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Investment Valuation: Tools and Techniques for Determining the Value of Any Asset, Third Edition by Aswath Damodaran

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CHAPTER 32

Value Enhancement: Economic Value Added, Cash Flow Return on Investment, and Other Tools

The discounted cash flow model provides for a rich and thorough analysis of all the different ways in which a firm can increase value, but it can become complex as the number of inputs increases. It is also difficult to tie management compensation systems to a discounted cash flow model, since many of the inputs need to be estimated and can be manipulated to yield the results management wants.

If we assume that markets are efficient, we can replace the unobservable value from the discounted cash flow model with the observed market price and reward or punish managers based on the performance of the stock. Thus, a firm whose stock price has gone up is viewed as having created value, whereas one whose stock price has fallen has destroyed value. Compensation systems based on the stock price, including stock grants and warrants, have become a standard component of most management compensation packages.

While market prices have the advantage of being up-to-date and observable, they are also noisy. Even if markets are efficient, stock prices tend to fluctuate around the true value, and markets sometimes do make mistakes. Thus, a firm may see its stock price go up and its top management rewarded, even as value is destroyed. Conversely, the managers of a firm may be penalized as its stock price drops, even though the managers may have taken actions that increase firm value. The other problem ...

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