FEVA: A Financial and Economic Approach to Valuation

Traditional valuation methods (economic value added, discounted cash flow, and Modigliani and Miller models) are mathematically equivalent and thus should provide the same result when the same inputs are used. They do not. Because these methods focus on different value drivers, we suggest an alternative valuation method that provides the adjustment necessary to produce consistent results. We also propose a new corporate valuation method (“financial and economic value added,” or FEVA) that integrates the EVA, DCF, and MM approaches and allows a detailed analysis of financial and economic corporate value drivers. Financial analysts face a fundamental problem: When different valuation models are applied to the same company, they yield significantly different results. Why does this happen? Shouldn't similar methods from the same family lead to the same result? We explain why, if properly applied, all traditional methods do yield the same result, and we offer a new method that reconciles differences among the traditional methods. In addition to traditional discounted cash flow (DCF) methods, one family of valuation models, economic value added (EVA) and other franchise factor approaches, has become a favorite methodology for corporate valuation. In EVA approaches, the key value driver is the spread between the return on the existing investments and their average cost of capital. Therefore, this approach focuses on the left-hand side of the balance sheet—investment analysis. Another family of corporate valuation methodologies is grounded in the work of Modigliani and Miller; it was developed in the economics literature and has not been so widely followed by practitioners as the EVA approach, although it is consistent with the EVA approach. MM models provide a framework for the analysis of the optimal financial structure. This approach aims to identify the links between financial decisions and corporate value and, therefore, how the right-hand side of the balance sheet—the financial structure—affects corporate value. Given these three approaches, several questions arise. First, from the practitioner point of view, are these methodologies equivalent? Do they yield exactly the same result? The emphasis on exactness is important. The principle of one value states that because these approaches share the same underlying assumptions, if the approaches are properly used and the same inputs are used in each, their results should not differ. All these methods should yield exactly the same result. We show that EVA, MM, and DCF methodologies are mathematically equivalent and that, therefore, the principle applies to the last decimal. We also show the adjustments required to produce consistent valuation results, especially for the MM valuation methods, in which tax shields and bankruptcy costs play such an important role. We provide a numerical example to illustrate the adjustments. The important aspect of this issue is not its technical interest or which of the different “values” of a company is correct but, rather, what the value drivers are that each method identifies. This issue leads directly to the second question: If these approaches are mathematically equivalent, can we not develop a formula or method that integrates all the value drivers identified for each methodology? Our answer is a “financial and economic value added” (FEVA) model. The FEVA model divides corporate valuation into eight value drivers—three economic drivers taken from the EVA approach and five financial structure drivers based on the MM approach—and differentiates the contribution of each driver. This model maintains the principle of one value because the FEVA formula is mathematically consistent with the standard methodologies.