non-priced) future events, e.g. CEO leaving.

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VF[e] = VF[b] (1+w)(e-b)

(20)

VM[e] = VM[b] (1+rM)(e-b)

(21)

VM[e] = VF[e]

(22)

VM[b] < VF[b]

(23)

VF[e] = VM[b] (1+rM)(e-b)

(24)

rM > w

(25)

Now if:

=>

Indeed, based on the expectation that the market value of the firm will reach its fair value in
year e, according to formulae 20, 21 and 24 the expected compound average market return on
the market value of the total capital invested in year b must be greater than the WACC, hence
expected Market Value Creation.

To paraphrase M&M, ex ante a firm is expected to create firm (/shareholder) value in the
market during a certain period if the expected compound average yearly market return on the
market value of the capital (i.e. the market value of the firm) is higher than the WACC, the
hurdle rate, ceteris paribus.

And ex post a firm is said to have created firm (/shareholder) value in the market during any
given period if the actual compound average yearly market return on the market value of the
capital (i.e. the market value of the firm) was higher than the WACC, the hurdle rate for that
period, ceteris paribus.

However, the compound average market return (rM) is a compound yearly average not taking
the actual timing of the correction into consideration. In order to calculate the fair value of

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the expected market value creation during any expected holding period (b,e) in year b, we
require a formula that calculates the net present value of the expected excess returns for
discrete points in time:
MVC V [b, e] = a '[b] +

a ' [t 1 ]
a ' [t 2 ]
a ' [e ]
+
+ ... +
( t1 b )
( t2 b )
(1 + w) ( e b )
(1 + w)
(1 + w)

a '[t i ] = r M [t i ] w V M [t i 1 ] for b< ti<e

(26)

(27)

Where:
t0=b, t1, t2,, tn=e
MVCV[b,e] = NPV of Expected (Firm) Market Value Creation for a given b,e period
a[ti] = fraction of the total expected MVCV occurring in ti

Yet based on the Efficient Market Hypotheses, in theory the correction towards the fair value
is by definition expected to be instantaneous, which means:
a[b] = VF[b] - VM[b]

(28)

a[t>b] = 0

(29)

There we have it, irrespective of the holding period, in theory11 the net present value of the
expected firm market value creation at any time t is:
MVCV = VF - VM

(30)

That is, the net present value of the expected market value creation or destruction in financial
markets for any firm at any time t is in theory simply identical to the difference in its fair
value and its market value at that time. Hence, the expected market return on the market
value of the total capital is, ceteris paribus, higher, lower or identical to the WACC if the
market value of the firm is respectively lower, higher or identical to the fair value of the firm.
Consistent with M&M only a market return above the WACC creates firm market value.

11

Formula 26 allows for the incorporation of timing expectations regardless, e.g. a 12 month price target

Roger Dayala 2014

This concludes the section on Market Value Creation. Yet I have subtly, if not abruptly,
moved from a cash return on actual capital invested to a market return on the market value of
the total capital. How such relates back to the cash return will be discussed in the following
two sections.
C. Capital Value Creation
I have distinguished between two types of value creation, one based on a market perspective
and one based on a cash perspective. The former has been called Market Value Creation and
the latter, based on a cash return on capital actually invested, I shall refer to as Capital Value
Creation (CVC).

In its core CVC is quite familiar to us: management selecting positive Net Present Value
projects (NPVP) by utilizing single project-defined risk-adjusted hurdle rates (x) according
to the classical NPV rule from Capital Budgeting theory:
NPVP = R[0] + R[t] / (1 + x)t

(31)

1-

That is, the net present value of the expected capital value creation of any project is
calculated by discounting the annual cash flows (R[t]) by utilizing the appropriate riskadjusted discount rate for such project (where R[0] typically represents the initial cash
outlay). A positive NPV project implies a return on investment that is in excess of the
appropriate risk-adjusted discount rate, hence capital value creation.

The consistency of CVC at the aggregate firm level with the classical NPV rule for project
appraisal then follows: for any firm at inception (0i) it is fair to say that the initial investment
for the firm is its total capital invested. That is, the negative value of the previously defined
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book value of the total capital, i.e. R[0i] = -KB[0i]. And by implication the annual firm cash
flows are identical to the annual expected free cash flows resulting from the firms operating
assets, or equally portfolio of investment projects, i.e. R[t] = C[t] (with t>0). And given
that the WACC (w) is the fair firm discount rate, reflecting the total risks of the operations of
the firm, that is of the firms portfolio of investment projects, it follows that the expected
capital value creation for any firm (CVCV) at inception (0i) can be defined fully consistent
with the NPV rule:
CVCV[0i] = -KB[0i] + C[t] / (1 + w)t

(32)

1-

And when consistently applied, as previously indicated, an RI based firm value calculation
(equation 4) and a firm DCF calculation (equation 5) are always indentical:
C[t] /(1 + w)t = KB[0] + [(rN[t] w) KB[t-1] / (1 + w)t
1-

(33)

1-

It then follows that equation (32) may equally be stated in terms of annual NOPAT returns
(rNt) in relation to the net capital invested:
CVCV[0i] = [(rN[t] w) KB[t-1] / (1 + w)t

(34)

1-

When next analyzing a company at any time t beyond inception, assuming a perfect DCF
model with perfect assumptions and a perfect estimate for the net capital employed at that
time (-KCE[0])12, then the net present value of the expected CVC of any firm at any time t can
in theory be restated as follows:
CVCV = [(rN[t] w) KCE[t-1] / (1 + w)t

(35)

1-

And since previously it had been established that irrespective of whether K is correctly
calculated or not, the following equation holds:
VF = K[0] + [(rN[t] w) K[t-1] / (1 + w)t

(4)

1-

12

We shall not concern ourselves here with whether KCE reflects the book value (KB), the economic value (KE)
or some other calculation of the capital invested, yet a narrower definition of KCE will be presented in section E.

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Therefore, in the new framework:

CVCV = VF KCE

(36)

In words, the net present value of the expected (Firm) Capital Value Creation at any time t is
identical to the differential of the fair value of the firm and the value of the net capital
employed. Analogously, the net present value of the expected (firm) capital value creation by
the market (CVCM) at any time t is the differential between the market value of the firm and
the value of the net capital employed:
CVCM = VM KCE

(37)

It further follows from equations (32), (35) and (36), consistent with M&M, that if there is an
expectation of net capital value creation (i.e. the fair value of the firm in excess of the value
of the net capital employed), then by default both the annualized average expected free cash
flow return (rC) and the annualized average expected NOPAT return (rN) are in excess of the
WACC:

=>

VF > KCE

(38)

rC > w & rN > w

(39)

Note also, and this is important, while annual CVC may provide a basis for comparing
relative capital efficiency, it may not, consistent with the NPV rule, be interpreted as annual
value creation (or destruction). Such irrespective of perfect estimates for the free cash flows
before net new investments, for the WACC and for the net capital employed. Rather, it is the
net present value of all expected CVC, that renders a firms forward plan value creative,
value destructive or value neutral.

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Lastly, it has been indicated that consistent with M&M, firm value creation and shareholder
value creation may be used interchangeably. Yet to be complete, (Firm) Market Value
Creation and (Firm) Capital Value Creation may equally and analogously be expressed
directly as Shareholder Value Creation (MVCS and CVCS respectively), with then the cost of
equity (kS) as the hurdle rate:
MVCS = SF - SM

(40)

CVCS = -ECE + A[t] / (1 + kS)t

(41)

1-

CVCSF = SF ECE

(42)

CVCSM = SM ECE

(43)

Where:
SF = The fair value of the Equity
SM = The market value of the Equity
ECE = The Equity Capital Employed
At = The Net Cash Flow after investments, interest and taxes in year t
kS = The fair Equity discount rate
D. Market Value Creation vs. Capital Value Creation
Now that both CVC and MVC have been defined, it is important to put those distinctive types
of value creation in their relative context: expected value creative actions from management
(CVC) that are in the price are realized from a market perspective (MVC) and for that reason
historic even while relating to (expectations of) future events. Hence, to the extent expected
Capital Value Creation is efficiently priced, zero opportunities for Market Value Creation
remain, even if management has only picked value creative investments and, is expected to
continue to do so!

Roger Dayala 2014

This notion, the effect of market efficiency, is arguably largely misunderstood in the
contemporary paradigm. A simplified illustration clarifies this. Lets reconsider formulae 6-8
(restated for KCE) and formulae 30 and 37 from the previous sections:
VF = C[1]/w

(6)

SB[0] + DB[0] = KCE[0]

(7)

C[1] = KCE rC

(8)

MVC = VF VM

(30)

CVCM = VM KCE[0]

(37)

VM[0] = VF[0]

(44)

rC = w

(45)

VF[0] = KCE[0] = VM[0]

(46)

If we now assume,

then it follows:

Hence, based on formulae (30) & (36) zero market value and zero capital value is created.

Now assume that investor A buys a position in this firm at t=0 and that suddenly (t=0), i.e.
seconds after t=0, the expectation emerges that:
rC > w

(47)

VF[0] > KCE[0]

(48)

VF[0] > VM[0]

(49)

=>

CVCM[0] > 0

(50)

=>

MVC[0] > 0

(51)

=>

rM > w

(52)

It then follows:

Roger Dayala 2014

If we next assume that investor A immediately (t=0) after this market expectation of
management adopting a value creative investment program emerges, decides to take profit
and sell his stake in the efficient market to investor B at VF[0], then it follows:
VF[0] = VM[0]

(53)

And since, ceteris paribus, no new expectations arose between t=0 and t=0 and since no
new capital was employed:
VF[0] = VF[0]

(54)

KCE[0] = KCE[0] = KCE[0]

(55)

=>

CVCM[0] > 0

(56)

=>

MVC[0] = 0

(57)

Hence:

In words
1. The value creative market return to investor A is realized because he bought his stake
at (a fraction of) VM[0] and sold at (at a fraction of) VM[0], hence rM > w
2. The expected market return to investor B is however expected to be value neutral
because he buys at VM[0] which is identical to the fair value VF[0], hence his
expected return is rM = w.
3. However, the expectation with regards to managements investment policy at t = 0
remains unchanged relative to t=0. It is expected to be value creative, because rC > w
4. During the whole period t=0 to t=0 the WACC is unchanged, because while the
return expectations have changed (rC), the riskiness of the operations have not.

It further follows that it is actually irrelevant whether investor A sells his stake or not, given
market efficiency the market value of the firm will immediately reflect the new fair value
regardless. Hence, while the expected value creative investment policy by management still

Roger Dayala 2014

needs to be executed it is already realized from a market perspective, leaving from t=0
zero expected Market Value Creation for shareholders going forward.

In sum, there is a distinction between a (n expected) value creative investment policy by the
management (CVC) and between (the expectation of) shareholder value creation in the
market (MVC). Value is created in the market today on the expectation of a cash return
tomorrow, that may or may not materialize.
E. Practical Implications
A highly detailed application with necessary accounting adjustments goes beyond the scope
of this paper, let alone engaging in the metrics war. Yet is it is essential, if only to guide
future research, that I clarify the underlying philosophy and intended consequences of the
novel framework further.

MVC is rather straightforward as it (only) requires market values and fair values, whether or
not based on a DCF calculation. CVC however requires some further guidance on its
interpretation, the calculation of the net capital invested and the calculation of the NOPAT.
With regards to the latter, I prefer the notion of Free Cash Flow Before Net New
Investments13 (C+I), reasserting the prominence of cash over profit, reasserting the direct link
between the two types of cash flow (C & C+I), reasserting the notion that ultimately
(discounted) cash flows drive valuations and emphasizing the consistency with the NPV rule.
In any case, what is relevant nonetheless14, and this is also what EVA and most competing
metrics try to achieve, is to make a distinction between costs and investments; or rather
between free operating cash flows and net new investments. Yet regardless of such
13

In the current assumption set NOPATs and Free Cash Flows before Net New Investments are identical
That is, in an attempt to create more insight in the composition of a firms value creation, because referring to
formula 32 CVC can also be calculated using simple free cash flows where such distinction is less relevant
14

Roger Dayala 2014

determinations (e.g. is R&D an investment, a cost, or a mixture of both?) consistency is key

for any meaningful comparison among peers. And let me reiterate, while annual CVC
provides a useful insight in the composition and structure of capital value creation and
provides a basis of comparison between companies, it cannot be interpreted as annual value
creation or destruction, irrespective of a perfect distinction between costs and investments.

The definition of the net capital employed however, poses a philosophical dilemma. Standard
textbooks tell us the net capital employed is the sum of the net working capital and the net
fixed assets. And for reader comprehension and to expose the flaw in the contemporary
frameworks in the preceding analysis a perfect estimate for this net capital employed at any
time t had been assumed. Yet in practice the net capital employed (at any time t) could either
mean
1) The total capital historically invested in the company (for instance adding back the
goodwill amortized as EVA proscribes)
2) The net capital actually employed in the business (for instance without sunk costs and
allowing fair value adjustments on goodwill, if not deducting goodwill altogether;
with the capital employed effectively reflecting the fair acquisition costs of the
operating assets at that time), or
3) The market value of the total capital invested, reflecting by definition the fair market
value of the operating assets.
The latter would equate an CVC analysis to an MVC analysis, since KCE would be equal
to either KF or KM, and while not without merit15, this would not allow for the type of
capital efficiency analysis as intended.

15

It could be argued that based on a going concern principle, the market value of the assets is a more relevant
measure than either its historic or fair current acquisition cost

Roger Dayala 2014

The former, calculating the total historic amount of capital invested, doesnt technically allow
for a calculation and relative assessment of the forward plan as it integrates historic capital
efficiency in the equation, creating a matching error potentially overemphasizing historic
investments / capital efficiency and potentially creating the illusion of capital tied up in the
business that is actually not employed and (therefore) not available for reallocation. That is, it
might provide a general overview of the historic, actual and expected capital efficiency (as
EVA claims), but it fails to distinguish between the timing of either. Arguably it is the
remaining definition that best allows for a straightforward assessment and comparison of
forward plans, eliminating unwanted matching errors, providing a fair view of the capital
actually available in the business, allowing an assessment of whether such capital is
efficiently employed or not and to what extent capital should be allocated differently/ more
efficiently.

To illustrate this, consider two production companies G&H with the following simplified
balance sheets that operate in a world without taxes and that pay out their free cash flow in
full to their financial stakeholders16:
BALANCE SHEET
Short term assets
Short term liabilities
Net Working Capital
Long Term Tangible Assets
Goodwill (net)
Long Term Liabilities
Cash
Short Term Interest-Bearing Debt
Long Term Interest-Bearing Debt
Net Debt
Equity
Minor. Interests
Total Assets
Net Capital Employed (unadjusted)

Company G
300
150
150
1,150
0
200
200
100
300
200
900
0
1,650
1,300

Company H
300
150
150
1,150
700
200
200
100
1,000
900
900
0
2,350
2,000

TABLE 1: Balance Sheets of Companies G&H

16

That is, interest payments to the debt holders and the remainder (the free cash flow to equity) in dividends to
the equity holder

Roger Dayala 2014

While the size of the balance sheets are quite different, for the sake of argument we further
assume both companies have identical production facilities, identical working capital levels
& working capital needs, identical expected operating revenues, identical operating costs,
identical operating cash flows in every state of the world and identical expectations of net
new investments in every state of the world. As a consequence, among other things, based on
a firm DCF analysis the fair firm values for both companies must be identical: VGF = VHF.

We also assume companies G&H have identical inception dates with (then) identical balance
sheets, yet that company H has acquired its operating assets debt financed through M&A,
explaining the large goodwill and net debt position, while company G has acquired its
operating assets at fair replacement cost. If we subsequently assume the current fair
replacement costs of the operating assets (at time t) of both companies are identical to the
unadjusted17 net capital employed of company G (KGCE = KHCE) in spite of the difference in
(unadjusted) Net Capital Employed, Equity and Net Debt the necessary distinctions
aforementioned immediately become apparent:

In spite of identical operating assets, identical expectations for free cash flows, risks and (net
new) investment decisions for both companies, utilizing the historic amount of capital
invested18 would suggest the quality of the forward plan of company H to be inferior to that
of company G given lower annual NOPAT returns. This would also create the illusion the
amount of capital employed or redeployable in company H is higher than that of company G.

17

Although in practice also company G could be subject to fair value adjustments to its net capital employed
In fact, ceteris paribus, the total amount of capital historically invested (KE) for company H would even be
somewhat larger than assumed in Table 1, due to the necessity to add back goodwill amortized over time

18

Roger Dayala 2014

The novel framework instead assuming both firms are fairly priced concludes:
1) The amounts of capital actually employed are identical
2) The forward plans of both companies are identical in terms of capital efficiency and
capital value creation CVCG = VGF KGCE = CVCH = VHF KHCE
3) Historically, while an identical size and quality of the forward plan, company H has a
weaker capital value creation record19 than company G
4) Neither the forward plan or the historical difference in capital value creation affects
the expected MVC, which would be zero for both companies going forward given the
assumption of both companies being fairly priced
5) Regardless of the factual historical difference in capital value creation, the market
values of both firms are identical
6) Yet the higher debt levels of company H will result in a lower fair equity value than
that of company G and subsequently in a lower historic Total Shareholder Return
(TSR) or equally, lower MVC performance than that of company G, ceteris paribus.

In sum, the novel framework allows a distinction between historic capital value creation and
historic market value creation vs. expected capital value creation and expected market value
creation respectively. Having said that, arguably the best proxy for assessing capital
efficiency for large ad hoc projects is provided by the market. That is, consistent with the
CVC calculation (whether DCF or RI based), any large investment project can only be
considered value creative if it results in an increase in the fair value of the firm or equally in
noticeable market value creation, ceteris paribus.

19

Whether or not company H (and company G for that matter) have actually destroyed capital value depends on
whether KHCE KHE < 0, regardless of its weaker relative record

Roger Dayala 2014

F. Reflecting on EVA
Before addressing the market imperfections under investigation in the next section it is useful
to first reflect briefly on how EVA compares to the novel framework. When then simply
looking at equation (35), but also given EVAs emphasis on traditional RI analyses, it is
immediately clear that rather than the intended integrated framework, EVA at best provides a
CVC framework.

Regardless, EVA is also flawed as a CVC framework: contrary to its assumptions, yet
consistent with the classical NPV rule, annual excess NOPAT returns are no measure of
annual Capital Value Creation, because cash flows may be lumpy and back-end loaded20.
Rather, consistent with the NPV rule, it is the net present value of all discounted RI in
relation to the net capital employed (KCE) that is decisive in rendering a companys forward
plan value creative or not. Simply put, the CVC framework is fully consistent with the NPV
rule, while EVA is not.

And although EVAs Market Value Added (MVA) calculation the net present value of all
future EVA optically resembles the suggested expected Capital Value Creation
calculation21, its interpretation is fundamentally different: where MVA is intended as a
cumulative measure to reflect the net present value of all historic, current and future
investment projects, CVC instead calculates the expected capital value creation of the
forward plan in relation to the net capital actually employed in the business. That is, in its
current form MVA mixes historic, actual and forward looking analyses in to one measure that
calculates neither.

20
21

This is consistent with Brewer et al. (1999) who already identified such shortsightedness in EVA
Specifically, in case KCE=KE then MVA= CVCM

Roger Dayala 2014

EVA must also be rejected as a Capital Budgeting tool. Based on the analysis by Ross et al.,
as aforementioned, EVAs emphasis on a generic hurdle rate is inferior to the classical NPV
analysis and it may result in the risk of a gradual increase in the riskiness of the operations of
a company when applying a generic hurdle rate for project appraisal. In their words: The
rigorous application of a generic discount rate could lead to a gradual increase in the riskiness
of the firm due to the increased chance of rejection of acceptable lower risk projects and a
relatively higher chance of accepting projects that are even riskier than the operations of the
firm itself, some of which that may even have been rejected when discounted over the
appropriate risk-adjusted discount rate. Or as Dayala indicates, it is the consistent selection
of positive NPV projects on the basis of individual risk-adjusted discount rates that results in
an average return in excess of the WACC by default, while counter-intuitively a generic
hurdle rate doesnt. (Dayala (2010: 5)).

With regards to Equity Valuation it is a mathematical fact that the consistent application of
any RI method yields a fair value that is identical to that of the firm DCF method regardless
of the soundness of the calculation for the value of the capital invested. Hence an EVA fair
value, when consistently applied yields a value identical to the firm DCF method or a CVC
based calculation. However, it has been illustrated that EVA incorrectly calculates and
interprets the annual RI and the expected forward plan.

Given the identified flaws of EVA for capital budgeting, for assessing the quality of the
forward plan, for overemphasizing historic investments, if not the misguided interpretation of
annual EVA as a measure of either yearly market value creation or yearly capital value
creation, it follows that methodologically EVA also fails both as an internal or external
management performance tool.

Roger Dayala 2014

Regardless, we must credit EVA and its competing metrics for creating awareness in the
subtleties of accounting distortions and anomalies and most significantly why we should
distinguish between costs and (net new) investments; which in its core is also relevant for
performing a sound CVC calculation and analysis.
G. Market Imperfections
With the introduction of the novel framework complete and the flaws of the EVA identified, I
will briefly and selectively reflect on several seminal contemporary empirical findings and on
various presumed market imperfections. Not least, the initial question still needs addressing:
why does the EVA method fail as a measure and forecasting tool of value creation in
financial markets?

To begin with the latter, it has been argued EVA mixes historic, actual and forward looking
capital efficiency analyses in to one measure that calculates neither and that subsequently it
fails in correctly assessing the (value of the) expected forward plan. Also, EVA misinterprets
the meaning of annual EVA as annual (capital) value creation. Yet more important in this
regard, it has been illustrated that even if any existing RI method were to calculate
expectations of CVC exactly, this cannot simultaneously be considered a meaningful measure
or even indicator of expected MVC.

That is, in theory all expectations (whether value creative or destructive) are efficiently priced
resulting in zero MVC going forward. Analogously the over- or undervaluation of companies
relative to their fair value (resulting in the potential for MVC), is principally unrelated to
expectations of CVC and therefore principally uncorrelated with expectations of CVC. Any
company that is expected to create or destroy CVC can be undervalued, overvalued or fairly
Roger Dayala 2014

priced. And any two companies that are expected to have positive CVC and negative CVC
respectively may be simultaneously undervalued. This results in expectations of positive
MVC for both, regardless of the difference in expectations for CVC.

This also implies incidentally, that the credo to exclusively invest in companies with
managements adopting value creative strategies and/or the assumption that such strategy
works in the long run is technically incorrect, ceteris paribus. Rather than this being the short
term effect of some presumed market imperfections, is it the structural effect of market
efficiency: expectations of shareholder value creation (which in this context should be
interpreted as CVC) are simply no meaningful indicator of expected shareholder returns
(which in this context should be interpreted as MVC ). That is, while a historic long term
relationship between CVC and MVC may exist because ultimately CVC drives MVC (I am
reminded of equation 10 and the preceding analysis), expected CVC cannot be a meaningful
forward looking indicator of MVC as efficient markets create a matching error. Rather, the
question relevant for investment selection is to what extent the quality of the management
(good or bad) is in the price22; the actual quality itself, once priced, is principally irrelevant
for investment selection, ceteris paribus. Analogously and consistent with the bulk of
empirical evidence, the same is therefore true for (expected) earnings or any other
accounting-based measure: these cannot provide a meaningful forward-looking indicator of
expected shareholder returns.

Regardless hereof, the finding of Easton and Harris (1991) that deflated earnings levels may
have significant explanatory power for annual stock returns after all, is nonetheless consistent
with the novel framework. That is, via accrual adjustments, earnings are typically a smoothed

22

That is, to what extent this is reflected in the market price relative to the fair value reflecting such issues

Roger Dayala 2014

proxy for cash flows, and based on equation (19) an efficiently prized stock should return its
discount rate. It then follows that deflated earnings, consistent with the inverse of common
P/E ratios for relative valuation purposes, is a simplified proxy of the earnings yield. So if
earnings are stable or largely transitory, then rather than earnings by themselves
predicting stock returns, it is actually so that under such conditions (only) they allow for a
reasonable (equity) discount rate estimate. According to the novel framework this is an
indicator by default, not of excess stock returns, but of total stock returns; that is, including
the component that is value neutral. Hence, the theory suggests that while prized expectations
of earnings, Free Cash Flows, CVC or any accounting based measure cannot be an indicator
of market value creation, assuming a (-n equity or) firm DCF method as a valuation model
under uncertainty, a fair proxy for the equity discount rate is an indicator of total stock
returns regardless. This would further suggest, that while neither earnings or CVC can be a
forward looking indicator of stock returns lest of all excess stock returns that when
consistently applied, perfectly estimated and calculated CVC may only have identical
explanatory powers for total stock returns as earnings or cash flows. That is, to the extent all
will yield an identical proxy for the discount rate, ceteris paribus.

More importantly perhaps, consistent with the seminal empirical finding from Ball and
Brown (1968), the novel framework also formally explains, ceteris paribus, why unexpected
earnings explain stock returns and why expected earnings or expected capital value creation
in principle cannot: in efficient markets only changes in expectations can create MVC
opportunities (or losses), while prized (free cash flow) expectations result in zero expected
MVC by default.

Roger Dayala 2014

This also explains incidentally, in conjunction with the agency problem23 that is, why in spite
of all expectations being prized, the monitoring of the quality of the management remains
relevant. And on a more practical level this explains why markets focus on earnings being in
line, below or above expectations, rather than on the actual quality of the earnings relative to
peers24; i.e. a superior financial performance is not necessarily matched by superior market
returns (going forward) a highly frustrating and often misunderstood phenomenon for
successful managers.

Lastly I should emphasize though, the above reflection is by no means to suggest the
contemporary paradigm or the EVA method in particular did not recognize that market
valuations incorporate expectations. Clearly, such notion is the core of the efficient market
theory, and in the context of RI, Feltham and Ohlson (1995) among others provide the
theoretical framework, while others have long considered Total Shareholder Return25 (TSR)
or a more sophisticated firm-return-measure as a bottom line indicator of shareholder/
stakeholder value creation. Rather, this paper aims to provide a framework on value creation
that explicitly incorporates market efficiency and that formally explains flaws in the
contemporary framework, related empirical findings and related (perceived) market
imperfections.

23

Investors dont have access to the information allowing them to exactly evaluate the proper use of the NPV
rule by the management. They will have to resort to proxies, if only to base their forecasts on.
24
Typically referred to as earnings myopia
25
Clearly TSR refer more to shareholder returns than to firm returns, but as previously indicated (see footnote 6)
when consistently applied an equity angle and a firm angle should yield identical conclusions with regards to
MVC; if only since the WACC can be decomposed of a cost of debt and a cost of equity.

Roger Dayala 2014

III.

CONCLUSION

I have investigated the empirical finding that EVA fails as a measure and forecasting tool of
value creation in financial markets. Through a modular reconstruction, the analysis then
reveals that rather than some unidentified market imperfection, it is the underlying
framework of the EVA method itself (and its competing metrics) that is fundamentally
flawed. Instead a novel framework in introduced that distinguishes between Market Value
Creation (MVC) and Capital Value Creation (CVC); explaining the empirical result.

MVC is an excess market return over the WACC and CVC is an excess return on capital
invested over the WACC. The former is calculated as the differential between the fair value
and the market value of any firm and the latter is calculated as the difference between either
the fair value or the market value of any firm and the value of its net capital employed. In
other words, consistent with M&M, the WACC, ingeniously as ever, is the discount rate to
determine fair values, the average hurdle rate (but not generic!) for the average return on the
actual capital invested to reflect CVC and the hurdle rate for the average expected return on
the market value of the firm to reflect MVC.

Consequently and counter-intuitively, expected CVC cannot be a meaningful forwardlooking indicator of expected MVC. That is, while ultimately CVC drives MVC, in efficient
markets all expectations are immediately prized and therefore even a perfect measure of CVC
has no bearing on the expectations for MVC. The concepts of the fair value of the capital and
the value of the actual capital employed and hence of CVC and MVC are identical (only) at
inception from an a priori angle in the (stringently) adapted reality of M&M, but market
efficiency decouples them.

Roger Dayala 2014

And since EVA is at best a proxy for CVC, the aforementioned distinction between MVC and
CVC explains the empirical result under investigation. It further explains why also no other
accounting based measure could be a forward looking indicator of stock returns and it also
appears consistent with the seminal empirical finding from Ball and Brown about unexpected
earnings.

With regards to EVA it has further been demonstrated that while it is based on the notion of
RI and the M&M propositions, it 1) fails to properly account for market efficiency, 2) fails to
properly incorporate the principles of the net present value rule for capital budgeting and 3)
overemphasizes the amount of capital historically invested, creating a timing mismatch when
assessing the quality of a companys forward plan.

In sum, in investigating and resolving various known failures of the EVA, this paper exposes
the core of EVA theory is fundamentally flawed and introduces a novel framework on Value
Creation, integrating the classic notion of RI and the M&M propositions with the NPV rule
and market efficiency.

Roger Dayala 2014

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