function of expected excess returns. Although there are
numerousversionsofexcessreturnmodels,wewillfocuson
one widely used variant, which is economic value added
(EVA), a measure popularized by Stern Stewart, a value
consultingfirm.Economicvalueaddedisameasureofthe
surplus value created by an investment or a portfolio of
investments.Itiscomputedastheproductoftheexcessreturn
made on an investment or investments and the capital
invested in that investment or investments.
Inthissection,webeginbylookingatthemeasurementof
economic value added and then consider its links to
discounted cash flow valuation.
Calculating EVA
ThedefinitionofEVAoutlinesthreebasicinputsweneedfor
its computation—the return on capital (ROC) earned on
investments,thecostofcapitalforthoseinvestments,andthe
capitalinvestedinthem.Inmeasuringeachofthese,wemake
manyof thesame adjustments discussedin the context of
discounted cash flow valuation.
Howmuchcapitalisinvestedinexistingassets?Oneobvious
answer isto use themarket valueof thefirm,but market
valueincludescapitalinvestednotjustinassetsinplacebut
in expected future growth.
10 Sincewewanttoevaluatethequalityofassetsinplace,we
needameasureofthecapitalinvestedintheseassets.Given
thedifficultyofestimatingthis number,itisnot surprising