For those interested in an EVA discussion, consider the following:
From thestreet.com:
An EVA Primer
By Andrew Greta
Special to TheStreet.com
1/31/99 12:18 AM ET
I've been getting lots of mail recently from readers interested in learning about the concept of economic value added as a tool for guiding investment decisions. Unfortunately, the most I could recall on the subject were the barest details of a single case study I completed in a corporate finance class that was largely dismissed by the prof as a kind of freak show curiosity.
So for the past month, I've been hitting the phones and the Net digging up everything I could find on the topic and synthesizing it into an actionable dispatch. Special thanks go out to Al Ehrbar, of Stern Stewart & Co. and author of EVA: The Real Key to Creating Wealth, who's generous assistance during several lengthy phone conversations helped me crystallize a massive jumble of new concepts into something resembling logic.
Here's what I found.
The Basics
In short, EVA is a performance metric that calculates the creation of shareholder wealth as opposed to accounting income. In order to see the distinction, consider a hypothetical firm called Monica's House of Stogies that made $90,000 in net income last year on a capital base of $1million by selling its wildly popular El Presidente cigar.
By all traditional measures, Monica is making great money with a healthy return on capital (ROC) of 9%. But the firm is a start-up venture, and the public's taste for trendy smokes tends to be fickle at best. As a result, let's say investment capital costs the firm 12% per year (either explicitly through loan payments, or implicitly through the required return that equity shareholders demand for tying up their cash in such a risky operation). So while the company appears to be making money from an accounting perspective, it is actually losing 3% a year and destroying shareholder wealth in the process.
By essentially charging the firm "rent" on any money that it is locking up to support operations, EVA captures this "hidden" cost of capital that accounting measures ignore. A positive number indicates that the firm is creating wealth, while a negative number means it is destroying it.
Running the Numbers
From a computational standpoint, EVA equals a firm's net operating profit after taxes (NOPAT) minus the firm's weighted average cost of capital (WACC%) times the total amount of investment capital employed (both debt and equity). For all you quant jocks out there, the formula looks like this:
EVA = NOPAT - WACC%*(TC)
It's a short formula, but deceptively complex. For starters, the method used to figure NOPAT as an indicator of value creation is up for considerable debate. Accounting notions of income don't always reflect the actual after-tax cash generated by the business that's available for reinvestment or distribution to investors. For example, generally accepted accounting principles (GAAP) require firms to immediately expense all R&D costs up front in the year they're incurred. An EVA approach, however, might choose to (more realistically) treat those expenses as an investment and amortize them over a period of years. Stern Stewart has identified more than 160 potential adjustments to standardized accounting profits to yield a "true" measure of a firm's performance for purposes of figuring EVA.
To further complicate matters, each firm's WACC is an intricate function of the company's capital structure (percentage of debt versus equity on the books), the stock's volatility as reflected by its beta, and the current market risk premium between riskless treasury bonds and risky equity returns. Figuring it out requires a hefty bit of number crunching probably best left to the backroom brainiacs who roamed the undergrad halls kicking matrix algebra problems in the faces of us less mathematically endowed business types.
If you don't want to hassle with it, no problem. Just look up the pre-calculated EVA figures on the Stern Stewart Web site. There, you'll find current EVA stats for the 1,000 largest U.S. firms neatly figured and ranked using a proprietary computation model that corrects for the most critical accounting vagaries.
Tool Time
So now that you know what the EVA hammer is made of, how do you put it to use smashing apart stocks to see if they're worth buying?
The simplest way to wield the tool is to simply compare EVAs directly across different firms. The companies with the higher EVAs are supposed to outperform ones with lower (or negative) EVAs over time -- all other things equal. So when faced with a choice between investing in a company like market titan Intel (INTC:Nasdaq) that created $4.8 billion of wealth in 1997 versus oafish General Motors (GM:NYSE), which destroyed $4.1 billion in the same period, the choice is pretty obvious.
Another method is to assess the spread between a firm's ROC and their cost of capital. Using the Stern Stewart figures, Intel is catapulting well over their capital cost bar with a huge 27.6 percentage points to spare (42.7% ROC vs. 15.1% WACC). Meanwhile, lumbering GM is fully 5 percentage points below its relatively meager 9.4% hurdle rate.
Both of these techniques give you a relative basis to compare the performance of different firms. Unfortunately they can't tell you if a company is priced fairly in the marketplace relative to its EVA performance. What we need is a way to link EVA to a stock's market price to figure out if it's a good buy today.
Enter MVA
Market value added (MVA) is defined as the present value of all the predicted future EVA of a firm as valued by the market. The real question becomes, is this market estimation of future EVA in line with a reasonable estimate of reality? To answer that question, first establish a base-case scenario by dividing the firm's current EVA by it's WACC. The resulting figure is the theoretical MVA of the firm if the market predicted zero growth for the company into eternity. At the beginning of 1998, that figure was $32 billion for INTC ($4.8 billion EVA divided by 15.1% WACC) well short of the then-current $90 billion that the market was valuing it at. Clearly investors were predicting some hefty growth in Intel's future, but just how much?
Taking the difference between the current MVA of $90 billion and the baseline calculation of $32 billion, and it seems that $58 billion needs to be explained by predicted EVA growth. So how much do revenues need to grow over the next 10 years to justify that amount? Doing a quick present value calculation, assuming that recent history is repeated and the company has 32% operating margins and our 15% cost of capital, the answer comes in at an aggressive 25% clip.
Sure the company has been able to maintain that pace for the last five years running, so the stock may be valued fairly in the marketplace. But if margins erode or sales slow over the next decade, it sure doesn't look like much of a bargain. The bottom line is that you're looking for stocks valued either wildly above or below a reasonable estimate of future growth.
Use in Moderation
The EVA method has its detractors among those who find the NOPAT calculations tedious and subjective. In addition, at least one obscure academic study (from Drake University) has cast doubt on EVA's ability to better predict future stock price performance relative to traditional measures like return on assets (ROA). On the other hand, EVA has been wholeheartedly adopted by some big-name investment banks as the valuation metric of choice.
It may not be a magic bullet, but EVA could be a valuable addition to your ammo belt next time you decide to go out on a stock hunt. Recognizing that my brief treatment here may have only whetted your appetite for more detail on applying EVA, send your questions on this or any other fundamental analysis topic and I'll answer them in future Q&As. Good luck and happy investing.
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