Useful management tool: future value

In Chapter 3 of our textbook, we show how EVA (Economic Value Added) and other EPP's (Economic Performance Plans) make visible the hidden-cost of capital, and lead to better investment decisions.

But EVA is not a panacea: it is a backward-looking measure, and fails to recognize actions that increase the future value of the enterprise. Today's WSJ recommends decomposing the market valuation of the firm into current value and future value so that managers can better "see" how the market is reacting to their actions. Here is how its done:

1. Calculate the enterprise value of the firm: Enterprise value is the sum of current stock market valuation (shares times price per share) plus the market value of interest-bearing debt.

2. Calculate the current value of the profit stream, assuming no profit growth: Divide current operating profit by the cost of capital.

3. Calculate the future value of the firm: Future value is enterprise value minus the current value

4. Track both future value and current value as a percent of enterprise value: This allows you to see how your current actions affect future vs. current value.

To understand how an analysis of future value can help executives shape business strategy, consider the big-box retailing sector.

For years, large retailers were rewarded with higher share prices for opening new stores at a breakneck pace. But growth through expansion may be nearing its limit for these retailers as their markets become saturated.

In our research on a select set of major retailers, we saw a downward trend for future value in the industry as a whole. From 1998 to 2006, most of the retailers continued to invest heavily in new-store openings, fueling an increase in the companies' current value. Future value, however, didn't keep pace with the growth in current value. In fact, future value as a percentage of enterprise value for the group as a whole declined from almost 75% to 30%, an indication that investors were losing faith in simple market-penetration and geographic-expansion strategies. Had these companies been tracking future value regularly, they might have recognized earlier that a strategy based on increasing scale was running out of room and begun investing differently for growth.