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EMV and Shareholder Value

I have long maintained that EMV of a project, properly evaluated, provided a measure of the value added to the corporation. In prior efforts to model project and company value from the shareholder's perspective, a persistent problem has been the inconsistency with the shareholder's time value of money and the typical capitalization rates inferred from stock prices (papers HEES3 and HEES5). A fundamental premise in the decision analysis approach is that the PV discount rate should represent only time value of money. Risking should be done with probabilities—not the PV discount rate. The logic of this became clear to me, long ago, when I visited a venture capital firm using a 70% PV discount rate!

In developing an example for the latest in a series of papers (HEES6), I was working to reconcile EMV per share versus share price. Using Value Line Investment Survey data for nine oil and gas producers, I was finding that share price was typically about half of the PV per share of forecast free cash flow. I used a multiplicative factor to represent an additional market value discount (MVD) factor. Factoring NPVs for risk is a time-honored adjusting method for people buying and selling cash-producing assets (such as petroleum producing properties). While I'm unaware of any theory suggesting this is the one, correct calculation method, this MVD factor provides a means to adjust values downward without resorting to an excessively-high PV discount rate.

My current (as of May 2006) thinking is:

EMV of a project or the company should be based upon modeling the project's contribution to the company's free cash flow.
Then, EMV of a project, properly evaluated, measures incremental EMV of the company.
EMV of the company (calculated from free cash flow) times a MVD factor equals market capitalization of the company.
Thus, shareholder value added by a project equals the project EMV times the MVD factor.

In my opinion, the appropriate free cash flow consists of the cash amounts that can be aggressively withdrawn from the company, without particular regard to maintaining the business. This free cash flow definition is different from the customary one that assumes that business assets are maintained or replaced.

If you have any comments or suggestions as to a better approach, please contact me immediately:

I hope to wrap-up this topic in yet one more paper or article. It will be about forecasting shareholder value—and showing this on the balanced scorecard dashboard—based upon a stochastic model of the enterprise.

—John Schuyler, Jan. 2006. Rev. May 2006.