Value and Valuation

The McKinsey EVA Approach

At some level, corporate finance work is all about value and valuation. Sometimes we do explicit valuation analyses, say of a capital investment project or of a business or company we might acquire (or sell). To do this work we use certain well established valuation methodologies, most notably DCF analysis. We forecast future expected cash flows, estimate a discount rate equal to the project or target company cost of capital, and discount the forecasted cash flows by the estimated cost of capital to come up with a net present value (NPV). A positive NPV implies that the forecasted IRR on the project exceeds the required return (i.e. the cost of capital) and the project is therefore expected to create economic value. A negative NPV implies that the forecasted IRR is below the cost of capital and the project is expected to destroy economic value. A zero NPV implies that the IRR equals the cost of capital and the projects is therefore value neutral, neither creating nor destroying value. Good finance executives don’t make investment decisions based solely on estimated NPVs (particularly not single-case NPVs), but they do take NPVs into consideration along with other important financial and non-financial considerations.

The methodology underlying DCF analysis is often referred to as Economic Value Added (EVA). The term “EVA” was trademarked by a now defunct consulting firm, Stern Stewart & Co., and you will often see it referred to by other similar names. (For example, John Deere & Co. calls their approach SVA: Shareholder Value Added). Those of you who are finance majors will have learned in school to do DCF analysis and you will have become very comfortable talking about WACCs, IRRs and NPVs. You may or may not recognize that what you are doing in a DCF valuation is really EVA analysis, but it is.

The principles of EVA apply even to corporate finance matters that may not involve explicit valuation analysis per se. Every decision a company makes—financial, operational, strategic— should at some level be taken with a view to enhancing the value of the company. Without value creation as its core objective, how else is a company supposed to decide what businesses to be in (or exit), what strategies to pursue, how best to manage its operations, or how to set financial policy? All of these decisions can and should be taken with at least an implicit consideration of the impact of the decision on the economic value of the company. This observation lies at the heart of the EVA approach to corporate finance, strategy and governance.

As a general matter, the purpose of a business corporation is to provide products and services that customers want in a way that generates attractive financial returns for its shareholders. Companies do this in many different ways and with different degrees of success. Companies that are highly valued in the market are generally those which consistently invest their owners’ capital in economically productive ways, generating project IRRs above the cost of capital. This is not always the case, of course. Sometimes good companies screw up big time, and sometimes the stock market puts high valuations on companies that turn out to have offered a lot more sizzle than steak. But at some point, both companies and the stock market self-correct. CEOs get fired, companies change course, and high flying stocks plummet to earth. For a good example of this playing out in real time, see my recent post on current market valuations in the EV (Electric Vehicle) space.

Economic value added (EVA) is very much at the heart of corporate finance theory and practice and those of you who hope to do this work professionally must master the underlying concepts and methodologies. Rather than lay it out for you here—which would make this a very long note—I am instead going to refer you to two excellent books written by Tim Koller and his colleagues at McKinsey, which use EVA methodology to explore and explain real world business decisions at the intersections of corporate finance, business strategy and corporate governance.

The first book is called Value: The Four Cornerstones of Corporate Finance (2010). This is the shorter and less quantitative of the two books and it is a very quick read. In this book, the authors explain the concepts underlying EVA in a very intuitive way, without any math and with relatively little accounting. This is the book I use in my Financial Strategy/Policy courses for undergrads and MBA non-finance concentrators. Most of what is in this book is also covered in the second book, but many students find the fist book Value the more approachable of the two. I suggest that most of you start with Value and then move on to Valuation if you feel so inclined. (Those of you who are more advanced can skip right to Valuation.)

Those of you pursuing careers in corporate finance will at some point also want to read the second book, Valuation: Measuring and Managing the Value of Companies, Koller (7th edition 2020). This is the valuation “bible” used by many corporate finance professionals, now in its 7th edition, and I highly recommend it. Valuation covers the same ground as Value, but in a lot more detail and with a much more quantitative approach. Unlike many academic finance texts, this book is very practitioner oriented with little theory or math but lots of examples using real companies and real financial statement information. Those of you who are not yet proficient with financial statement analysis may find parts of this book hard going, but I encourage you to give it a try. [Note to those of you who have not yet taken Professor Agnew’s new Valuation course: You might want to read Value before taking her course and then Valuation afterwards. The text she uses in her course is also excellent and has many of the same strengths as Valuation, particularly in its use of real companies’ financial statement information.]

As you would expect from authors who work at McKinsey, both Value and Valuation link together the principles of corporate finance, strategy and governance in a way that most other finance and valuation books do not. These two McKinsey books really are “must reads” for those of you pursuing careers in corporate finance.

You can find these books for a very reasonable price on Amazon. You will want to read these books now (or soon) and keep them on the shelf for future reference. Here are the Amazon links:

Value: The Four Cornerstones of Finance (2010): https://smile.amazon.com/Value-Four-Cornerstones-Corporate-Finance-ebook/dp/B0047O2HLK/ref=sr_1_2?dchild=1&keywords=Koller+Value&qid=1624473742&sr=8-2

Valuation: Measuring and Managing the Value of Companies (7th ed. 2020): https://smile.amazon.com/Valuation-Measuring-Managing-Companies-Finance/dp/1119610885/ref=sr_1_1?dchild=1&keywords=Koller+Value&qid=1624473742&sr=8-1