International Journal of Finance and Accounting 2015, 4(1): 79-107

DOI: 10.5923/j.ijfa.20150401.08

A Cash-FLow Theory of Stock Valuation

Randa I. Sharafeddine

Finance Department, Lebanese International University, Lebanon

Abstract This article introduces a theory of stock valuation based on cash-flow analysis to price stocks, where the cash
receipts and the cash payments of the firm is projected for each time period for ever where a continuous adjustment of the
variables affecting the discounted present value of the cash-flow stream will show its effect on the value of the company’s
stock. Not only does this starting point by-pass certain measurement problems, but it also direct attention to the relevant
variables in a manner that other approaches may not. The financial manager is now required to generate a cash-flow net not
only to satisfy the explicit cost but also the implicit cost of the providers of funds in order to create value. And to determine
the optimal cash balance that minimizes the opportunity cost and maximizes shareholders’ wealth.
Keywords Invested Capital, Net Cash-flow, Shareholder Value Added, Economic Profit, Accounting Profit, Business
Profit, Pure Profit, Working Capital Requirements, Economic Value Added

This Cash Flow Concept of Stock valuation also implies

1. Purpose that a decision to undertake investment projects in the future
influences the value of the stock today. The stock value is
The purpose of this study is to show that the whole based entirely upon future cash flows, and it makes no
financial system is becoming a Cash-flow system where a difference whether the flows are expected in connection with
continuous adjustment of the variables affecting the a project that has already been undertaken or a project that is
discounted present value of the cash-flow stream will show going to be undertaken in the future. It makes no difference
its effect on the value of the company’s stock. Our Financial that is unless the cash flows associated with future projects
System would react to the cash-flow and corporation reacts are considered to be more risky than those associated with
to what investors react and vice versa. All investors operate current projects.
on time value of money. From here rises a cash flow As a financial manager in his decision making that would
concept of profit associated with the cash-flow theory of maximize the market value of its securities should respond to
stock valuation. the investor behaviour, who as a rational trader will manage
This theory of stock valuation is based on the assumption his economic asset so as to maximize the satisfaction he
that the cash receipts and the cash payments of the firm have derives from them. Under the article of Friedman and Savage
been projected for each time period for ever. So, we should “The Utility Analysis of Choices Involving Risk”, the
live day per day this reality in order to operate in the future. consumer unit will choose the income to which he attaches
And the whole financial system would become a the most utility. A rational investor will try to maximize the
Cash-flow system where a continuous adjustment on monetary value of the assets he owns. From this
hour per hour, day per day of the variables affecting the interpretation of income and value follow the broad outlines
discounted present value of the cash-flow stream will of modern financial theory. Investors will be faced with a
show its effect on the value of the company’s stock. trade-off between risk and return and as we don’t have
A careful definition of cash flows and a theory of stock homogeneous investors, their expectation may also vary
pricing based on cash-flow analysis is required because affecting the value of the stock in the firm. So, this trade off
previous discussions have been concerned with investment would become the central problem of Finance.
decisions rather than stock pricing. They have therefore been In the business we don’t talk anymore about net income
concerned with the cash flow associated with a particular but about net cash-flows. The concept of profit is different
investment project, rather than with the flows to the firm as a from the conventional concept called “Earnings”, the word
whole, and we must recognize the possibility that cash flows “profit” can be reversed for the cash flow concept. Earnings
generated by one project will be used to finance another of a period are associated with the difference between the
project. sales value and the cost of production of the goods sold
during the period. Earnings are not influenced by changed
* Corresponding author:
randa.sharafeddine@gmail.com (Randa Sharafeddine)
expectations about the future as profits are. There have been
Published online at http://journal.sapub.org/ijfa a number of attempts to test whether investors are myopic.
Copyright © 2015 Scientific & Academic Publishing. All Rights Reserved For example, McConnell and Muscarella examined the
80 Randa I. Sharafeddine: A Cash-Flow Theory of Stock Valuation

reaction of stock prices to announcements of capital subdivided.

expenditure plans. If investors were interested in short-term Though capital structure decisions are influenced by a
earnings, which are generally depressed by major capital firm’s ability to generate future cash flows, the
expenditure programs, then these announcements should theoretical literature has neglected the dynamic relation
depress stock prices. But they found that increases in capital between leverage and firm specific earnings behaviour.
spending were associated with increases in stock prices and HOWEVER, with the cash-flow theory of stock
reductions were associated with falls. Similarly, Jarrell, Lehn, valuation, under a theory of continuous time, we have
and Marr found that announcements of expended R&D adjustments in the business (capital) structure, policy
spending prompted arise in the stock price. See J. McConnell and optimality on hour per hour and day per day basis in
and C. Muscarella, “Corporate Capital Expenditure order to avoid the risk inherent in the capital structure of
Decisions and the Market Value of the Firm,” Journal of the business. We will use the article of Steven Raymar “A
Finanacial Economics, 14:399-422 (July 1985), and G. Model of Capital Structure when Earnings are
Jarrell, K. Lehn, and W. Marr, “Institutional Ownership, Mean-Reverting” to give a clear meaning to a theory of
Tender Offers, and Long-term Investments,” The Office of continuous time. Raymar assumes a linkage between firm
the Chief Economist, Securities and Exchange Commission value and earnings, which would affect the optimal
(April 1985). leverage decisions. So, leverage is reviewed and
Despite the fact that according to Modigliani and reoptimized every period and the variability of leverage is
Miller the value of the firm is determined on the positively related to variability in earnings and firm value.
left-hand side of the balance sheet by real assets and not EBIT follows an exogenous process that is unaffected by
by the proportions of debt and equity securities issued by leverage or default. Its parameters are such that the firm
the firm or its capital structure, this was subsequently never liquidates if optimal policies are followed. The
subjected to empirical testing by Durand and shown to autocorrelation between earnings at time t and t+1 is φ, if φ=0,
be invalid. So, according to MM a firm cannot change the earnings are serially independent, and as φ approaches 1 the
total value of its securities just by splitting its cash-flows into process tends toward a random walk, implication of the
different streams. Modigliani and Miller argued that the process is that, while a firm may experience a bad or a good
value of the firm is determined only by its basic earnings year over time, it is expected to revert to a normal
power and its business risk, so a firm’s basic resource is the performance level. An unlevered firm is valued as the
stream of cash-flows produced by its real assets and not by discounted sum of expected future after-tax earnings,
the securities it issues or on how this income is split between because stockholders receive the firm’s income stream in
dividends and retained earnings, when the firm is financed perpetuity, it must never be optimal for them to relinquish
entirely by common stock, all those cash-flows belong to the ownership, as it might be if income were negative, this would
stockholders, when the firm issues both debt and equity be optimal for stockholders to maintain the unlevered firm as
securities, the cash-flows is divided between debtholders and a going concern, given any feasible earnings realization.
stockholders. However, in our study we should state a When debt is introduced in the financing activities of the
linkage between firm value and earnings, which would corporation, the firm is assumed to issue single period debt
affect the optimal leverage decision. and to optimally recapitalize at each date.
Although the problem that confronts us can be approached As firm optimally and continuously recapitalize, under
in a variety of ways, our preference is to commence with net continuous time the focus is not on conflicts of interest
cash flows from operations and to consider the effect of among claimants, because debt has a one period maturity, the
additions to, and subtractions from, these flows upon stock optimal policy should maximize both equity and firm value,
values. Not only does this starting point by-pass certain so adjustments are made on daily basis and when earnings
measurement problems, but it also direct attention to the are low, a firm should optimally reduce its leverage ratio and
relevant variables in a manner that other approaches may not. debt level or otherwise said reducing its cost of capital and
Net cash-flows from operations are available for (1) the the earnings process permits one firm to be safer than another
payment of interest and principal on debt or the equivalent over a short horizon. At each date, the firm is recapitalized so
and (2) capital expenditures and dividend payments. as to maximize the wealth of current owners. This process is
Operating cash-flows can of course, be supplemented in any costless if the firm is solvent, but otherwise the transfer of
period by debt or equity financing. Debt financing creates ownership and control is assumed to induce bankruptcy
obligations to pay out cash in future periods and thereby reorganization costs and the model is unaffected as long as a
reduces cash flows available for capital expenditures and clear distinction between debt and equity remains. Default
dividends in those periods. Equity financing, in turn that caused liquidation in the past is now resulting in an
diminishes the pro rata share of total cash-flows available for optimal reorganization. Since an optimal debt decision
dividends and reinvestment. The issue becomes one of needs to consider only the future cash-flows of the firm
dividing the stream of operating cash-flows among debt, and is independent of past earnings and debt levels. Then
dividends and reinvestment and it may no longer be feasible a change in the autocorrelation between earnings at time
to assume that the size and shape of the stream of operating t and t+1, also affects future debt decisions and firm
cash-flows is independent of the manner in which it is values. From here rises a cash-flow concept of profit
 International Journal of Finance and Accounting 2015, 4(1): 79-107 81

associated with the cash-flow theory of stock value. company at this point is just Io. Suppose Io is invested in a
project of limited life, terminating in some period t = t*.
It is assumed that cash returns to this investment are paid
2. The Notion of Income and Wealth to the shareholders as dividends, and that i is constant over
time.
Under the notion of income, we will differentiate between If the investment will earn a rate of return greater than i,
Income and wealth. We will start by giving the broad then Vo>Io, and there is an immediate increase in the value of
outlines of modern financial theory that follow from the the company’s stock as soon as the company is committed to
interpretations of income and value; we must look at income the investment. This increase in value represents income.
from the shareholders’ point of view, since the criterion is The income in year zero, Yo, would be given by Vo–Io, or,
the maximization of the present value of a share of stock to since Io is a negative cash flow, Vo +Fo. This income is
present stockholders. a ”Windfall gain,” which accrues to the owners of the firm as
I will also try to show in this part that the discounted a result of their being able to invest in a project that is more
present value DPV approach to value and income is one facet profitable than the standard market rate.
of a more general theory of the valuation of shares in the Once the windfall gain is realized through the increase in
market where value is determined by the DPV approach value of the owners’ stock, income will continue to be
which is the preferable after establishing that different ways realized at a rate of exactly i on the value of their equity for
of looking at income and wealth result in substantially the remainder of the project’s life. It follows from the
different ways of reporting the results of a given investment discounted present value (DPV) definition of wealth that the
and cash-flow pattern. income of any period j is the net cash flow Fj plus the
Income from the point of view of the shareholders of the appreciation (or minus the depreciation) in value during the
firm may be defined as the increment in the shareholders’ period.
personal wealth as a result of their ownership of the firm’s Now, a necessary condition for capital market equilibrium
stock over a specified period. is that the company earn at a rate just equal to i once the
To trace out the implications of this definition, suppose a windfall gains have been realized.
group of investors contributes a total of Io dollars for N The DPV approach to value and income is one facet of a
shares of stock of some corporation. The total value of the more general theory of the valuation of shares in the market.

A. Accounting Income Statements

t=0 t=1 t=2 t = t*= 3
Revenues 0 75.000 200.000 170.000
Expenses before
0 60.000 105.000 80.000
Depreciation
Gross income 0 15.000 95.000 90.000
Depreciation 0 20.000 20.000 20.000
Net income (loss) 0 (5.000) 75.000 70.000
Taxes (50% rate) 0 0 35.000 35.000
Net income (loss)
after taxesª 0 (5.000) 40.000 35.000
B. Funds Flow Statements
t=0 t=1 t=2 t = t*= 3
b
Funds from operations 15.000 60.000 55.000
Less: investment in
Fixed assets - 60.000
Less : investment in
Working capital© - 40.000 + 10.000 - 15.000 + 45.000
Net cash flow - 100.000 + 25.000 + 45.000 + 100.000

a
Net of tax carry forward from loss in t = 1.
b
That is, revenues minus expenses requiring funds or, equivalently, net income plus depreciation.
c A negative sign denotes an addition to working capital, a positive sign a reduction.
82 Randa I. Sharafeddine: A Cash-Flow Theory of Stock Valuation

And the development of the central idea underlies a large Assume Io consists of a total outlay of $100,000, $60,000
part of this volume. Our position is that the objective of of this for equipment (depreciated on a straight line basis)
financial management should be to maximize the value of and $40,000 for working capital. The investment project will
the company to present shareholders. last three years, i.e., t* = 3. The tables above labelled A and
In any case where value is determined by the DPV B show accounting income and funds flow for the project. It
approach, the DPV notion of income is clearly the is again assumed that cash returns on this investment are paid
appropriate one. We should however, establish that out to stockholders and not reinvested in the firm; also, the
different ways of looking at income and wealth result in discount rate is set at i = 0.10 or 10%.
substantially different ways of reporting the results of a We can solve by using the following equation to obtain r =
given investment and cash-flow pattern. One such 0.25 or IRR = 25%
divergent method is the accounting process except to remark
that basing income on historical data rather than expectations
∞
Ft
is antipodal to the notion of DPV- based income.
=PV ∑
=
t
0
t = 0 (1 + r)
Another way in which wealth as monetary value can be
viewed, which has a certain common-sense appeal, is based Now, the table below sets out the figures obtained for
on the internal rate of return (IRR) basis for evaluating income and wealth in period zero to period three, by
profitability. This method defines wealth as applying the DPV, IRR, and accounting approaches. The
"owner-contributed funds plus the return on these funds DPV approach gives a windfall gain in t = 0 of $35,049
as the internal rate of return less withdrawal." (later in my paper called pure profit); neither of the
Specifically, for the same hypothetical company investing Io, other approaches indicates that any income is realized
assume that the return on this investment will be r> i. during this period. Wealth, at the end of t = 0, is $135,049
Rather than working through all the implications of where the DPV method is used, and $100,000 in each of the
this notion formally, we will present a more or less other cases. (Wealth is Vj in the DPV method, Ij in the IRR
realistic example of how the different interpretations of method, and the book value of equity in the accounting
income would work out if applied to a hypothetical method).
investment project.

Reported Income and Wealth

Period Item DPVa IRRb accounting
0 Initial investment 100.000 100.000 100.000
Windfall gain income 35.049
Total wealtho 135.049 100.000 100.000
1 Income for period 1 13.505 25.000 (5.000)
Wealth before cash
Distribution 148.554 125.000 95.000
Cash distribution 25.000 25.000 25.000
Total wealth 123.554 100.000 70.000
2 Income for period 2 12.355 25.000 40.000
Wealth before cash
Distribution 135.909 125.000 110.000
Cash distribution 45.000 45.000 45.000
Total wealth 90.909 80.000 65.000
3 Income for period 3 9.091 20.000 35.000
Wealth before cash
Distribution 100.000 100.000 100.000
Cash distribution 100.000 100.000 100.000
Wealth 0 0 0

a DPV = “discounted present value” basis.

b IRR = “internal rate of return” basis.
c “Wealth” is wealth remaining in the firm at the end of the period. The term has nothing to do with stockholders' personal wealth.
 International Journal of Finance and Accounting 2015, 4(1): 79-107 83

Hint: Windfall gain income is the pure profit, I would The accounting approach warns of a substantial loss in
explain it below under the concept of profit. period 1, the accounting figures indicate substantially
For the DPV method, the reported income in period 1 is higher income in later periods.
$23,505 which is 10 per cent of the wealth at the beginning HINT: Under the DPV approach as more and more of
of that period. Since $25,000 is paid out to the shareholders, the project’s returns are paid out, the value of the stock
the value at the end of period 1 must be less than at the end of declines, and consequently the income earned by the firm
period 0, that is, $ 123,554 is less than $135,049. The income declines (even though the stockholders’ personal wealth
in period 2 is 10 per cent of $123,554 and so on. may be continually increasing). Income figures obtained
Under the IRR approach, the wealth at the beginning of by other methods, however, do not follow this pattern
period 1 is $100,000, since the actual increase in the and as a consequence, are not related in any simple way
stockholders’ value is not reported. Income in this period is to the value of the firm’s stock.
figured at 25 per cent of wealth, or $25,000. By chance, The table below summarizes the income reported by
exactly this amount is paid out. Income in period 2 is 25 per the three methods. It will be noted that the total income
cent of the remaining wealth, again $25,000, but in this case reported over the three-year period is the same in every
$45,000 is paid out, leaving a smaller base for period 3 case only the timing of the reported income differs.
income.

Results of Applying Different Notions of Income

t=0 t=1 t=2 t = t* = 3 Total
IRR basis 0 25.000 25.000 20.000 70.000
Accounting basis 0 (5.000) 40.000 35.000 70.000
DPV Basis :
Windfall gain 35.049 35.049
Ordinary income 0 13.505 12.355 9.091 34.951
Total 35.049 13.505 12.355 9.091 70.000

This is not to say that alternate concepts of income

D1 + P1
may not be useful or necessary or both, but we must look Po =
at income from the shareholders’ point of view. This is (1 + K )
the basic reason why the DPV approach is preferable.
Second:
Assume that additional capital investment will be made at
3. A Theory of Cash-Flow time one, but that all earnings will be paid out as dividends
after that time. Then the value of a share of stock at time one
The Link between Stock Price and Net Cash-Flow: is:
A Cash-flow theory says that the value of the stock is the P1 = V 1 / n + m (Equation 1)
present value of the future net cash flows. And this Net
V1 is the value of the firm at time one
Cash-Flow is the cash-flow between the firm and its
n is the number of shares outstanding at time zero
stockholders. A positive net cash-flow represents a cash
m is the number of shares that must be issued at time one
payment by the firm to the stockholders, while a negative net
to raise capital for predetermined new investments.
cash-flow represents a cash payment by the stockholders to
Then:
the firm.
Y1 + mP1 = I1 + n D1 (Equation 2)
Example 1
I1 is the amount of new equity required for capital
Before going further in explaining the concept of investment at time one, so I1 = mP1, is a flow of cash from
“Cash-Flow Concept of Stock Valuation”, I would like to the stockholders to the firm.
introduce a small example related to “Dividend Policy and Y1 is the amount of income at time one, and as all earnings
Value” where I would show that the total value of the are paid as dividends, so Y1 = n D1, is a flow of cash from
company depend on the Net Cash-flow between the firm and the firm to the stockholders.
its stockholders and not on dividend : Then,
First: (Eq.2) mP1 = I1 + nD1 – Y1
We already know that the value of a share of stock is (Eq.1) nP1 + P1m = V1
established as the present value of all future dividends: If we substitute eq. 2 in eq. 1 we have the following:
84 Randa I. Sharafeddine: A Cash-Flow Theory of Stock Valuation

nP1 + (I1 + nD1 – Y1) = V1 DIV1 EPS1

=r =
nP1 + nD1 = V1 – I1 + Y1This equivalent to say P1 = [(V1 – Po Po
I1 + Y1) / n] – D1 10.00
Substituting P1 in the following Equation: Po = (P1 + D1) / = = .10
100
1+K
The price equals
Po = 【 [(V1 –I1 + Y1) / n] – D1 + D1】/ 1 + K
Simplifying Po = [(V1 – I1 + Y1) / n] / 1 + K Po= DIV1 = EPS1 = 10.00 = 100
V1 is the present value at time one, predetermined set of r r 0.1
investment.
I1 is the amount of new equity required for capital The expected return for growing firms can also equal the
investment at time one, a flow of cash from the stockholders earnings-price ratio. The key is whether earnings are
to the firm. A negative sign. reinvested to provide a return greater or less than the market
Y1 is the amount of income available at time one, a flow of capitalization rate. For example, suppose our monotonous
cash from the firm to the stockholders. A positive sign. company suddenly hears of an opportunity to invest $10 a
n is the number of shares outstanding at time zero. share next year. This would mean no dividend at t=1.
K is the required return for investment of this risk level. However, the company expects that in each subsequent year
The important thing to note is that dividends have the project would earn $1 per share, so that the dividend
disappeared ; the value of a share of stock have been defined could be increased to $11 a share.
by the net cash-flows determined as the flows between the Let us assume that this investment opportunity has about
firm and its stockholders, and that the Gordon Model used the same risk as the existing business. Then we can discount
to find the value of a constant growth stock has become a its cash flow at the 10 percent rate to find its net present value
cash-Flow theory of stock valuation. at year 1:
These flows are not changed by the decision to finance
internally or to issue new stock. If the stockholders receive a 1
Net present value per share at year 1 = -10 + =0
dividend of $1 million, this is a net cash-flow of plus $1 .10
million. If $1 million of new stock is sold, this is a net cash = - Io + Yo = 0
flow of minus $1 million. If both transactions take place in
the same period, the net cash-flow is the sum of the two, or What effect will the decision to undertake the project have
zero. This is exactly what the net cash-flow would be if no on the company’s share price? Clearly none.
dividends were paid, no new stock was issued, and the This could be explained in two different ways:
project was financed internally.
First: Trough a Link between stock price and Net
From here rises the cash-flow profit of stock valuation
Cash-Flows
defined as the increase (decrease) in the stock value V1 plus
Second: Trough a Link between stock price and Earnings
the net cash-flow for the period (-I1 + Y1).
First: To explain the effect of the investment on the
Example 2 valuation of the firm according to the Net Cash-Flow Theory
Let us take another example to clarify and stress the cash defined as the cash-flows between the firm and its
flow concept of stock valuation, and let us make a shift from stockholders for the period (- Io + Yo).
what was traditionally acceptable, “link between stock price 1
In our equation: NPV = -10 + =0
and earnings “to “a link between stock price and 0.1
cash-flows”. Io = -10
This example is from the book of Brealy and Myers titled
“Principles of Corporate Finance” chapter four. is the capital investment to undertake the project, a flow of
Imagine the case of a company that does no grow at all. It cash from the stockholders to the firm, a negative sign.
does not plow back any earnings and simply produces a
1
constant stream of dividends. Its stock would be rather like Yo =
the perpetual bond and the return on perpetuity is equal to the 0.1
yearly cash-flow divided by the present value. The expected is the amount of income the project would earn at time one
return on our share would thus be equal to the yearly discounted to time zero, a flow of cash from the firm to the
dividend divided by the share price (i.e., the dividend yield). stockholders, a positive sign.
Since all the earnings are paid out as dividend, the expected The Net Cash-Flow is the sum of the two, or zero, this is
return is also equal to the earnings per share divided by the exactly what will be the effect on the stock valuation.
share price (i.e., the earnings-price ratio). For example, if the Second: To explain the effect of the investment on the
dividend is $10 a share and the stock price is $ 100, we have: value of the firm according to the Earnings valuation.
Expected return = Dividend yield = Earnings-price ratio Brealy and Myers in their book said:
 International Journal of Finance and Accounting 2015, 4(1): 79-107 85

The investment opportunity will make no contribution to project. Note that the earnings-price ratio, measured in terms
the company’s value because its prospective return is equal of EPS1, next year’s expected earnings, equals the market
to the opportunity cost of capital. The reduction in value capitalization rate r only when the new project’s NPV = 0.
caused by the nil dividends in year one is exactly offset by This is an extremely important point; managers
the increase in value caused by the extra dividends in later frequently make poor financial decisions because they
years. Therefore, once again the market capitalization rate confuse earnings-price ratios with the market
equals the earnings-price ratio: capitalization rate.
Effects on stock price of investing an additional $10 in
EPS1 10
=r = = 0.10 year 1 at different rates of return. Notice that the
Po 100 earnings-price ratio overestimates r when the project has
The table below repeats our example for different negative NPV and underestimates it when the project has
assumptions about the cash-flow generated by the new positive NPV.

Project's Impact

Project Rate of Incremental Project NPV in on Share Price in Share Price in EPS1
r
Return Cash Flow, C Year 1* Year Ot Year O, Po Po
.05 S.50 - $ 5.00 - $ 4.55 S 95.45 .105 .10
.10 1.00 0 0 100.00 .10 .10
.15 1.50 + 5.00 + 4.55 104.55 .096 .10
.20 2.00 + 10.00 + 9.09 109.09 .092 .10
.25 2.50 + 15.00 + 13.64 113.64 .088 .10

In our last example both dividends and earnings were In a world of certainty it would be unprofitable for a
expected to grow at 10 percent, but this growth made no firm to hold cash. Any cash not needed immediately to
net contribution to the stock price. Be careful not to make payments would be lent at interest, as liquidity is
equate firm performance with the growth in earnings per worthless if all future cash needs can be perfectly foreseen,
share. A company that reinvests earnings at below the and there are no flotation costs associated with lending,
market capitalizations rate may increase earnings but borrowing or repaying money. In the presence of
will certainly reduce the share value. uncertainty, cash balances are held because they provide
In general, Brealy and Myers said in their book “Principle liquidity. In principle, the decision to purchase liquidity by
of Corporate Finance” That we can think of stock price as the increasing cash balances or to sell liquidity by reducing cash
capitalized value of average earnings under a no-growth balances should be analysed in the same way any other
policy, plus PVGO, the present value of growth investment decision is analysed. An increase in cash
opportunities: balances is therefore considered as a purchase of liquidity
EPS1 and is defined as a cash payment. A reduction in cash
Po = + PVGO balances is a sale of liquidity and is defined as a cash receipt.
r If a firm receives cash from the sale of a product and
The important thing to note here is that: increases its bank balance, this involves both a cash receipt
The first part of the equation is nothing than the and a cash payment, so that the net cash flow is zero.
discounted cash balance (V1) which will give its effect on Subsequently, when the firm reduces its bank balance to pay
the value of the stock. wages, this is again both a cash receipt and a cash payment,
The second components (PVGO) is nothing then the with a net cash-flow of zero The net cash-flow in any period
pure profit defined as the return in excess of the normal therefore is the difference between cash received by the firm
discount rate on invested capital (-Io + Y1). from purchasers, debtors, or banks, and the cash used by the
So, under the Cash-Flow Theory of Stock Valuation, firm to increase cash balances, to pay for goods and services,
the price of the stock is determined by two components: to pay interest or repay debt, or to lend and such flows must
The First Component: be associated with equity valuation.
The first component is the present value of the future net We could exclude all dealings in the firm’s financial
cash-flows. Where management should project the future obligations from the cash receipts and payments. The
cash receipts and cash payments of the firm with various net-cash flow would then include transactions with
cash balances, subtract the payment from the receipts to debtholders as well as stockholders. The present value of
determine net cash-flows, and then select that cash balance the net cash flows would be the total value of all the
(i.e., purchase that amount of liquidity) which maximizes the firm’s financial obligations, and the value of the stock
present value of the net cash flows. would be the total value of the obligations less the value
86 Randa I. Sharafeddine: A Cash-Flow Theory of Stock Valuation

of the debt. And this would provide the justification for 15 percent, the company is expected to pay a dividend of $5
the treatment of cash balances. cash balances are held in the first year, and thereafter the dividend is predicted to
because they provide liquidity. In principle, the decision increase indefinitely by 10 percent a year. We can therefore,
to purchase liquidity by increasing cash balances or to use the simplified constant-growth formula to work out
sell liquidity by reducing cash balances should be Fledging’s price:
analysed in the same way any other (investment) decision
DIV1 5
is analysed. Po
= = = $ 100
HINT: Management should project the future cash r − g 15 − .10
receipts and cash payments of the firm with various cash Suppose that fledging has earnings per share of $8.33. Its
balances, subtract the payments from the receipts to payout ratio is then
determine net cash-flows, and then select that cash
balances (i.e., purchase that amount of liquidity) which DIV1 5.00
 Payout
= = = .6
maximizes the present value of the net cash flow. EPS1 8.33
The net cash flow in any period therefore is the difference
In other words, the company is plowing back 1 - 0.6, or 40
between cash received by the firm from purchasers, debtors,
percent of earnings. Suppose also that Fledging’ ratio of
or banks, and the cash used by the firm to increase cash
earnings to book equity is ROE = 0.25.This explains the
balances, to pay for goods and services, to pay interest or
growth rate of 10 percent:
repay debt, or to lend. Such flows must be associated with
equity obligations, i.e., the net cash flow is the cash flow Growth rate = g = plowback ratio × ROE =.4 ×.25 =.10
between the firm and its stockholders. A positive net cash The capitalized value of Fledging’ earnings per share
flow represents a cash payment by the firm to the would be
stockholders, i.e., a dividend payment or a stock
repurchase, while a negative net cash flow represents a EPS1 8.33
  = = $ 55.56
cash payment by the stockholders to the firm, i.e., a new r .15
stock subscription. But we know that the value of Fledging stock is $100. So,
The associated theory of stock valuation is based on the the question we can raise is, why investors are paying the
assumption that the cash receipts and the cash payments of difference of $44,44 per share. Let’s see if we can explain
the firm have been projected for each time period for ever. that figure:
We assume that there are no transaction or flotation costs, or Each year Fledging plows back 40 percent of its earnings
any costs other than interest (or dividends) involved in into new assets. In the first year Fledging invests $3,33 at a
borrowing or repaying money, or in buying or selling permanent 25 percent return on equity. Thus the cash
financial obligations. We also assume that stockholders are generated by this investment is 0.25 x 3,33 = $.83 per year
indifferent between capital gains and dividend income, so starting at t = 2. The net present value of the investment as of
that we would ignore problems which arise because of the t = 1 is
different taxes on income and capital gains. The net
cash-flow would then include transactions with debtholders .83
NPV1 = - 3.33 +   = $ 2.22
as well stockholders. The present value of the net cash flows .15
would be the total value of all the firm’s financial obligations, Everything is the same in year 2 except that Fledging will
and the value of the stock would be the total value of the invest $3,67, 10 percent more than in year 1 (remember g
obligations less the value of the debt. So, that the present =.10). Therefore at t = 2 an investment is made
value of the net cash flows is the value of the stock.
.83
Since the peculiar treatment of cash balances does not arise NPV2 = - 3.33 × 1.10 +   = $ 2.44
in evaluating any decision except the decision about the level .15
of cash balances themselves, our treatment of cash balances These are the forecasted future cash-flow growing at 10
does not impair the usefulness of the cash-flow concept in percent per year, to calculate their present value we use the
investment decisions, but adds to its usefulness in stock simplified DCF formula,
valuation.
The associated theory of stock valuation is based on Present value of growth opportunities = PVGO
the assumption that the cash receipts and the cash NPV1 = 2.22 = $ 44.44
payments of the firm have been projected for each time =    
r − g. 15 − .10
period for ever.
The Second Component: Now everything checks:
The second component of the equation in order to be Share price = present value of level stream of earnings
explained let us take an example of PVGO and link it to the + present value of growth opportunities
cash flow concept of stock valuation. Let us turn to a EPS1
=   + PVGO
well-known company, Fledging Electronics, Where its r, is r
 International Journal of Finance and Accounting 2015, 4(1): 79-107 87

Then, Po = $55.56 + $44.44 = $100 to pay out cash in future periods and thereby reduces cash
Why is Fledging Electronics a growth stock? Not because flows available for capital expenditures and dividend in
it is expanding at 10 percent per year. It is a growth stock those periods. Equity financing in turn, diminishes the pro
because the net present value of its future investments rata share of total cash-flows available for dividends and
accounts for a significant fraction (about 44 percent) of reinvestment.
the stock’s price. Before the thrust shifted to dividends, the basic issue in the
Here we have used the NPV to calculate this fraction of cost of capital discussion was one of dividing the stream of
the stock’s price linked to the future cash-flow generated by operating cash-flows between debt and equity in such a
the future investments of the firm. manner as to maximize the market value of the enterprise. In
Stock prices today reflect investors’ expectations of future an analogy to cost of capital, and when dividends enter the
operating and investment performance. Growth stocks sell at picture, the issue becomes one of dividing the stream of
high price-earnings ratios because investors are willing to operating cash-flows among debt, dividends and
pay now for expected superior returns on investments that reinvestment in such a way as to achieve the same result. The
have not yet been made. Michael Eisner, the chairman of principal difference in the character of the analysis is that it
Walt Disney Productions, made the point this way: “In may no longer be feasible to assume that the size and shape
school you had to take the test and then be graded. Now of the stream of operating cash-flows is independent of the
we’re getting graded, and we haven’t taken the test. manner in which it is subdivided.
“This was in late 1985, when Disney stock was selling at Much the same as contractual interest payments and other
nearly 20 times earnings. See Kathleen K. Weigner. “The financial outlays, the continuation of cash dividends at their
Tinker Bell Principle,” Forbes, December 2, 1985, p. 102. prevailing rate is assigned a priority by management. In such
So, our second components - PVGO - is nothing then instances, the burden of oscillations in operating cash-flows
the pure profit or the concept of profit defined as the is placed upon lower-priority outlays, namely capital and
return in excess of the normal (discount rate) on invested related expenditures, unless management is both willing and
capital. Cash-flow theory says that all pure profit is able to compensate by adjusting the level of external
earned when the stock value makes a change that had not financing. Even if management is willing to seek funds
been anticipated by the market. The market value of the outside the firm, the uncertainties inherent in the terms under
stock is always determined in such a way that the expected which external financing can be obtained in the future reduce
return, net cash-flow (dividends) plus capital gains, is the the likelihood of such action in the event of operating cash
normal return on the market value at the start of the period. If deficiencies in any period. The reason is that current cash
all goes as expected, the actual return, business profit, will be dividends may well be capitalized somewhat differently
the expected normal return, and pure profit will be zero. If from anticipated future cash-flows.
expectation changes, a pure profit or loss is made It may be observed that the relative instability of
immediately as the stock price makes an unexpected expenditures designed to augment future cash-flows shows
adjustment so that the newly expected future returns will up even in the aggregate. The change from year to year for
equal a normal return on the new stock value (investment). new plant and equipment averaged 19 percent for all
manufacturing corporations in the post period to 1961, as
compared with 9 percent for cash dividends. The maximum
4. The Cash-Flow Concept of Dividend declines from one year to the next were 40 percent for new
Policy plant and equipment and but 2 percent for dividends.
Again, as in the case of debt versus equity, investor
Although the problem of dividends were approached in a reactions to dividend policy changes can nullify in whole or
variety of ways, our preference said James E. Walter in his in part their price effect. Whenever the stockholder is
article on “Dividend policy and its influence on the value of dissatisfied with the dividend payout, the balance between
the enterprise ” is to commence with net cash flows from present and future income can be redressed by buying or
operations and to consider the effect of additions to, and selling shares of stock and perhaps by other means as well.
subtractions from, these flows upon stock values. Not only for instance, by “lending” or “borrowing” on the same risk
does this starting point by pass certain measurement terms that cash dividends are paid. If dividends are deemed
problems, but it also directs attention to the relevant insufficient, the desired proportion of current income can be
variables in a manner that other approaches may not. The obtained by periodically selling part of the shares owned. If
question is whether dividends are in some sense of the word current income is too high, cash dividends can be used to
weighted differently from retained earnings at the margin in acquire additional shares of stock. The one thing that
the minds of marginal investors. shareholders cannot do through their purchase and sale
Net cash-flows from operations are available for (1) the transactions is to negate the consequences of investment
payment of interest and principal on debt or the equivalent decisions by management. If, as may well be the case,
and (2) capital expenditures and dividend payments. investment decisions tend to be linked with dividend policy,
Operating cash flows can be supplemented in any period by their neglect in the analysis of dividend effects seems
debt or equity financing. Debt financing creates obligations inappropriate.
88 Randa I. Sharafeddine: A Cash-Flow Theory of Stock Valuation

The conditions for no dividend effect under which rise to a new and different equilibrium point. The fact that the
changes in dividend payout have minimal influence upon substitutions of future cash-flows for present dividends
stock values can now be stated. For the most part, they superimposes an element of market risk upon the basic
follow from the logics of stream-splitting: uncertainty of the operating cash-flow stream. As contrasted
The level of future cash-flows from operations, that is the with cash dividends in which the stockholder receives a
growth rate, is independent of the dividend-payout policy. In dollar for each dollar declared, there is no telling what price
essence, this condition implies that the impact of a change in the shareholder will realize in the market at any given time
dividend payout upon operating cash-flows will be exactly for his stake in future cash-flows. From here rises the need
offset (or negated) by a corresponding and opposite change for a theory of stock pricing based on cash-flow analysis.
in supplemental (or external) financing. An increase in A recent article by John Lintner, concludes that
dividends can be offset only by the sale of equity shares. So, “generalized uncertainty “ is itself sufficient to insure that
an increase in dividend payout will leave operating shareholders will not be indifferent to whether cash
cash-flows unchanged in the aggregate, but the share of dividends are increased or reduced by substituting new
future cash-flows accruing to existing stockholders will equity issues for retained earnings to finance given capital
decline, since additional stock has to be sold to finance the budgets.
planned capital outlays. The existing shareholder can, of The frequently observed association between
course, reconstitute his former pro rata position by dividend-payout policy, capital structure, and rate of growth
purchasing shares in the market with his incremental is a useful case in point. The survival of the corporation
dividends. ordinarily does not depend; in the short run at least, upon any
Implicit in these remarks is the presumption that the specific rate of growth. The prime considerations affecting
market completely capitalizes anticipated growth in growth, apart from profit opportunities, are (1) the
operating cash-flows. New shares are thus acquired at a willingness of corporations to go into the public market place
price that returns new investors only the going market rate for additional funds and (2) their attitude toward dividends,
for the relevant class risks. The present value of including their willingness to return unneeded funds to the
extraordinary returns from investment by the corporation investors.
goes to existing stockholders, rather than to new For firms that are reluctant to get involved in external
shareholders. To the degree that the anticipated level of financing, and there appear to be many, then the burden of
operating cash-flows, that is, the growth rate, is connected expansion rests upon residual internal sources, that is,
with the dividend payout for one reason or another, the operating cash-flows less cash dividends and debt servicing
market value of the firm may be conditioned by variations in net of additions to debt. Decisions to increase or decrease
dividend payout. The policy changes may be unexpected, dividends thus condition the value of the enterprise as long as
and their price effect lies at least upon the relation between the returns on new investments differ from the market rate.
the internal and market rates of return. If the former exceeds Whenever the available investment opportunities are unable
the latter, the present value of a dollar employed by the firm to earn their keep, the specter of liquidating, dividends or
(other things being equal) will be greater than a dollar of repurchase of shares or debt retirement arises. If there is no
dividends distributed and invested elsewhere. This issue was debt outstanding and if the repurchase of shares is not
considered in 1956 paper by James E. Walter. From here contemplated, the burden of liquidation falls upon dividend
rises a Cash-Flow Concept of Stock Valuation where the payout.
value of the stock is the present value of the future net So, we can conclude that we should have a look not on the
cash-flows. And this Net Cash-Flow is the cash-flow dividend effect on the value of the enterprise but on the effect
between the firm and its stockholders; a positive net of cash-flow from operation on stock valuation, because and
cash-flow represents a cash payment by the firm to the if the change in the level (increase or decrease) of dividend
stockholders, while a negative net cash-flow represents a would affect the future cash-flow from operation not
cash payment by the stockholders to the firm. The question necessary on the aggregate, but on the share of future
that arises here is, do the weights employed or in other words, cash-flows accruing to existing stockholders. This must have
the discount factors, independent of the dividend-payout its effect on the value of the stock and indirectly we should
policy? Provided that the system of weights remains discount the (decrease - increase) in the cash-flow from
unchanged, a change in current cash dividends will alter the operation and compare it to the discounted (decrease or
stockholder’s stake in future cash-flows. increase) in cash dividend, and find out the net effect on the
According to the question of the independence of the price of the stock. This would bring us back to our definition
weights used from the dividend-payout policy, a change in of the cash-flow concept of stock valuation where the net
dividend payout undoubtedly disturbs the investors in that cash-flow when discounted will have its effect positively or
stock to some extent unless the modification was anticipated negatively on the value of the enterprise and this Net
previously. Insofar as costs of one kind or another and other Cash-flow is nothing than the flow of cash between the firm
factors prevent the shareholders thus activated from and its stockholders.
completely reconstituting their old position and thereby give
 International Journal of Finance and Accounting 2015, 4(1): 79-107 89

5. The Cash-flow Concept of Stock and accounting purposes, these costs will be depreciated on a
Valuation and the Cost of Capital straight-line basis over three years. (Annual depreciation will
be $200,000 per year at t = 1, 2, and 3.)
To solve the problem of the calculation of the cost of At the end of three years, the company will get out of the
capital or the cost of equity or the required rate of return by business and will sell the fixed assets at a salvage value of
the shareholders or the implicit cost. Let us have a look on $100,000.
the benefit of the net cash-flow. The project will require a $50,000 increase in net
We would show in this part that depreciation and implicit operating working capital at t = 0, which will be recovered at
cost need not be considered since they don’t give rise to t = 3.
cash-flows. Cash-flow analysis accounts for these costs The company’s marginal tax rate is 35 percent.
much more simply, by charging the cost as a cash payment The new business is expected to generate $2 million in
when the asset is bought. sales each year (at t = 1, 2, and 3). The operating costs
Calculating Project NPV: excluding depreciation are expected to be $1.4 million per
year.
Maple Media is considering a proposal to enter a new line
The project’s cost of capital is 12 percent.
of business. In reviewing the proposal, the company’s CFO
What is the project’s net present value (NPV)?
is considering the following facts:
Solution:
The new business will require the company to purchase
additional fixed assets that will cost $600,000 at t = 0. For tax

New project NPV

0 1 2 3
Equipment purchase -$600,000
NOWC -50,000

Sales increase $2,000,000 $2,000,000 $2,000,000

Operating costs 1,400,000 1,400,000 1,400,000
Operating income $ 600,000 $ 600,000 $ 600,000
Depreciation 200,000 200,000 200,000
EBIT $ 400,000 $ 400,000 $ 400,000
Taxes (35%) 140,000 140,000 140,000
EBIT(1 - T) $ 260,000 $ 260,000 $ 260,000
+Depreciation 200,000 200,000 200,000
Operating cash flow $ 460,000 $ 460,000 $ 460,000
Recovery of NOWC 50,000
Equipment sale +100,000
Taxes on sale _______ ________ ________ -35,000
Net CF -$650,000 $ 460,000 $ 460,000 $ 575,000

NPV = -$650,000 + $460,000/1.12 + $460,000/(1.12)2 + $510,000/(1.12)3

= -$650,000 + $410,714.29 + $366,709.18 + $363,007.9264
= $490,431.3964 ≈ $490,431

Let us now calculate the Economic profit. Then calculate We conclude that the discounted economic profit is equal
the discounted present value of the economic profit: to the discounted cash-flow or the Net Present Value (NPV).
The important thing to notice is that Depreciation and
Economic profit = Earnings – Cost of equity implicit interest need not be considered since they do not
Hint: Equity is decreased every year by the depreciation give rise to cash flows. Cash-flow analysis accounts for these
Year 1 = $260 000 – ($650 000 x 12%) = $182 000 costs much more simply by charging the cost as a cash
Year 2 = $260 000 – ($450 000 x 12%) = $206 000 payment when the asset is bought.
Year 3 = $260 000 – ($250 000 x 12%) = $230 000 This come to emphasize what have been already
challenged by Professors Biddle, Bowen, and Wallace in
PV of Economic profit = $182 000/ 1.12 + $206 000 / their article “EVA and its Critics” in the Journal of Applied
(1.12)2 + $230 000 / (1.12)3 Corporate Finance, Summer 1999.Where they argue that
= $490 431.39 ≈ $490 431 Cash-flow from operations, accruals and interest expense,
are already included in the profits numbers that companies
90 Randa I. Sharafeddine: A Cash-Flow Theory of Stock Valuation

are required to disclose in their annual reports. The question EBIT follows an exogenous process that is unaffected by
is whether or not the two elements not explicitly included in leverage or default. Its parameters are such that the firm
mandated disclosures, the capital charges and accounting never liquidates if optimal policies are followed. The
adjustments are significantly related to stock prices. autocorrelation between earnings at time t and t+1 is φ, if φ=0,
Unhappily the answer is NO. They show that while the earnings are serially independent, and as φ approaches 1 the
cash-flow and actual components are consistently significant, process tends toward a random walk, implication of the
the components unique to EVA are not. process is that, while a firm may experience a bad or a good
In our example we excluded the salvage value. What about year, over time it is expected to revert to a normal
if we add the salvage value to our calculation: performance level. An unlevered firm is valued as the
NPV = -$650,000 + $460,000/1.12 + $460,000/(1.12)2 discounted sum of expected future after-tax earnings,
+ $575,000/(1.12)3 because stockholders receive the firm’s income stream in
= -$650,000+$410,714.29+$366,709.18 + $409,273.64 perpetuity, it must never be optimal for them to relinquish
= $536,697.11 ≈ $536,697. ownership, as it might be if income were negative, this would
be optimal for stockholders to maintain the unlevered firm as
Under the discounted economic profit we consider the a going concern, given any feasible earnings realization.
salvage value as a cash payment from the firm to the When debt is introduced in the financing activities of the
shareholders and in our case it is equal to: corporation, the firm is assumed to issue single period debt
Equipment sale $ 100 000 and to optimally recapitalize at each date.
Taxes on sale $ (35 000) As firm optimally and continuously recapitalize, under
continuous time the focus is not on conflicts of interest
PV (Economic profit) = $182000/1.12+ $206 000 /(1.12)2 among claimants, because debt has a one period maturity, the
+ $230 000 /(1.12)3 + $ 65 000 /(1.12)3 optimal policy should maximize both equity and firm value,
= $536 697.1119 ≈ $536 697 so adjustments are made on daily basis and when earnings
The important thing to notice is that Depreciation and are low, a firm should optimally reduce its leverage ratio and
implicit interest need not be considered since they do not debt level or otherwise said reducing its cost of capital and
give rise to cash flows. Cash-flow analysis accounts for these the earnings process permits one firm to be safer than another
costs much more simply, by charging the cost as a cash over a short horizon. At each date, the firm is recapitalized so
payment when the asset is bought. as to maximize the wealth of current owners. This process is
costless if the firm is solvent, but otherwise the transfer of
5.1. Debt or Equity Financing under the Cash-flow ownership and control is assumed to induce bankruptcy
Theory of Stock Valuation reorganization costs and the model is unaffected as long as a
clear distinction between debt and equity remains. Default
If we continue with the same example of Maple Media
that caused liquidation in the past is now resulting in an
Corporation using debt financing, we will find out that the
optimal reorganization. Since an optimal debt decision needs
discounted present value of the economic profit using debt
to consider only the future cash-flows of the firm and is
financing is always equal to the Net Present Value meaning
independent of past earnings and debt levels. Then a change
that the way of financing is not affecting the value of the firm
in the autocorrelation between earnings at time t and t+1,
as long as the net cash-flow is not changing. We will have
also affects future debt decisions and firm values. From
access to reducing debt financing only when the net
here rises a cash-flow concept of profit associated with the
cash-flow is decreasing in order to reduce the effect of
cash-flow theory of stock value.
reduction on the net cash-flow on the value of the firm.
Though capital structure decisions are influenced by a
firm’s ability to generate future cash flows, the theoretical 6. The Traditional Performance
literature has neglected the dynamic relation between Measures
leverage and firm specific earnings behaviour. HOWEVER,
with the cash-flow theory of stock valuation, under a theory The problems and the effective performance measures like
of continuous time, we have adjustments in the business, Return on Asset (ROA), Return on Equity (ROE), Return on
capital structure, policy and optimality on hour per hour and Investment (ROI) and Economic Value Added (EVA), and
day per day basis in order to avoid the risk inherent in the how these measures correlate positively with stock-returns
capital structure of the business. We will use the article of and stock prices, will be discussed below.
Steven Raymar “A Model of Capital Structure when
6.1. Problems with Return on Equity (ROE)
Earnings are Mean-Reverting” to give a clear meaning to a
theory of continuous time. Raymar assumes a linkage We said that managers should strive to maximize
between firm value and earnings, which would affect the shareholder wealth. If a firm takes steps to improve its ROE,
optimal leverage decisions. So, leverage is reviewed and does it mean that shareholder wealth will also increase? Not
reoptimized every period and the variability of leverage is necessarily, for despite its widespread use and the fact that
positively related to variability in earnings and firm value. ROE, and shareholder wealth are often highly correlated,
 International Journal of Finance and Accounting 2015, 4(1): 79-107 91

some problems can arise when firms use ROE as the sole the company is in the 40 percent tax bracket, and interest
measure of performance. expense is tax deductible, the after-tax cost of debt is only 6
First, ROE does not consider risk. While shareholders percent. On the basis of their assessment of the company’s
clearly care about returns, they also care about risk. To risk shareholders require a 14 percent return. This 14 percent
illustrate this point, consider two divisions within the same return is what shareholders could expect to get if they were to
firm. Divisions S, has very stable cash flows and a take their money elsewhere and invest in stocks that have the
predictable 15 percent ROE. Division R, on the other hand, same risk as Keller. Keller’s overall cost of capital is a
has a 16 percent expected ROE, but its cash-flows are very weighted average of the cost of debt and equity, and it is 10
risky. If mangers were compensated solely on the basis of percent, found as 0.50(6%) + 0.50(14%) = 10%. The total
ROE, and if the expected ROEs were actually achieved, then dollar cost of capital per year is 0.10($100,000) = $10,000.
Division R’s manager would receive a higher bonus than Now let us look at Keller’s income statement. Its operating
Division S’s manager, even though Division S may actually income EBIT, is $20,000, and its interest expense is
create more value for shareholders as a result of its lower 0.10($50,000) = $5,000. Therefore its taxable income is
risk. $20,000 - $5,000 = $15,000. Taxes equal 40 percent of
Second, ROE does not consider the amount of invested taxable income, or 0.4($15,000) = 6,000, so the firm’s net
capital. To illustrate this point, let’s consider a rather income is $9,000, and its return on equity, ROE, is
extreme example. A large company has $1 invested in $9,000/$50,000 = 18%.
Project A, which has an ROE of 50 percent, and $1million Now what is Keller’s EVA?
invested in Project B, which has a 40 percent ROE. The
EVA= EBIT (1 - Corporate tax rate) – (Operating capital x
projects are equally risky, and the two returns are both well
After-tax percentage cost of capital)
above the cost the company has to pay for the capital
= $20,000(1-0.4) – ($100,000)(0.10) = $2,000
invested in the projects. In this example Project A has a
This $2,000 EVA indicates that Keller provided its
higher ROE, but since it is so small, it does little to enhance
shareholders with $2,000 more than they could have earned
shareholder wealth. Project B, on the other hand, has the
elsewhere by investing in other stocks with the same risk as
lower ROE, but it adds much more to shareholder value.
Keller’s stock. To see where this $2,000 comes from, let’s
Consider one last problem with ROE. Assume that you
trace what happens to the money:
manage a division of a large firm. The firm uses ROE as the
sole measure of performance, and it determines bonuses on  The firm generates $20,000 in operating income.
the basis of ROE. Toward the end of the fiscal year, your  $6,000 goes to the government to pay taxes, leaving
division’s ROE is an impressive 45 percent. Now you have $14,000.
an opportunity to invest in a large low-risk project that has an  $5,000 goes to the bondholders in the form of interest
estimated ROE of 35 percent, which is well above the cost of payments, thus leaving $9,000.
the capital you need to make the investment. Even though  $7,000 is what Keller’s shareholder’s expected to
this project is profitable, you might be reluctant to make the earn:
investment because it would reduce your division’s average 0.14($50,000) = $7,000.
ROE, and therefore reduce the size of your year-end bonus.
Note that this $7,000 payment is not a requirement to stay
These three examples suggest that a project’s return must
in business, companies can stay in business as long as they
be combined with its risk and size to determine its effect on
pay their bills and their taxes. However, this $7,000 is what
shareholder value. To the extent that ROE focuses only on
shareholders expected to earn, and it is the amount the firm
rate of return, increasing ROE may in some cases be
must earn if it is to avoid reducing shareholder wealth.
inconsistent with increasing shareholder wealth. With this in
mind, academics, practitioners, and consultants have tried to  What is left over, the $2,000, is EVA. In this case,
develop alternative measures that overcome ROE’s potential Keller’s management created wealth because it
problems when it is used as the sole gauge of performance. provided shareholders with a return greater than what
Thus the level of ROE does not tell the owner if the they presumably would have earned on alternative
company is creating shareholders wealth or destroying it. investments with the same risk as Keller’s stock.
Thus ROE is an informative measure and can’t be used to  We said that EVA is different from the traditional
decision making or to guide operations. accounting measure of profit in that EVA explicitly
considers not just the interest cost of debt but also the cost
6.1.1. How Is ROE Connected To EVA? of equity. Indeed, using the simple example above, we
To better understand the idea behind EVA and how it is could also express EVA as net income minus the dollar
connected to ROE, Let us look at Keller Electronics, Keller cost of equity:
has $100,000 in operating capital, which in turn, consists of EVA = Net income – [(Equity capital) (Cost of equity
$50,000 of common equity and $50,000 of long-term debt. capital)]
The company has no preferred stock or notes payable. The = $9,000 – [($50,000)(0.14)]
long-term debt has a 10 percent interest rate. However, since = $2,000
92 Randa I. Sharafeddine: A Cash-Flow Theory of Stock Valuation

Note that this is the same number we calculated before The balance sheet on the left is a normal balance sheet. On
when we used the formula for calculating EVA. Note also the right we see a balance sheet in which short-term
that the expression above could be rewritten as follows: non-interest-bearing liabilities are netted against short-term
EVA = (Equity capital) [(Net income / Equity capital) – operating assets – inventories, receivables, and prepaid
Cost of equity capital] expenses. The left side of this balance sheet is referred to as
“net assets”; “invested capital” appears on the right side.
Or simply as: The latter problem was a serious risk in Japanese
EVA = (Equity capital) (ROE – Cost of equity capital) companies. Few large Japanese firms have earned large
RONAs in recent years, and with the country’s recent
This last expression implies that EVA depends on three
economic downturn, the situation has worsened. The average
factors: rate of return, as reflected in ROE; risk, which
RONA in 1997 for large publicly traded Japanese companies
affects the cost of equity; and size, which is measured by the
was practically zero. Still growing capital market pressure
amount of equity capital employed.
has led several of these companies to adopt RONA or return
6.1.2. Problem with Return on Net Assets (RONA) on equity (ROE) as a measure of corporate performance. If
managers of these companies are evaluated on RONA, and
The return on net assets (RONA) is calculated as RONA is significantly lower than WACC, which it is for
follows: most large Japanese companies, managers might be tempted
RONA = NOPAT / net assets to invest in capital projects that will earn less than the
Net assets = Cash + Working Capital Requirement + WACC as long as they are expected to earn more than the
Fixed Assets existing RONA. The result is that value-destroying Japanese
Working Capital Requirements = (Receivables + companies may invest ever-increasing amounts of capital in
Inventories + Prepayments) – (Short- term non-interest value-destroying activities, digging themselves, and the
bearing liabilities). Japanese economy, into an ever-deeper hole.
Why not using RONA by itself? A few years ago, Apple Computer faced a very different
The risk to companies of using RONA, is that divisional problem. Its managers too, were evaluated on the basis of
managers might bypass value creating projects because they RONA. Moreover, as recently as the early 1990s, the
would reduce RONA (a risk whenever RONA is greater than company’s RONA was 30 percent, among the highest of any
WACC), or they might undertake value destroying projects large American business. This high RONA made
because they would increase RONA (which can happen management reluctant to make further investments, passing
when RONA is less than WACC). Either way, reliance on up opportunities with expected returns of 20 percent despite
RONA alone can lead to suboptimal behaviour. the fact that these returns far exceeded the company’s cost of
capital. The result is that Apple systematically underinvested,
The balance sheets shown below clarify how invested
contributing to the massive problems that brought the
capital is defined:
company to the brink of the collapse in 1997. Choosing the
Short-term wrong measure to focus on certainly didn’t help. We invest
Cash
Debt whenever the returns are expected to exceed the cost of
Receivables
Short-term NIBL
capital.
+ Still RONA is a major improvement over the measures
Inventories
+ Long-term that companies have normally relied on to measure
prepayments Debt performance. We learned this lesson firsthand from work
with a well-known German manufacturer. This company had
Other long-term liabilities
invested heavily over a period of several years in new plant
Fixed
Assets Shareholders equity
and equipment. Senior managers congratulated themselves
on the resulting improvements in employee productivity that
showed steady growth in output per employee. To these
Cash Short-term managers, this meant that the company has achieved huge
Debt efficiency gains. Yet they were puzzled by the company’
mediocre financial performance. On closer inspection, it
WCR
Long-term
became clear that what the company had really accomplished
Debt was the substitution of labour with new but capital-intensive
technologies. Output per employee grew, but the company’s
output charts conveniently ignored the huge increase in
Other long-term
Fixed capital that made the output gains possible. Employees had
Liabilities
Assets become more “efficient,” but only at the expense of lower
Shareholders asset and capital efficiency.
Equity An important virtue of RONA is that it not only captures
any productivity gains achieved by the company’s workforce,
 International Journal of Finance and Accounting 2015, 4(1): 79-107 93

but it also considers the assets the workforce uses to achieve that the cost of equity capital is deducted when EVA is
its output. Although it does not explicitly measure capital calculated. Other factors that could lead to differences
charges, it does remind managers that there is a cost to include adjustments that might be made to depreciation, to
acquiring and holding assets. research and development costs, to inventory valuations, and
so on.
6.2. Problems with Economic Value Added EVA represents the residual income that remains after the
Economic Value Added was developed and popularized cost of all capital, including equity capital has been deducted,
by the consulting firm Stern Stewart & Co., EVA helps whereas accounting profit is determined without imposing a
managers ensure that a given business unit is adding to charge for equity capital. Equity capital has a cost, because
stockholder value, while investors can use it to spot stocks funds provided by shareholders could have been invested
that are likely to increase in value. What exactly is EVA? elsewhere where they would have earned a return.
EVA is a way to measure an operation’s true profitability. Shareholders give up the opportunity to invest funds
The cost of debt capital (interest expense) is deducted when elsewhere when they provide capital to the firm. The return
calculating net income, but no cost is deducted to account for they could earn elsewhere in investments of equal risk
the cost of common equity. Therefore, in an economic sense, represents the cost of equity capital. This cost is an
net income overstates “true” income. EVA overcomes this opportunity cost rather than an accounting cost.
flow in conventional accounting. Note that when calculating EVA we do not add back
Surprisingly, many corporate executives have no idea how depreciation. Although it is not a cash expense, depreciation
much capital they are using or what that capital costs. The is a cost, and it is therefore deducted when determining both
cost of debt capital is easy to determine because it shows up net income and EVA. Our calculation of EVA assumes that
in financial statements as interest expense. However, the cost the true economic depreciation of the company’s fixed assets
of equity capital, which is actually much larger than the cost exactly equals the depreciation used for accounting and tax
of debt capital, does not appear in financial statements. As a purposes. If this were not the case, adjustments would have
result managers often regard equity as free capital, even to be made to obtain a more accurate measure of EVA.
though it actually has a high cost. So, until a management An Alternative to Accounting-Based EVA: The Refined
team determines its cost of capital, it cannot know whether it EVA (REVA).
is covering all costs and thereby adding value to the firm. There is an approach to calculating EVA that reduces
Although EVA is perhaps the most widely discussed reliance on accounting conventions. In this version of EVA,
concept in finance today, it is not completely new; the need invested capital is based on the market value of the firm,
to earn more than the cost of capital is actually one of the instead of the book value of invested capital. Although
oldest ideas in business. However, the idea is often lost NOPAT is still based on GAAP under this approach,
because of a misguided focus on conventional accounting. invested capital is not. In this way, its advocates assert, the
The basic formula for EVA is as follows: relationship between EVA and share price significantly
EVA = Net operating profit after taxes, or NOPAT – improves.
After-tax dollar cost of capital used to support operations To understand the nature of this argument, consider an
EVA = EBIT (1- Corporate tax rate) – (Operating capital) example:
x (After-tax percentage cost of capital). Total market value, beginning of the year $100 M
Invested capital, beginning of year $ 50 M
Net operating income $8M
Net sales WACC 10%
- Operating expense
When conventionally measured, based on beginning
= Operating profit(or earnings before interest and tax, EBIT) invested capital, EVA equals $3 million [$8 million – ($50
- Taxes million x 10 percent)]. Critics argue, however, that the firm’s
= Net operating profit after tax (NOPAT) $100 million market value implies that its capital providers
- Capital charges (Invested capital x Cost of capital) would have expected a $10 million return ($100 million x 10
= EVA percent) had they invested their funds elsewhere. Therefore,
as the argument goes, if the company is to create value in that
Operating capital is the sum of the interest-bearing debt, year, it must generate a return greater than $10 million. In
preferred stock, and common equity used to acquire the this case, despite a positive EVA of $3 million, net operating
company’s net operating assets, that are its net operating income is obviously not sufficient to earn an acceptable
working capital plus net plant and equipment. Operating return on capital. The problem stems from the measurement
assets by definition equals the capital used to buy operating of capital, which is based solely on the assets in place and
assets. ignores the net present value of future investment
EVA is an estimate of a business’s true economic profit opportunity (which may be priced by the market but ignored
for the year, and it differs sharply from accounting profit, the on the balance sheet).
most important reason EVA differs from accounting profit is The proposed solution is a modified version of EVA that
94 Randa I. Sharafeddine: A Cash-Flow Theory of Stock Valuation

its creators call refined EVA (or REVA). Under REVA, of its success in previous periods of creating FGV. In other
capital charges are based on the market value of the firm, and words, the company has been highly successful in
not the market value of the firm, and not the adjusted book convincing the capital markets that future EVAs will be
value approach. In this example, REVA equals a negative $2 much higher than historical EVAs. Perhaps the company has
million [$8 million – ($100 million x10 percent )], which is created valuable strategic options that are expected to
more consistent with the company’s performance that year translate into outstanding financial results in the future.
from the shareholders’ perspective and more highly While the value of these options is reflected in market value,
correlated with stock market returns than conventional EVA. it will not, and cannot, be reflected in REVA. In short,
But because it is measured from market values, and market REVA will always ignore value-creating activities that are
values are usually available only at the firm wide level, not reflected in the current year’s operating results, while
REVA can be used only at the corporate level. EVA would charging management for a capital base that includes the
still be needed at lower levels of the organization. The capitalized value of such activities from previous years.
problem with REVA results from confusing market values, Coke’s REVA may be -$5 billion, implying massive
which incorporate expectations of future performance for the underperformance, but because it created valuable growth
long-term, with single-period measures of operating opportunities that year, shareholder values was created, not
performance. destroyed. The irony of REVA is that those companies that
Consider the case of Coca-Cola. Suppose Coca-Cola has a are most successful in creating future growth opportunities,
market value of $150 billion at the beginning of the REVA and therefore the companies with the highest excess returns,
measurement period. If its WACC is 10 percent, capital will have the lowest and most negative REVAs.
charges total $15 billion. These days, even outstanding
performance by the company in the coming year –say, a 6.2.1. Problem with Return on Investment (ROI) and the
NOPAT of $5 billion, will yield a REVA of negative $10 Discrepancy in Accounting Rate of Return and EVA
billion! Does this mean that the company destroys value? Every project that a firm undertakes should have positive
Probably not. It is quite possible, indeed even probable, that Net present value (NPV) in order to be acceptable from the
Coca-Cola can produce NOPAT of $5billion (and a negative shareholders point of view. This means that a project should
REVA of $10 billion) and still cause its share price to have internal rate of return bigger than the cost of capital.
increase because the $5 billion of NOPAT in the current With practical performance measuring the internal rate of
period is higher than what the market expected. The market return cannot be measured and some accounting rate of
may then reasonably interpret this performance to indicate return is used instead to estimate the rate of return to capital.
that even more EVA will be generated in the future than was Typically this rate of return is some form of return on
expected before Coca-Cola’s results were known. In other investment (ROI). Unfortunately, any accounting rate of
words, even if REVA is hugely negative, which is always the return cannot on average produce an accurate estimate of the
case for the most successful value creators, the implications underlying true rate of return. Although EVA is a value
of the current year’s performance for future EVAs could based measure, and it gives in valuations exactly same
result in a higher share price. How then do we interpret a answer as discounted cash flow, the periodic EVA value still
negative REVA? have some accounting distortions. That is because EVA is
One of REVA’s creators has privately conceded this point after all an accounting based concept, suffering from the
to us but argues that the measure’s real value is detecting same problems of accounting rate of returns (ROI). In other
mispriced securities and not as a measure of corporate words, the historical asset values that distort ROI distort
performance. Companies with highly negative REVA stocks EVA values as well. The following formula shows that EVA
would be viewed as overpriced. While highly positive is based on the accounting return.
REVA stocks would be viewed as under-priced. The
EVA = (ROI-WACC)*CAPITALEMPLOYED
problem with this logic is that nearly all companies with
large EVA growth expectations impounded in their existing Unfortunately accounting rate of return has at least two
share price will have a negative REVA. Are all, or even most, severe pitfalls: first, wrong periodising meaning EVA is
such companies overpriced? divided unevenly between different years. With normal
Under the REVA approach, invested capital is measured depreciation schedules, EVA and ROI tend to be small at the
on the basis of total market value, including the capitalized beginning of a project and big at the end of the project.
value of future growth opportunities. Meanwhile, NOPAT is Therefore companies with a lot of new investments have
based entirely on current operating performance, ignoring, as lower EVA than their true profitability would imply. Second,
does any short-term financial measure, the value-creating distortions caused by inflation and asset structure. Historical
effects of investing activities, such as R&D, that may deliver asset values are distorted by inflation which affects also
huge amounts of EVA in the future. EVA values. As proved many times in financial literature,
If a company is systematically creating future growth accounting rate of return is also unable to describe the true
value, its capital charges under REVA will increase from one rate of return even with no inflation. The extent of this
year to the next. For Coca-Cola, the company’s huge market problem depends on the asset structure (the relative
value at the beginning of the period ($150 billion) is a result proportions of current assets, depreciable assets,
 International Journal of Finance and Accounting 2015, 4(1): 79-107 95

un-depreciable assets) and on the length of investment (ROS). Additionally they study how companies’
period. performance, measured in terms of EVA and MVA, effect on
Moreover, the change in assets structure during one the CEO firings. Finally they examine the relationship
investment period might increase or decrease wrong between EVA/MVA and corporate focus. Lehn and Makhija
periodising. For example, if a company has a lot of new find an inverse relation between EVA/MVA and abnormal
assets, and new investments, it is likely to have low ROI CEO turnover. They also find that firms with greater focus
compared to true rate of return due to the change of assets on their business activities have significantly higher MVA
proportion from the beginning to the end of the investment than their less focused counterparts. Lehn and Makhija
period. conclude that their results suggest EVA and MVA to be
Other than the problem of wrong periodising, ROI is a effective performance measures that contain information
poor measure of a company’s true rate of return due to about the quality of strategic decisions and serve as signals of
inflation. When the difference between accounting ROI and strategic change.
IRR. Salmon and Laya proved this inflation effect in 1967 The idea of EVA bonuses is that if management can be
and De Villiers discussed it in 1976, and it is well paid some bonuses, shareholders would be better off, earning
documented in economic literature. In addition to inflation, higher return on their capital than they expect. Thus, it would
the duration of the project and the assets structure affects the be beneficial for both management and the shareholders,
discrepancy between ROI and IRR, the longer the duration of because performance measure will rise when introducing
the project the higher the difference between the two rates. EVA bonus system (Wallace 1997). Wallace (1997) studied
These discrepancies when they exist, they affects EVA since the effects of adopting management bonus plans based on
it is calculated from the accounting based figures. EVA residual income measures. The sample in the study consists
overstates shareholders value if ROI overstates IRR. In order of forty firms that have some residual income measure,
to decrease the discrepancies, De Villiers suggested in 1997 mainly EVA, as bonus base. This sample was compared to
to adjust EVA by using current value of assets and capital in sample of same size consisting of similar companies where
calculating accounting rate of return (ROI) (Makelainen, the bonus is tied to accounting based measures. Wallace tests
1998). with various methods the management actions in these
sample groups and concluded that the results as being
6.2.2. The Effectiveness of EVA in Management Bonus
consistent with a residual income-based performance
Plans and its Correlation to Share Prices
measure providing incentives for managers to act more like
According to the EVA theory the market value of a owners, thus mitigating the inherent conflict between
company is, its book value plus the current value of future managers and shareholders.” The firms that adopted residual
EVA: income based compensation outperformed the market over
Market Value of Equity =Book Value of Equity + Present the twenty-four month period by over 4% points in
value of all future EVA. cumulative terms.
This relationship between EVA and the market value of a EVA bonus system is considered as a motivating bonus
company suggests that EVA drives the market values of system that encourages managers to exceed the normal
shares. Studies made on the American and European performance level. Bonus can be paid according to some
companies in the late eighteens concluded that EVA percentage of positive EVA or according to some percentage
correlates positively with stock returns and this correlation is of improved EVA. Thus managers have incentives to
slightly better than with traditional performance measures maximize performance and value of their corporation.
like return on assets, return on equity, and return on sales. EVA bonus systems are also good in decreasing agency
They also conclude that EVA is an effective measure that problems. And with this system managers avoid investments
contains information about the quality of strategic decisions that produce less than WACC and also avoided investing in
and change to be taken by management. Stern Stewart & Co. not so good projects, because when producing a return less
made a study on 100 bank holding companies data between than WACC decrease the bonuses. Therefore, EVA bonus
1986 and 1995. They found that the correlation between systems unite the interest of group management and
some performance measures and market share to be as shareholders or the interest of group and managers.
follows: EVA 40%, ROA13%, ROE 10%, and earnings per In addition, EVA bonus system is a way to pay employees
share 6%. Moreover, companies which went on EVA have according to the change in productivity. Thus EVA bonuses
noticed increase in its Market value added (MVA) and could bring some elasticity in the payroll of workers, and
noticed an increase in share prices. Lehn and Makhija (1996) avoid some oversized wage increase demands.
study EVA and MVA as performance measures and signals Implementing EVA in a company requires of course some
for strategic change. Their data consists of 241 U.S. kind of management effort. However, if right actions are
companies and cover years 1987, 1988, 1992 and 1993. The taken straight from the beginning then implementing EVA
researchers first find out that both measures correlate should be one of the easiest changes that a company goes
positively with stock returns and that the correlation is better through. The actions required by management include the
than with traditional performance measures like return on following: first, gaining the understanding and commitment
assets (ROA), return on equity (ROE) and return on sales of all the members of the management group through
96 Randa I. Sharafeddine: A Cash-Flow Theory of Stock Valuation

training and discussing. Managers should know exactly what attitude in this sense because it emphasizes the requirement
EVA is all about and what differences there are compared to to earn sufficient return on all capital employed.
other measures like EPS and ROI. CEO and all the divisions’ Including capital costs in the income statement helps
managers should communicate their support and believe in everybody in the organization to see the true costs of capital.
the concept to the whole company. Second, training of the When calculating EVA, the cost of equity and debt can be
other employees, especially all the key persons in every subtracted in the income statement earlier than after the net
department because they are the ones who use it operating profit.
operationally, and their understanding of the concept is At best EVA can be a new approach to view business.
essential in bringing EVA downwards to all company levels. Perhaps the biggest benefit of this approach is to get the
Third, adopting EVA in all levels of organization should not employees and managers to think and act like shareholders.
be only a tool for management. EVA is powerful at It emphasizes that in order to justify investments in the long
operational levels to illustrate the costs of working capital, run they have to produce at least a return that covers the cost
inventories, sales, receivables etc… to operating employees of capital. In other case the shareholders would be better off
like sales people, operating engineers and others. EVA investing elsewhere. This approach includes that the
approach helps employees to see how costly capital is. EVA organization tries to operate without lazy or excess capital
can be calculated by producers and by customers in every and it is understood that the ultimate aim of the firm is to
day’s operations. Fourth, integrating EVA as a bonus create shareholder value by enlarging the product of positive
incentive plan for all employees, EVA bonus system helps spread between return and cost of capital multiplied with the
employees to struggle for the common goal of which is capital employed. The approach creates a new focus on
increasing shareholder value. minimizing the capital tied to operations. According to
EVA became a popular performance measure despite its Wallace study (1996), companies using EVA had gained
suffering from some accounting distortions like ROI. It helps superior-performance.
understanding the cost of capital of a company and it gets
employees and managers to think and act like shareholders. 6.2.3. The main Problems with EVA in Measuring Operating
Moreover, they start to consider that long-term investments Performance are
produce at least a return that covers the most of capital EVA is poor in periodising the returns of a single
otherwise shareholders will be better off investing elsewhere. investment. It underestimates the return in the beginning and
Management should not operate with lazy or excess capital overestimates it in the end of the period. Some growth phase
and should aim in to create shareholders value by enlarging companies or business units have a lot of new investments.
the spread between return and cost of capital multiplied by Such growth phase companies are likely to have currently
capital employed. Capital tied to operations should be negative EVA although their true rate of return would be
minimized. The idea is to cut excess capital and not only to good and so their true long-term shareholder wealth added
cut costs. The power of EVA approach is that studies fail to true long-term EVA would be positive. Also EVA suffers
trace the correlation between EVA and share prices but at the from other distortions including failing to estimate the value
same time they can prove that EVA is better correlated to added to shareholders, because of the inflation and other
share prices than other traditional performance measures. factors. That is also the reason why EVA is criticized to be a
In order to achieve high EVA, managers should be trained short-term performance measure.
to act and think like owners. EVA bonus plans give It certainly holds also more generally that EVA or any
managers interest in performance improvements by paying other financial performance measure do not in itself provide
bonuses that are a fixed percentage of all changes in EVA. managers with sufficient information. Financial measures
This EVA bonus plan should have four objectives: First, tell us the outcome of many different things. They usually
giving managers motivation and compensation to choose hide the causes of good or bad profitability. The good or bad
strategic decisions that maximize shareholders value. Second, performance of individual processes is seldom visible in
train and motivate managers to work long hour, take risks financial performance measures. Some other measures
that some managers would take during industry downturns pinpoint the current situation of critical success factors much
and recessions, fourth, to keep shareholder costs at a better. Therefore every company should use many measures
reasonable level (Stewart, 2002) in estimating how their plans are going and strategic goals
As a performance measure in corporate world, EVA helps are reached.
the management and also other employees to understand the
The new famous concept called Balanced Scorecard
cost of equity capital mainly in big public companies, which
(Kaplan & Norton 1996) presents that companies should use
do not have a strong owner, shareholders have often been
several different perspectives in measuring performance to
conceived as a free source of funds. Similarly, business unit
avoid the distortions of EVA. The perspectives suggested are
managers often seem to think that they have the right to
(Kaplan & Norton 1996):
invest all the retained earnings that their business unit has
accumulated although the group would have better  Financial (How should we appear to our shareholders?)
investment opportunities elsewhere. EVA might change the  Customer (How should we appear to our customers?)
 International Journal of Finance and Accounting 2015, 4(1): 79-107 97

 Internal Business Process (To satisfy our shareholders today and expect positive cash flow in a distant future, are
and customers, what business processes we must excel considered extreme examples and EVA is not a primary
at?) performance measure for them. One example would be
 Learning and growth (To achieve our vision, how will telecommunication operators who heavily invest in
we sustain our ability to change and improve?) infrastructure with very long- term payoffs.
Professors Kaplan and Norton present that in order to Another problem is that EVA measure tells us if the
fulfil financial objectives set by shareholders, the company outcome is good or bad and whether value is added or
should concentrate on besides financial measures also on reduced but it hides the causes of this outcome, so more
measures of the other perspectives. If a company has measures should be taken by one company to understand
measured customer perspective well and reacted in it with more its strategic goals. Finally, as ROI fails on average to
operations (internal business process perspective), the result estimate the true return, EVA fails on average to estimate the
is often improved financial performance. Financial measures value added shareholders due to inflation and assets structure
do not often show the reasons but the consequences. and project duration. Using the current value of assets
Therefore it is utmost important to have also other measures. instead of book value is the solution (Ehbar, 1998).
Sometimes focus on EVA and shareholder value is EVA is an effective method for teaching workers. The first
incorrectly viewed as opposite approach to Balanced measure is to change managers behaviour, making them
Scorecard. On the contrary Professors Kaplan and Norton thinks and act like owners. Most important, it is a good
(1996) present that EVA is one suitable and widely used analysis tool and a good internal motivation system for
financial performance measure for financial perspective. managers and employees for the best performance possible
According to Kaplan and Norton (1996) the financial (Ehrbar, 1998).
perspective is the critical summary and the main goal. It must
not be neither over nor underemphasized. “A failure to 6.2.4. Stock Market Returns: Is EVA Beating Earnings or Is
convert improved operational performance in the Scorecard, Cash-Flow Really Better?
into improved financial performance should send executives Professors G.C. Biddle, R. M. Bowen, and J. S. Wallace in
back to their drawing boards to rethink the company’s their article “Does EVA Beat Earnings? “Evidence on
strategy or its implementation plans.” (Kaplan & Norton Associations with Stock Returns and Firm Values” Journal
1996). In the end, every strategic plan has to convert into of Accounting & Economics, December 1997, pp. 301-336,
long run profitability in order to be justified. who argue that earnings have more explanatory power than
A good example of the necessity of different measures is EVA. The Biddle, Bowen, and Wallace study provides
provided with the browser and other Internet software evidence on the information content of EVA, residual
producer Netscape. The company did huge losses in its early income (i.e., unadjusted EVA), net income (before
years but still it was viewed as valuable company because of extraordinary items), and cash-flow from operations.
the expected big positive future cash flows. Information content describes the relation between the
The Problems with EVA is that, EVA is distorted by ROI measure in question and changes in stock prices. The first
due to underestimating the return in the beginning and question addressed is whether EVA (either in its adjusted or
overestimating it in the end of the project period especially in unadjusted form) dominates net income and cash-flow from
the case of a single investment. Some companies that have operations in explaining annual stock market returns. When
many investments in the beginning will have a current they look at a large sample of firms covering the period 1984
negative EVA but the ROI will be good compared to IRR, to 1993, the authors find R square for net income of 12.8
hence their true long term shareholder wealth added would percent, versus 7.3 percent for residual income (i.e.,
be positive. Ceasing investments can increase short term unadjusted EVA), 6.5 percent for EVA (the adjusted version),
EVA and that is why EVA is criticized to be a short –term and 2.8 percent for cash-flow from operations. In other
performance measure. Companies focusing on long term words, annual accounting earnings had nearly twice the
investments that do not occur in a continuous stream showed power of EVA in explaining one-year stock returns. The
no interest in EVA. authors then extended the study to include five-year return
Another short sightedness is that the true EVA of long intervals. Again, accounting earnings did better with R
term investments cannot be measured objectively because square of 31.2 percent, versus 18.9 percent for cash-flow
future returns cannot be measured but can be subjectively from operations, 14.5 percent for EVA, and 10,9 percent for
estimated. The only subjective component to be used in EVA residual income. The differences in explanatory power
model is the depreciation schedule. In addition, the problem between net income and each of the three other performance
of wrong periodising and its effect on long term results measures are highly significant for both the one-year and the
should be considered. This problem should be solved in case five-year intervals. The authors even segmented the sample
all investments proved to be really profitable as ROI for firms known to have adopted EVA and those that had not,
approaches IRR. It can be expected that companies with a lot on the assumption that firms may adopt EVA at least in part
of new undepreciable assets have negative EVA in the near because their past experience indicates a strong relation
future and that is why companies have invested heavily between EVA and stock returns. Also investors may become
98 Randa I. Sharafeddine: A Cash-Flow Theory of Stock Valuation

more attuned to EVA and, therefore, more likely to Table 1. Shows the coefficients for the regression on five-year stock
returns, where the independent variables are five-year sums
incorporate it in pricing shares for companies that announce
they are adopting it. Alas, EVA still fails to outperform Variable Coefficient Predicted Sign
earnings, although earnings no longer dominate EVA. Constant -0.373
The study then addresses whether components unique to CFO-current 2.128 +
EVA or residual income help to explain stock returns beyond CFO-prior -0.731 -
that explained by net income and cash-flow from operations.
Accrual-current 1.659 +
The logic behind this test can be seen below:
Accrual-prior -0.072 -
EVA = CFO ± Accruals + After-tax interest expense
AT interest-current -0.509 -
– Capital charges ± Accounting adjustment
AT interest-prior 0.089 -
Cash-flow from operations is embedded in net income.
Capital charge-current -0.088 -
The difference between the two figures is a function of
accrual accounting. Depreciation, deferred taxes, and Capital charge-prior 0.275 +
receivables are examples of items that cause cash-flow from Acct. adj.-current 0.549 +
operations and net income to diverge. In short, Acct. adj.-prior 0.487 -
Cash-flow from operations (+) or (–) the various elements
of accrual accounting equal net income. Adding after-tax However, a more careful look at the regression
interest expense back to net income produces a measure of coefficients shows that capital costs matter a good deal more
unlevered profit, or NOPAT. Residual income is calculated than the capital charge coefficient suggests. The regression
by subtracting capital charges capital charges from NOPAT. obscures the impact of capital costs because it does not fully
The difference between residual income and EVA is caused separate financing and operating performance. Cash-flow
by the various adjustments. These adjustments are added to from operations includes after-tax interest expense. This
or subtracted from residual income to produce EVA. The means that current period after-tax interest expense appears
first three elements in the EVA calculation – cash-flow from in the regression three times as a negative component of the
operations, accruals, and interest expense – are already capital charge ; and as a separate independent variable. This
included in the profit numbers that companies are required to implies that the aggregate coefficient on current period
disclose in their annual reports. The question the authors after-tax interest expense is –2.735 (or –2.128 + -0.509 +
seek to answer is whether or not the two elements not -0.088). This in turn, has two very puzzling implications.
explicitly included in mandated disclosures – capital charges First, it implies that $1.29 (or $2.735/$2.128) of positive
and accounting adjustments – are significantly related to cash-flow from operations is needed to offset the economic
stock prices. Unhappily, the answer is no. They show that cost of $1 of after-tax interest expense. Since after-tax
while the cash-flow and accrual components are consistently interest expense is computed using the statutory corporate
significant, the components unique to EVA are not. tax rate, one explanation for this odd differential is that the
Still, the Biddle, Bowen, and Wallace results are not effective tax saving is less than the statutory rate. Second,
entirely persuasive. One problem is that their regression and much more puzzling, it implies that $1 of after-tax
analysis seems to show that while investors put great weight interest expense has the same economic cost as 31 (or
on the cost of debt, the cost of equity is apparently ignored. $2.735/$0.088) of equity capital cost.
For more extensive critique of the Biddle, Bowen, and This is an odd result, because it suggests that equity capital
Wallace study, see S.F. O’Byrne, “EVA and its Critics,” is basically free. Biddle, Bowen, and Wallace may have
Journal of Applied Corporate Finance, Summer 1999. The overlooked the issue raised by after-tax interest expense
independent variables in these regressions are current and because they expected the after-tax interest variable to have a
prior period values for each of the five EVA components negative sign. It should have a positive sign in the regression,
shown in the figure below: CFO, accruals, after-tax expense, just as it does in the EVA components equation, since
capital charges, and accounting adjustments. after-tax interest expense is adding back the expense buried
The coefficients tell us that an additional dollar of in cash-flow from operations.
cash-flow from operations adds $2.128 to the five-year The problem with the accounting adjustments proposed
return, while an additional dollar of capital charge subtracts for the calculation of EVA is not that they are illogical. In
$0.088. This implies that $24 of capital charge (or some circumstances, adjustments are necessary. For example,
$2.128/$0.088) is needed to offset the economic benefit of in cases where retail companies lease nearly all their assets
$1 of cash-flow from operations, which suggests that and thus keep them off the balance sheet, meaningful EVA
investors are virtually indifferent to capital costs. This is a far figures require that leases be capitalized, even if GAAP says
cry from EVA, which reminds us of what should be an differently. Still for most companies, the assumption of zero
obvious fact - $1 of capital charge offsets the economic adjustments is a logical starting point in deciding how EVA
benefit of +$1 of earnings. is to be measured.
 International Journal of Finance and Accounting 2015, 4(1): 79-107 99

7. From Economic Value Added (EVA) invested our $100,000 in our best alternative instead of in
to the Cash-Flow Concept of Stock this business? We started with $100,000 on 1/1/X, and that
Valuation amount would have grown to $110,000 by 12/31/X if
invested at 10 % our assumed opportunity in our best
Let us take the following example to show the link alternative investment vehicle. What is my situation in this
between the Economic Value added and the cash-flow business? We can determine that by looking at our new
concept of stock valuation. This example, we are able to see balance sheet:
is a very simple model of the business. Adding hired labour
and raw materials to the model makes it a bit more complex,
Assets Liabilities
but the lesson still holds. Here then, is the problem:
In 1/1/ X, we buy a business for $250,000. We pay $233,000 (M,B and T) Debt $150,000
&100,000 of our own money (Which we could have $32,000 (cash)
“invested” elsewhere at 10 %), and borrow $150,000 from a
bank, on which we pay a 10 % interest rate. At that point, my Net Worth 115,000
balance sheet shows Assets of $250,000; Liabilities of
$150,000, and a Net Worth of $100,000. To focus on the Notice the asset item for $32,000 (cash). This comes from
issues at hand, let us suppose the business is extremely the fact that we received $47,000 in Total Revenue during
simple. Specifically, we have no outlays on raw materials or the year, but only paid out $15,000 in bank interest. The
hired labour, and we don’t supply any of our own labour or remainder is assumed to have gone into our bank account.
entrepreneurial services. Over the course of the year, The M, B and T asset reflects the “true economic
suppose we receive revenue of $47,000 and pay out bank depreciation” in their value from $250,000 to $233,000 over
interest of $15,000. Also suppose the value of our physical the year. We also assumed that we paid only the interest due
assets (machines building and tools) decreases by $17,000, on our bank loan. The key thing to notice is that we are
from $250,000 to $233,000. Then our economic income $5,000 wealthier because we bought and operated this
statement is very simple: business than we would have been if we had invested our
$100,000 in our best alternative. (It would be easy to put
Item Amount items for supplying our own labour, hiring other labour, and
Revenue $47,000
buying raw materials, but they would only complicate the
story at this point, without giving us any new insights).
Bank Interest 15,000 Now how the results could be seen under the cash-flow
Foregone Interest on my Investment 10,000 concept of stock valuation:
We already know that Pure Earning P1 is equal to:
Decrease in Value of Assets 17,000
P1 = N1 – D1 + B1 + rNo( here No is a negative number
Economic Profit 5,000 because it is a flow of cash from stockholders to the firm ).
P1 = Pure earning in year one
Remember that economic profit is calculated by N1 = $32,000 (Cash-flow generated in year one).
subtracting total economic cost from total revenue. Total D1 = $17000 (Depreciation expense)
economic cost, in turn, is the sum of explicit cost and implicit B1 = Zero (Current Debt repayment)
cost. rNo= 10% ( $-100,000) (Cost of Equity Capital)
Explicit cost is the outlays the firm makes for resources P1 = $32,000 - $17,000 +0 – $10,000 = $5,000 which is
that are used up during the year. the EVA calculated above, and which is the pure profit
In this example, the only explicit cost is bank interest. which is above the normal profit of 10% of the beginning
Implicit costs are forgone inflows. Because the owners’ investment by shareholders at the start of the year, leading to
resources are put to use in this firm, instead of their best the following new balance sheet under the cash-flow concept
alternative use, those owners are not able to obtain the flow of stock valuation:
of dollars they would get in the alternative use (Of course,
the reason the resources are put in this use is that the owners Assets Liabilities
expect to get more here.). In this example, implicit cost
(foregone interest plus “economic depreciation”) is $27,000 $233,000 (M,B and T) Debt $150,000
($10,000 plus $17,000). Thus total economic cost is $42,000, $32,000 (cash)
and economic profit (total revenue minus total economic cost)
is $5,000. Net Worth 115,000
What we want to show is that the $5,000 economic profit
represents the amount by which we are richer than we would The expected increase in net worth was 10% out of the
have been if we had deployed our resources ( in this case, our $100,000 the initial investment of shareholders at the
$100,000) in their best alternative use rather than in this beginning of the period. However an increase in wealth of
business. What would my position have been if we had $5,000 was created to shareholders:
100 Randa I. Sharafeddine: A Cash-Flow Theory of Stock Valuation

Pure profit = Actual end-of-period wealth – Expected decisions must necessarily be subjective. Decision-makers
end-of-period wealth must make a subjective judgment about what the owners
= $115,000 - $100,000 (1+0.1) ‘resources could earn in their best alternative use and what
= $115,000 - $110,000 = $5,000 the firm’s assets could be sold for today and in the future.
In our example, suppose that accounting depreciation
Business Profit = Pure profit + rSo
equalled economic depreciation ($17,000). Then accounting
= $5,000 +$10,000 = $15,000
cost would be $32,000, and accounting profit would be
How would things be different if we looked at them in an $15,000. The only difference between economic cost and
accounting framework? accounting cost is now that economic cost counts the amount
Accounting profit is calculated by subtracting total the owners could have earned by investing elsewhere as a
accounting cost from revenue. Accounting cost, in turn, is cost, whereas accounting cost does not include this item. By
equal to explicit costs plus what might be called a “capital adding to accounting cost an item for forgone interest, we
consumption allowance,” or accounting depreciation. The can get an approximation to economic cost. In this case, that
accounting measure of depreciation will usually differ from foregone interest (calculated by multiplying the return
economic depreciation. Remember that economic owners could earn elsewhere by the amount they could have
depreciation is the actual decrease in the market value of the cleared by selling out at the beginning of the year) is $10,000.
firm’s assets over the year. By any of contrast, accounting Subtracting that $10,000 from the year’s accounting profit
depreciation is calculated by using the original purchase gives us our measure of economic profit, $5,000.
price, the assumed life of the asset, and a salvage value at the While it can be useful for a decision-maker to know
end of its life, and some rule or formula for allocating the whether the firm made an economic profit over the past year,
difference between the original purchase price and the the way economists use economic profit is always
salvage value over the assumed life of the asset. forward-looking. That is, we assume decision-makers decide
Accounting cost can differ from economic cost (and what to do (for example, whether to stay in this business) by
accounting profit can differ from economic profit) both trying to estimate the resources supplied by owners can be
because the two approaches measure depreciation differently better here than in their best alternative, that is, they try to
and because accountants do not attempt to measure foregone estimate whether the firm will make an economic profit, an
inflows, such as interest that the owners could have earned if economic loss, or break-even economically in the future.
they had invested their funds elsewhere (or, in a more However, in the cash flow concept of stock valuation we
complicated example, wages that a proprietor could have have shown that the depreciation and implicit interest need
earned if he had been employed elsewhere instead of running not be considered since they don’t give rise to cash-flow.
his own business). And the present value of the pure earnings is the present
In this story, accounting profit is simply revenue ($47,000) value of the net cash-flows.
minus bank interest paid ($15,000) minus accounting The differences between the cash-flow profit approach
depreciation. Let’s suppose that accounting depreciation is and the traditional earnings approach can be illustrated by
$20,000. Then accounting profit is $12,000. What does this the analysis of a simple investment project. The project
tell us? Since the calculation does not ascertain what the requires a capital outlay of $1000 at the beginning of the first
resources that are being used in this firm could have done year. At the end of the first year the firm will receive $1120
elsewhere. It could be that owners are happy earning what in sales revenue and will pay $400 in wages and $60 in
they earn here or unhappy, but there is no way of knowing corporate income taxes. At the end of the second year the
just from looking at the accounting profit number. By way of firm will receive $1310 in sales revenue and pay $500 in
contrast, economic profit tells owners at a glance what they wages and $205 in corporate income taxes. The income taxes
want to know, namely whether they are doing better here are calculated by charging $600 of depreciation expenses the
than they would in their best alternative employment. If first year and $400 the second, which we assume the tax laws
economic profit is positive, they are doing better here than to permit. A 50 percent tax rate is then applied to taxable
they could anywhere else. If economic profit is negative even income (revenue minus wages minus depreciation) of $120
if accounting profit is positive, owners’ resources would be the first year and $410 the second year. No other receipts or
able to earn more in their best alternative employment than payments are associated with the project.
they could here. If economic profit is zero, owners are doing The project therefore has a net cash-flow of -$1000 at the
exactly as well here as they could in their best alternative start of the first year, +$660 at the end of the first year and
employment. Thus, if owners of a firm could get an accurate +$605 at the end of the second year. If we assume a discount
measure of economic profit, they would know whether or not rate of 10 per cent, the present value of the net cash flow is
they could increase their wealth by leaving this business. +$100 for the project.
What we claim in economics is that, if decision-makers Now let us see the implications of the cash-flow
are interested in increasing their wealth, they should make analysis of this project with its associated profit and
decisions using economic profit, because that number will stock values if we assume that an entrepreneur incorporates
tell them whether they are in the right business. But since that solely for the purpose of engaging in this project, and that
number is inherently subjective, this means that business this project is equity financing by assuming a net cash-flow
 International Journal of Finance and Accounting 2015, 4(1): 79-107 101

of -$1000 when the asset is purchased. By definition, a net the stock value at the start of the year. Business
cash-flow is a transaction with stockholders, and the profit is therefore $55 and pure profit is still zero.
negative sign implies a flow of cash from the stockholders to Cash-flow theory says that all pure profit is earned
the firm. The simplest case to consider is one in which the when the stock value makes a change that had not been
investment project was not anticipated by the market, but the anticipated by the market. The market value of the stock
market adopts the firm’s forecast of the future net cash-flows is always determined in such a way that the expected
immediately when the asset is purchased. return, net cash-flow (dividends) plus capital gain, is the
1. An entrepreneur takes $1,000 of his own money and normal return on the market value at the start of the
buys an asset with the expectation that he can get a period. If all goes as expected, the actual return, business
net cash flow of $660 at the end of the first year, and profit, will be the expected normal return, and pure
$605 at the end of the second. profit will be zero. If expectations change, a pure profit
2. He incorporates and issues stock to himself at the (or loss) is made immediately as the stock price makes an
same time that he buys the asset. unexpected adjustment so that the newly expected future
3. The market values of the stock is at $1100 when it is returns will equal a normal return on the new stock
issued, because this is the present value of the value (investment).
expected future cash-flows, discounted at 10 per Analysis of the project within the context of traditional
cent. earnings theory requires information about economic
4. The entrepreneur therefore makes a capital gain of depreciation which cash-flow analysis does not require.
$100 at the time that he issue the stock since he has Cash-flow analysis requires only information about
paid $1,000 for the asset and has stock which he can corporate income taxes, which requires knowledge about
liquidate for $1100. This increase in his wealth takes legal depreciation but not about economic depreciation
place whether or not he actually sells the stock, and (another way of looking at this is to observe that no
in his “initial investment” in the firm. It is also a depreciation calculation would be required for cash-flow
business profit, and a pure profit, received at the start analysis if there were no income tax, while depreciation
of the first year, since his actual wealth is $1100, and would still be required for earnings analysis). While there is
his expected (by the market) wealth had been $1000. some debate, particularly among accountants, about the
5. If all goes as expected, the firm returns $660 to its precise meaning of economic depreciation, we shall assume
stockholders at the end of the first year. If the that it is the change in the market value of the asset. We can
expectations for the second year are unchanged, the assume, for the time being, that legal depreciation and
stockholders also have stock valued at $550, which is economic depreciation are the same, i.e, that the asset has a
the present value of the cash flow of $605 expected at value of $400 at the end of the first year. Traditional earnings
the end of the year. The stockholders’ actual analysis then says that the firm raises $1000 in capital at the
end-of-period wealth is $660 + $550 = $1210, and start of the first year. It earns (net of taxes) $60 the first year.
business profit is $110 in the first year. Pure profit is Since it returns $660 at the end of the year, $600 of this
zero since the stockholders’ normal 10 percent rate of represents a return of capital, and the stockholders still have
return on their initial investment of $1100 is also $400 invested. The second year earnings are $205. Since
$110. $605 is paid to stockholders at the end of the year, this
6. If expectations continue to be realized, the firm represents a disbursement of the earnings and a full return of
returns $605 to its stockholders at the end of the the $400 investment.
second year, and the stock becomes worthless. In the table below we can summarize the cash-flow
End-of-period wealth is therefore $605. The initial and the earnings analysis:
investment for the second year is $550 since this is

CASH – FLOW ANALYSIS EARNINGS ANALSIS

Stock- Stock-

Business Pure holders' Pure holders'

Time Profit Profit Investment Earnings Earning* Investment

Start of First Years $ 100 $ 100 $ 1100 0 0 $ 1000

End of First Years $ 110 0 $ 550 $ 60 $ - 40 $ 400

End Second Years $ 55 0 0 $ 205 $ 165 0

102 Randa I. Sharafeddine: A Cash-Flow Theory of Stock Valuation

Since the discount rate is 10 % we have equity return (net cash-flow), but we continue to assume that
the appropriate discount rate, as influenced by the debt issue,
-40 165 -40 165 121
+ += + = =100 is known. In this case interest is included explicitly; cost
1.1 1.2 1.21 1.21 1.21 would be overstated by including an implicit interest expense
Cash-flow analysis therefore shows an immediate capital on the entire undepreciated asset balance.
gain of $100, with subsequent business profits of a normal The inclusion of implicit interest on net worth makes the
10% on investment and no pure profit. Earnings analysis present (start of first year) value of the costs charged to
shows no immediate capital gain, earnings of 6% on equity capital in each year, depreciation minus debt
investment the first year and 51% the second year. repayment plus implicit interest, equal to the initial equity
We now turn to the discussion of the reasons for investment. Since the present value of the debt repayment
preferring the cash-flow approach: and associated interest expenses must equal the initial debt
investment, all capital charges are accounted for.
First, the depreciation problem, To justify this point please follow the example below:
The fundamental criticism of the treatment of depreciation Consider a case in which the net cash flows are No at the
in earnings analysis is that the economic depreciation start of the first year, N1 at the end of the year N2 at the end of
expense understates the capital costs involved. The actual the second years. Bonds (B) are issued at the start of the first
cost is $1000 at the start of year one, while the depreciation year, of which B1 are due at the end of the first year and B-B1
expenses over the two years add (undiscounted) to $1000. at the end of the second year. The initial asset value is A =
The present (start of year one) value of the depreciation B-No, since we raise No from stockholders. Depreciation is
expenses is therefore less than the actual cost of $1,000. D1 the first year and A-D1 the second year. The book value of
(This criticism applies to long-run static equilibrium where the net worth is-No at the start of the first year, so the implicit
depreciation just covers replacement in each period so that interest charge is- rNo. The firm returns N1 to its stockholders
the initial investment never gets charged as an expense. Let at the end of the first year, of which N1-D1 + B1 represent
the initial investment be I, with annual replacement of R. The earnings and D1-B1represent a return of capital. Book value
present value of the investment plus replacement is therefore of net worth is therefore, –No-D1 + B1 at the end of the first
I + R/r. If the annual depreciation charge is D, the present year, and implicit interest of r(-No-D1 + B1) must be charged
value of the depreciation charges is D/r. In long-run static in the second year. Charges (C) against equity capital are
equilibrium D=R, and the true cost of investment, I+R/r, depreciation minus debt retirement plus implicit interest. So
exceeds the present value of the depreciation expenses by the we have:
initial investment, I.).
C1 = D1- B1 - rNo
The solution to this problem, within the framework of
earnings analysis, is to charge an implicit interest expense on C2 = A - D1 - (B - B1) + r (-No - D1 + B1)
the book value of the stockholders’ investment (net worth) at = A - B - rNo + (1+ r) (B1 - D1)
the normal rate of return, 10%. In the case of equity = -No - rNo + (1 + r) (B1 - D1)
financing which we have been considering, this is equivalent = (1 + r) ( B1- D1 -No)
to charging implicit interest on the undepreciated asset
balance. However, if the asset is financed in whole or in part We can now define pure earnings as earnings minus
by debt, this of course, would change the net cash flows. In implicit interest, and pure earnings then account for all
our example, if $500 is raised by debt borrowing the net cash capital costs. In our example, the book value of the
flow at the start of the first year is only -$500. There is a cash stockholders’ investment is $1000 at the start of the first year
payment of $1000 for the asset and a cash receipt of $500 and $400 at the start of the second, so implicit interest would
from debtholders. Only $ 500 is raised from stockholders, be $100 the first year and $40 the second, and pure earnings
and this is the net cash flow. The net cash flows would be account for capital costs means that the present (start of first
reduced in subsequent periods also, because debt repayment year) value of the pure earnings is the same as the present
and interest are cash payments which must be subtracted value of the net cash-flows, which also account for all capital
from the cash receipts to get the cash flows (to stockholders). costs.
The debt financing might also raise the discount rate on the Let us use the table below to justify our finding:

CASH – FLOW ANALYSIS EARNINGS ANALSIS

Stock- Stock-
Business Pure holders' Pure holders'
Time Profit Profit Investment Earnings Earning* Investment
Start of First Years $ 100 $ 100 $ 1100 0 0 $ 1000
End of First Years $ 110 0 $ 550 $ 60 $ - 40 $ 400
End Second Years $ 55 0 0 $ 205 $ 165 0
 International Journal of Finance and Accounting 2015, 4(1): 79-107 103

Since the discount rate is 10 % we have Suppose that a firm must select either that project or an
-40 165 -40 165 121 alternative project which has identical cash flows, but which
+ += + = =100 has economic depreciation of $500 in each of the two years.
1.1 1.2 1.21 1.21 1.21 Such a project would be indistinguishable from the first
using cash-flow analysis. Earnings analysis, however, would
More generally, denoting the pure earnings by
show earnings of $160 the first year (instead of $ 60 as the
P1 and P2, we have
original project) and of $105 the second year (instead of
$ 205). Pure earnings would be $60 the first year (instead of
P1 = N1 – D1 + B1 + rNo -$40) and $55 the second year (instead of $165). Earnings
P2 = N2 – (A – D1) + (B – B1) – r(- No – D1 + B1) maximization would lead to the selection of the alternative
= N2 – A + B + rNo – (1 + r) (B1 – D1) project, since it earns $100 more the first year and $100 less
the second year. Maximization of pure earnings, however,
= N2 + No + rNo – (1 + r) (B1 – D1)
again leads to the conclusion that the projects are equally
= N2 – (1 + r) (B1 – D1 – No) profitable since the present value of the pure earnings is $100
for either project.
Cash-flow analysis accounts for these costs much more This is not a coincidence and illustrates a very important
simply, however, by charging the cost as a cash payment point. The present value of the pure earnings of a project
when the asset is bought. Depreciation and implicit interest does not depend in any way on the economic depreciation
need not be considered since they do not give rise to cash pattern, even though the economic depreciation is charged as
flows. an expense in the various periods. We have already seen that
the present value of the pure earnings equals the present
Second, the maximization problem,
value of the net cash-flows, and neither the net cash-flows
The correct calculation of capital costs is necessary for nor their present value is influenced by the pattern of
decision making. This means that the maximization of economic depreciation. The conclusion is that earnings
earnings is not in the stockholders interest, while the maximization is not an appropriate decision criterion unless
maximization of pure earnings is. the earnings are corrected for implicit interest on the book
The maximization of earnings can be misleading even in value of the net worth to obtain pure earnings. The present
the determination of the output rate by setting marginal cost value of the pure earnings, however, is independent of the
equal to marginal revenue in the framework of comparative depreciation pattern so that it hardly seems worthwhile to go
statics. In this case the marginal revenue is the same as the to the trouble of determining depreciation and the implicit
marginal cash receipts and marginal cost is the marginal cash interest charge. It is simple (but logically the same) to
payment so that the difference between marginal revenue maximize the present value of the net cash flows.
and marginal cost is the marginal net cash-flow. Since a
positive marginal net cash-flow necessarily increases the Third, the timing problem,
present value of the future net cash-flows and so increases The only possible advantages of pure earnings over
profits, cash-flow theory confirms the traditional result that cash-flow profit would be either that they give a more
output should be increased if marginal revenue exceeds accurate picture of the timing of the benefits from the
marginal cost. investment project, or that they are more easily measurable at
This is true, however, only if both revenues and costs the end of the period.
increase at the same time. If the cost increases first and With respect to timing, cash-flow theory says that the
sometime elapses before the product is sold and revenue original project creates a pure profit of $100 at the start of the
increases, then the cash outlay during this time interval must first year, and then earns only a normal 10 per cent profit on
be regarded as an investment in the context of earnings investment in the next two years. Earnings theory says that
analysis or as a net cash payment in the context of cash-flow there are no pure earnings at the start of the first year, that the
analysis. Earnings will rise if marginal revenue exceeds return on investment during the first year falls short of a
marginal cost, but the output should be increased only if the normal 10 per cent return by $40 (pure earnings of -$40) and
difference is large enough to provide a normal rate of return exceeds a normal 10 percent return by $165 during the
on the additional (equity) investment, so that earnings second year. Since the present (start of first year) value of the
maximization is an inadequate decision criterion. Cash-flow pure earnings is the same as the present value of the pure
analysis gives the correct result by requiring that the present profit, the dispute is really about the timing of the realization
value of the future net cash receipts generated when the of the pure profit or earnings, not about the total amount
marginal revenue exceeds marginal cost be at least as large involved.
as the present value of the net cash payments generated after The approaches agree in defining pure profit as the
the marginal cost has risen but before the marginal revenue ordinary profit (Which we call business profit) or earnings
has risen. less a normal return on invested capital. They differ both in
An example related to the investment project discussed in their measurements of the ordinary profit or earnings and in
the last section will illuminate some of the problems. their measurements of the ordinary profit or earnings and in
104 Randa I. Sharafeddine: A Cash-Flow Theory of Stock Valuation

their measurement of the amount of invested capital. liquidity ) which maximizes the present value of the net cash
If we adopt the strongest version of traditional theory and flows.
value assets at market, so that depreciation is the change in In a world of certainty it would be unprofitable for a firm
market value, then both cash-flow and traditional theory base to hold cash. Any cash not needed immediately to make
their measurements of profit (or earnings) and invested payments would be lent at interest, as liquidity is worthless if
capital on market values. Earnings are associated with the all future cash needs can be perfectly foreseen, and there are
potential sale of the firm’s assets at market value. Cash-flow no flotation costs associated with lending, borrowing or
profit is associated with the potential sale of the firm’s repaying money. In the presence of uncertainty, cash
equities at market value. balances are held because they provide liquidity. In principle,
Traditional earnings are the difference between the book the decision to purchase liquidity by increasing cash
value of the net worth at the end of the year and book value at balances or to sell liquidity by reducing cash balances should
the beginning of the year, plus the net cash flow. It is be analysed in the same way any other investment decision
associated with asset values because the net worth is the is analysed. An increase in cash balances is therefore
residual when debt is subtracted from the market value of the considered as a purchase of liquidity and is defined as a cash
assets. It therefore shows the gains accruing to the payment. A reduction in cash balances is a sale of liquidity
stockholder because the firm refrained from selling its assets and is defined as a cash receipt. If a firm receives cash from
at market for an additional year. Cash-flow business profit is the sale of a product and increases its bank balance, this
the difference between the market value of the stock at the involves both a cash receipt and a cash payment, so that the
end of the year and its market value at the beginning of the net cash flow is zero. Subsequently, when the firm reduces
year also plus the net cash-flow. It therefore shows the its bank balance to pay wages, this is again both a cash
income accruing to stockholders because they held their receipt and a cash payment, with a net cash-flow of zero The
stock for an additional year, if we define income in the usual net cash-flow in any period therefore is the difference
way as that maximum possible consumption without between cash received by the firm from purchasers, debtors,
reducing wealth. or banks, and the cash used by the firm to increase cash
The traditional approach is to measure the stockholders’ balances, to pay for goods and services, to pay interest or
investment as the book value of the net worth, and we have repay debt, or to lend and such flows must be associated with
already seen that this is the appropriate base in the equity valuation.
determination of implicit interest. Cash-flow theory We could exclude all dealings in the firm’s financial
measures the stockholders’ investment as the market value of obligations from the cash receipts and payments. The
the firm’s stock. net-cash flow would then include transactions with
Fourth, the measurement problem, debtholders as well as stockholders. The present value of the
net cash flows would be the total value of all the firm’s
If the objective of the firm is to earn a profit for its financial obligations, and the value of the stock would be the
stockholders, the amount of profit earned during a period can total value of the obligations less the value of the debt. And
be used as a criterion in measuring the performance of the this would provide the justification for the treatment of cash
firm. It is therefore desirable to have a profit concept which balances, cash balances are held because they provide
can be measured on the basis of market values, so the liquidity. In principle, the decision to purchase liquidity by
measurement will be objective in the accounting sense. increasing cash balances or to sell liquidity by reducing cash
Of the four profit concepts we have considered, two, balances should be analysed in the same way any other
business profit and earnings, are measurable from market (investment) decision is analysed. HINT: Management
data. Neither pure earnings nor pure profit is so measurable should project the future cash receipts and cash payments of
since they both require the use of the normal rate of return the firm with various cash balances, subtract the payments
and this is not directly observable in the market. As earnings from the receipts to determine net cash-flows, and then select
maximization is not in the stockholders’ interest, it is not a that cash balances (i.e., purchase that amount of liquidity)
satisfactory measure of performance. This leaves business which maximizes the present value of the net cash flow.
profit as the only satisfactory measure of performance. The net cash flow in any period therefore is the difference
between cash received by the firm from purchasers, debtors,
8. The Net Cash-flow Theory of Stock or banks, and the cash used by the firm to increase cash
Valuation is the Daily Cash balances, to pay for goods and services, to pay interest or
Transaction between the Firm and Its repay debt, or to lend. Such flows must be associated with
Stockholders equity obligations, i.e., the net cash flow is the cash flow
between the firm and its stockholders. A positive net cash
The present value of the future net cash-flows where flow represents a cash payment by the firm to the
management should project the future cash receipts and cash stockholders, i.e., a dividend payment or a stock repurchase,
payments of the firm with various cash balances, subtract the while a negative net cash flow represents a cash payment by
payment from the receipts to determine net cash-flows, and the stockholders to the firm, i.e., a new stock subscription.
then select that cash balance (i.e., purchase that amount of The associated theory of stock valuation is based on the
 International Journal of Finance and Accounting 2015, 4(1): 79-107 105

assumption that the cash receipts and the cash payments of involves both a cash receipt and a cash payment, so that the
the firm have been projected for each time period for ever. net cash flow is zero (The net cash-flow is this cash between
We assume that there are no transaction or flotation costs, or the firm and its stockholders). Subsequently, when the firm
any costs other than interest (or dividends) involved in reduces its bank balance to pay wages, this is again both a
borrowing or repaying money, or in buying or selling cash receipt and a cash payment, with a net cash-flow of zero
financial obligations. We also assume that stockholders are The net cash-flow in any period therefore is the difference
indifferent between capital gains and dividend income, so between cash received by the firm from purchasers, debtor,
that we would ignore problems which arise because of the or banks, and the cash used by the firm to increase cash
different taxes on income and capital gains. The net balances, to pay for goods and services, to pay interest or
cash-flow would then include transactions with debtholders repay debt, or to lend and such flows must be associated with
as well stockholders. The present value of the net cash flows equity valuation.
would be the total value of all the firm’s financial obligations, More than this the financial manager should consider and
and the value of the stock would be the total value of the take into consideration any cash inflow and cash outflow on
obligations less the value of the debt. So, that the present the cash budgeting of the firm in order to depict any value
value of the net cash flows is the value of the stock. Since creation inside the firm and to be able to correct any
the peculiar treatment of cash balances does not arise in deviation of maximizing wealth on daily basis, hour per hour
evaluating any decision except the decision about the level of and which is not depicted through economic value added.
cash balances themselves, our treatment of cash balances Financial Managers should project the future cash receipts
does not impair the usefulness of the cash-flow concept in and cash payments of the firm with various cash balances ,
investment decisions, but adds to its usefulness in stock subtract the payments from the receipts to determine net
valuation. cash-flows, and then select that cash balances (i.e. , purchase
that amount of liquidity) which maximizes the present value
of the net cash flow . So, the financial system has become a
In Conclusions cash-flow system where a continuous adjustment on hour per
hour, day per day of the variables affecting the discounted
We developed Gordon Model for stock valuation to present value of the cash-flow stream will show its effect on
become a net cash-flow between the firm and its the value of the company’s stock (The net cash-flows would
stockholders where dividend left the equation and become the cash flows between the firm and its
disappeared. We also said that the net cash-flow concept is a stockholders).
better approach than Economic Value Added where we need
many adjustments for EVA to link it to value added, however,
the net cash-flow concept is a better approach because it
needs no adjustments.
The associated theory of stock valuation is based on the
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