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EVATM: Economic Value Added

Chris Argyrople, CFA

Concentric Investments

EVATM & Securities Analysis

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Long Term or Short Term View?

• Be cognizant of both your LT & ST outlook• Bull Markets: Quality Rules• Bear Markets: Quality Rules• All Markets: Visibility Rules• Coming out of a recession: Small Caps do

well• Sector rotation is the key to great

performance (asset allocation, not stock selection drives performance)

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Defining Quality

• What is Quality?• Right now:

–Quality is low debt–Reasonable Valuation–Visibility in the Sector–Good Management–No blowups in the food chain–STOCK HAS EARNINGS

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Forecasting a Stock Price

• Traditional Method– Discount Cash Flows back to Present– Problem is that forecasting out 1 year is impossible,

forecasting out further is mythology

• Using Multiples– P = P/E * E (both are forecasts)– P = TEV/EBITDA * EBITDA - DEBT

• This is an art, not a science

• Your logic dictates your grade

• Should the multiple expand or contract??

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Weighted Avg. Cost of Capital

• WACC = Weighted Average Cost of Capital

• WACC = %D * Rd (1 - taxrate) + %E * Re

• %D = % Debt % E = % Equity

• %D + %E = 100% Market Values NOT Book

• Rd = Cost of Debt

• Re = Cost of Equity = Rf + Beta * (Rm - Rf)

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Calculating WACC

• Too much time is spent in Finance curriculums on this issue.

• Don’t spend much time calculating WACC.• Use the marginal taxrate.• For Rd use the company’s market

borrowing rates.• Rf = use time horizon equal to your

investment horizon. Stewart advocates 20 years. Between 5 & 10 years is sufficient.

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My Thoughts on Beta

• Q) What stock is < risky than the market? A) Very Few.

• Thus, Plug the Beta when you get a number like 0.9 or 1.0. Why?

• Imagine a one stock portfolio. You can always drastically reduce the risk by adding 5 or 10 stocks. In my opinion, a market-like Beta of 1.0 is not very realistic.

• Use Ibbotson risk premia (about 11%)

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Why is WACC Important?

• Imagine that your local bank will lend you $1 million at 10% interest.

• After getting the loan, you invest this in a stock that has an E(r) of 30%(not too far fetched in my opinion).

• Your projected cash flows in one year are:– Pay $(1,100,000) million on the loan– Receive $ 1,300,000 from the sale of the stock– P/(L) $ 200,000 Profit

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WACC is Capital Budgeting’s Benchmark

• Standard Capital Budgeting Rule– INVEST IN PROJECTS THAT EXCEED WACC– INVEST IN POSITIVE NPV PROJECTS

• Ask the CFO what the firms WACC is.

• You would be surprised how many CEOs and CFOs can’t answer this question.

• This is a good hint that they don’t understand the value creation process.

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Behavior of WACC

WACC incorp: Business Risk & Financial Leverage

Rd < Re bec:

Senior Claim &

Tax Benefits

WACC

Tax Shield Cost of

Benefits Financial Distress

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EVATM: Economic Value Added

• EVA is trademarked by the Stern Stewart Corporation. They would like you to hire them as consultants.

• Two methods of calculating EVA:

• EVA = (ROIC - WACC) * Invested Capital

• EVA = NOPAT - WACC * Invested Capital

• ROIC = NOPAT / Invested Capital

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EVATM Terminology

• NOPAT = Net Operating Profit After Taxes• NOPAT = EBIT - Adjusted Taxes• NOPAT = NI + Aftertax Interest Expense• Note that depreciation is included because

Stern Stewart believes that it represents a true Economic expense. WHETHER OR NOT THIS IS TRUE IS YOUR CALL. You could substitute maintenance CAPEX for depreciation.

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Delever the Rate of Return

• Return = NOPAT / Capital

NOPAT Capital

= NI = Common Equity

+ Incr. Equity Equiv. + Equity Equivalents

+ Aftertax Int. Exp. + Debt (all debt)

+ Pref Dividends + Preferred Stock

Measures ROE assuming equity financing.

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Minority Interest Provision

• Stern Stewart recommends:– Adding the Minority Interest Provision from

the income statement to Net Income and – Adding the Minority Interest liability from the

balance sheet to Capital• I Disagree with this adjustment:

Minority Interest represents the earnings which the firm IS NOT ENTITLED TO. Adding it back just skews ROIC higher or lower (depends on ROIC of the subsidiary)

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Why we Delever Returns

• ROE is misleading– LEVERED METRIC– TOUGH TO TELL WHETHER IT CHANGES

DUE TO OPERATING OR FINANCIAL REASONS

– IF ROE IS GOAL, MGT. CAN ACCEPT LOUSY DEBT FINANCED PROJECTS AND/OR REJECT GOOD EQUITY FINANCED PROJECTS

• Return = EBITDA / TEV Similar to EVATM

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Another Method of Calc NOPAT

NOPAT = Operating Income

Less: Adjusted Taxes

Tax Provision

- Deferred Taxes

+ Interest Tax Shield

- Taxes on Interest Income

Plus: Goodwill Amortization

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Complex Method: Calc NOPAT

NOPAT = EBIT + Incr. Bad Debt Reserve +Incr LIFO Reserve + Goodwill Amort + Incr Net Capitalized R&D + Other Operating Income (excluding passive income) - Cash Oper. Taxes

Cash Oper. Taxes = Tax Provision - Incr Deferred Tax Reserve + Tax saved from unusual losses + Interest Tax Shield - Tax on Passive Income (last 3:marginal corp)

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Unlevered Free Cash Flow

• Unlevered FCF = FCF + Adj Interest Exp.

• or FCFunlev = NOPAT - Inv. Future Growth

• Inv in Future Growth = Delta WC + Net Capex + Net Acquisitions

• Value Entire Firm:– Discount Unlevered FCF at WACC

• Value Equity Only– Discount FCF at Cost of Equity

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Defining Equity Equivalents

• Deferred Tax Reserves• LIFO Reserves (FIFO - LIFO Value)

– bec. FIFO approx. current cost of inventory

• Cumul. Goodwill Amortization or Unrecorded Goodwill (Pooling Acquisition)

• Full Cost Reserves (for those who use successful efforts accounting)

• Cumulative Unusual Losses• Bad Debt Reserves

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EVATM Define: Invested Capital

Two Methods of Calculating Invested Capital

Financing Method Operating Method

Common Equity Cash

+ Equity Equivalents + Inventory

= Adj Common Equity + PP&E

+ Pref Stock + A/R

+ All Debt - A/P - Accd Expense

+ Other Accounts

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Invested Capital

• Two methods of calculating invested capital look at both sides of balance sheet.

• I only use the financing method. Add:– PV of non-capitalized leases– Bad Debt, Warranty, Obsolescense Reserves– Cumulative Goodwill Amort (& unrecorded

Goodwill)– Cumulative Unusual Losses– Capitalize R&D Expense over 5 yrs (going concern)– Deferred Tax Reserve, LIFO Reserve

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Invested Capital

• Remove Excess Cash (from Capital and NOPAT)

• Remove Minority Interest (from Capital and NOPAT) because Management can’t totally control.

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Market Value Added MVA

MVA = Market Value - Invested Capital

Capital

TEV vs. MVA

Price x MVAShares

EquityEquival.CommonEquity

Other LT Other LTLiabilities LiabilitiesDebt + Debt + Leases Leases

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Uses of EVA

• Quantify Improving / Deteriorating Trends not yet reflected in EPS

• Forecast Target Price for a Stock

• Identify Value Drivers

• Use EVA to spot changes

• Identify what Divisions subsidize others

• Look at ROIC - WACC spread over time

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Is EVA Unilaterally Useful?

Public Companies

• 1/3rd Add Value

• 1/3rd EVA Neutral

• 1/3rd Destroy Value

Value Destroyers have embedded options that price improved future performance.

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EVA: Makes Analysts Think

Goal: Variant Perception

• Strategic Assessment 90% of Time

• EVA 10% of Time

• Earnings are an Opinion, Cash is a Fact

• How much capital is required to sustain growth rate?

• How much risk embedded in current Mult?

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Misconceptions about EVA

• Misconception #1: Negative EVA guarantees a falling stock price.

• Example:– All equity financed firm– Cost of Equity = 10% - ROIC = 5%– Stock goes up something like 5% . The point

here is twofold 1) The stock goes up 2) 5% returns are pitiful, you are better off in the bank

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ROIC < WACC, Rising Stock

Income Statement Year 1 Year 2 Year 3 Year 4

Revenue 250.5 250.5 250.5

COGS (133.7) (133.7) (133.7)

SG&A (26.0) (26.0) (26.0)

Depreciation (34.1) (34.1) (34.1)

Operating Income 56.7 56.7 56.7

Interest Expense/Inc. (1.0) 0.5 1.6

PBT 55.7 57.2 58.3

Taxes (22.3) (22.9) (23.3)

NI 33.4 34.3 35.0

Capital Expenditures (47.0) (47.0) (47.0)

Free Cash Flow 20.5 21.4 22.1

Beginning of Year B/S:

Cash - 10.5 31.9 54.0

Debt 10.0 - - -

Stock Market Value 500.0 520.5 541.9 564.0

Enterprise Value 510.0 510.0 510.0 510.0

NOPAT 34.02 34.02 34.02 -

Invested Capital 650.0 683.4 717.8

ROIC 5.2% 5.0% 4.7%

Stock % Return 4.1% 4.1% 4.1%

A

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Misconception #2

• Positive EVA = Rising Stock Price in Short Run

• Positive EVA may be accompanied by excessive valuation & a falling stock price (in the intermediate term)

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Importance of EVA Factors

• 1) ROIC - WACC % Spread : Most Import

• 2) Dollar EVA : Second Most Important. Why? Because there may not be many high value added projects. GM is a good example

• 3) Direction of ROIC - WACC Spread. Sometimes this is most important.

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EVA trend key to Valuation Chg

Company A Company B1994 1995 1996 1997 1994 1995 1996 1997

ROIC 10% 11% 14% 16% ROIC 16% 14% 11% 10%WACC 13% 12% 13% 14% WACC 10% 9% 10% 11%ROIC - WACC -3% -1% 1% 2% ROIC - WACC 6% 5% 1% -1%Invested Capital 100 105 110 115 Invested Capital 100 105 110 115 EVA (3.0) (1.1) 1.1 2.3 EVA 6.0 5.3 1.1 (1.2)

Firm A: Rising EVA Trend

-4%

-2%

0%

2%

4%

1994 1995 1996 1997Year

RO

IC -

WA

CC

Firm B: Falling EVA Trend

-2%

0%

2%

4%

6%

8%

Year

RO

IC -

WA

CC