Virtually everyone in business is familiar with the famous equation 11, the discounted cash flow (DCF) approach to valuation, from Miller and Modigliani’s (M&M) 1961 Journal of Business article, “Dividend Policy, Growth, and the Valuation of Shares.” Equation 11 is as follows:

where MV₀ is the market value today, X_t is net operating profit after taxes (NOPAT) at the end of year t, I_t is new investment at the end of year t, X_t − I_t are the free cash flows (FCFs) in year t, and ρ is the cost of capital. But M&M also described their so-called Investment Opportunities Approach (IOA), equation 12, which they proved was equivalent to DCF (equation 11). In fact, M&M thought the IOA was the more natural from the standpoint of an investor considering an acquisition because it offered a view of value based on whether the return on new investments would exceed their cost of capital.¹

The IOA proposed that a firm’s value can be broken into the value of its recurring business operations today and expectations of additional value that will be created from new investments in the future—that is, the known and expectational components of current market value. This approach is the foundation of what became known as the economic value added (EVA) concept, popularized by Bennett Stewart in the 1990s and refined and extended by Stephen O’Byrne.²

Serious finance practitioners will know the IOA equation, equation 12:

where X₀ is the uniform perpetual “earnings” on the current asset base, I_t is the new investment at the end of year t, ρ*(t) is the constant rate of return on I_t in the year immediately following the investment, and ρ is the cost of capital. Equation 12 assumes that return on current investments is constant.

Equation 12 essentially separates current market value into two components: the value from maintaining current operations (the perpetuity value of the uniform perpetual stream of “earnings” on the current asset base) and the value of future growth expected from new investment, expressed as the capitalized present value of the constant annual spreads between the return on invested capital and the cost of capital for each new investment (in the year following the investment). Recasting what investors would be willing to pay for a company in this way allows us to thoughtfully consider how much better a company would be expected to perform, in terms of creating additional value, than it does today.

Maintaining current performance, the uniform perpetual stream of earnings will yield only a cost-of-capital return on the perpetuity value of that stream (X₀/ρ × ρ = X₀) each year but would not justify any additional value for an investor. Thus, the only way for a company to justify value above the value of current operations is to achieve performance improvements that exceed the cost of capital on new investments. This logic forms the underpinnings of the EVA approach.

From a strategy perspective, that would imply creating or exploiting advantages relative to competitors. That is the economic essence of a go-forward business plan, as M&M explained in 1961:

Formula (12) has a number of revealing features and deserves to be more widely used in discussions of valuation. For one thing, it throws considerable light on the meaning of those much abused terms “growth” and “growth stocks.” As can readily be seen from (12), a corporation does not become a “growth stock” with a high price-earnings ratio merely because its assets and earnings are growing over time. To enter the glamor category, it is also necessary that ρ*(t) > ρ. For if ρ*(t) = ρ, then however large the growth in assets may be, the second term in (12) will be zero and the firm’s price-earnings ratios will not rise above a humdrum 1/ρ. The essence of “growth,” in short, is not expansion, but the existence of opportunities to invest significant quantities of funds at higher than “normal” rates of return.

Equation 12 offers several uniquely helpful qualities. First, it allows the perpetuity value of recurring “earnings” to be easily separated from growth value. Second, it allows value added from growth to be considered on a periodic basis by taking an explicit charge for any additions of capital in each year. Finally, and more fundamentally, it makes two things perfectly clear: 1) maintaining current performance only justifies a company’s value equal to the present value of current operations (its perpetuity value), and 2) future investments must earn a return on investment greater than the capital charge for those investments to justify a market value greater than the present value of current operations.