FREE online courses on Financial Management and Creating Value - Chapter 3 -
Cash Flow Return on Investment - CFROI
The second approach to measuring value that we want to
discuss is Cash Flow Return on Investment or CFROI. Valuations are a function of
looking into the future and adjusting for things that will alter value. For
example, the operating cash flows we receive in the future are adjusted downward
to reflect inflation. We also recognize that the marketplace is not without
limitations when it comes to judging value. For example, the marketplace can not
readily comprehend the cost of capital (this is difficult enough for insiders to
figure out) and thus the marketplace reacts to things like earnings to determine
short-term values. We need a way of measuring value that emphasizes operating
cash flows (adjusted for inflation) and compares this return to investments that
are also adjusted for inflation. Such an approach to measuring value is called
Cash Flow Return on Investment (CFROI).
CFROI = Inflation Adjusted Cash Flows (Cash In) / Inflation
Adjusted Investment (Cash Out)
Unlike EVA, CFROI expresses cash flows and investments in
current dollars. CFROI does not concern itself with the cost of capital. It
looks ahead and establishes a market rate based on what investors expect over
the long-term. Because of this approach to valuation, CFROI tends to be more
accurate than EVA in measuring value. Under CFROI, economic performance is
calculated and measured by:
- Identifying cash inflows and outflows over the
economic life of the assets.
- Adjusting both cash inflows and outflows into
units of constant purchasing power.
- Calculating a CFROI rate similar to how the
Internal Rate of Return is calculated; i.e. what is the rate where inflows =
outflows?
