The Valuation Handbook: Valuation Techniques from Today's Top Practitioners

CHAPTER 9

The Economic Profit Approach to Securities Valuation

 

James L. Grant

JLG Research and Professor of Finance, University of Massachusetts Boston

 

 

This chapter provides a foundation on the economic profit (EVA^®1) approach to securities valuation. The EVA model differs from other well-known approaches to securities valuation such as the dividend discount model (DDM) and the free cash flow (FCF) model because it provides a direct measure of the value added to invested capital.² In financial terms, the wealth added to invested capital is called the firm’s net present value (NPV). Assuming market efficiency, the firm’s market value added (MVA) will be equal to the intrinsic value added measured by its net present value. As shown by Grant (2003), the firm’s NPV is equal to the present value of the anticipated future economic profit stream.³

In turn, the question of whether economic profit is positive or negative is of interest to corporate managers and securities analysts, as it relates to the period in which a company can actually generate a return on capital (ROC) that exceeds the opportunity weighted average cost of capital (WACC). Common assumptions about economic profit beyond a forecast period are that (1) EVA is zero due to competitive forces, (2) EVA decays over time to zero, (3) EVA is perpetuity, or (4) EVA is growing at some long-term rate that is less than WACC.

In the next sections, we will look at several economic profit valuation models with the goal ...