If
there has been a shift in corporate finance
and valuation in recent years, it has been
towards giving "excess returns" a more central
role in determining the value of a business.
While early valuation models emphasized the
relationship between growth and value - higher
growth firms were assigned higher values -
more recent iterations of these models have
noted that growth unaccompanied by excess
returns creates no value. With this shift
towards excess returns has come an increased
focus on measuring and forecasting returns
earned by businesses on both investments made
in the past and expected future investments.
In this paper, we examine accounting and cash
flow measures of these returns and how best
to forecast these numbers for any given business
for the future.
The
notion that the value of a business is a function
of its expected cash flows is deeply engrained
in finance. To generate these cash flows,
though, firms have to raise and invest capital
in assets and this capital is not costless.
In fact, it is only to the extent that the
cash flows exceed the costs of raising capital
from both debt and equity that they create
value for a business. In effect, the value
of a business can be simply stated as a function
of the "excess returns" that it generates
from both existing and new investments.
While
this principle is intuitive and easily proved,
measuring excess returns has proved to be
difficult to do. On one side of the equation
are the costs of debt, equity and capital.
While there are clearly significant questions
that remain to be addressed, a significant
portion of the research in finance has been
directed towards estimating these numbers
more precisely. On the other side of the equation
are the returns themselves and surprisingly
little has been done in coming up with a cohesive
and consistent measure of returns generated
on investments and how these returns can be
expected to evolve over time.
In
the first part of this paper, we will lay
out what we are trying to measure with these
returns and why it matters so much that we
get a good estimate of the numbers. In the
second part of the paper, we will look at
both accounting and cash flow based measures
of returns and the advantages and disadvantages
of both. In the third part of the paper, we
will consider factors that may cause the measured
returns for a firm to deviate from its true
returns and how best to fix the problems.
In the fourth part of the chapter, we will
turn our attention to forecasting investment
returns and how best to incorporate the effects
of competition into these forecasts.
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