For more than 30 years, mainstream finance has devoted surprisingly little attention to detailed individual-firm valuation models. This is the result of a research methodology that (a) reveres elegant mathematical theorizing, (b) accepts a theory's assumptions as not needing to correspond to reality, and (c) treats the stock market as such an efficient mechanism for forecasting firms' economic performance that valuation analysis becomes unproductive.

With its foundation in elegant mathematical specification of efficient portfolios, the capital asset pricing model (CAPM), first elucidated in the early 1960s, was quickly embraced by finance academics even though it requires a host of assumptions that have no counterpart in the way investors actually value individual firms.

The primary competitor individual-firm model to the CFROI model is the residual income (RI) model. Residual income is what a firm earns in excess of that required to compensate owners for the cost of their capital. RI valuation models have appeal for their simplicity.

For the firm's equity discount rate, RI models use the CAPM/beta approach, in which the firm's discount rate is calculated as a base risk-free rate for the time of the valuation plus a risk premium. This risk premium begins with the excess return of the general equity market over the risk-free rate for some selected historical period. It is then adjusted depending upon a firm's stock price volatility as measured by beta. The historical nature of the CAPM/beta risk premium is a severe flaw. In...