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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