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In the past two decades corporations have dramatically changed their ways of doing business. They have realized that earnings or profit alone are not enough to increase shareholder’s and/or owner’s wealth. This understanding is the basis for measures such as Stern Stewart’s Economic Value Added (EVA®), Free Cash Flow Models (FCF), Cash Flow Return on Investment (CFROI) among others. These measures incorporate profitability with asset management giving rise to a new financial management system – Value Based Management (VBM).

Typically the success or failure of any strategy is measured by certain metrics. These metrics are generally based on historical accounting information that is readily available. Examples of some such measures are:

• Net Operating Income
• Profit Margin
• Return on Investment
• Earnings Growth

These accounting-based measures of performance suffer from two important limitations:

• these performance measures are based solely on one historical period of operations and there is no reason to believe that they are good indicators of value to be created over the entire life of the venture.
• accounting information systems do not incorporate an opportunity cost of the owner’s capital.

Value Based Management systems attempt to overcome such limitations and provide a metric to measure wealth creation or erosion. Three principal subgroups of VBM tools are:

• free cash flow
• economic value added/market value added (EVA/MVA)
• cash flow return on investment/total shareholder return (CFROI/TSR)

Example
This spreadsheet provides an example of a Free Cash Flow Model. It goes to show that owner's wealth does not necessarily increase with sales growth or net operating income growth (accounting measures). The model shows that even in a no sales growth situation owner's wealth is higher than what was observed in a growing sales projection.