EVATM: Economic Value Added

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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.
• Dont spend much time calculating WACC.
• Use the marginal taxrate.
• For Rd use the companys 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 lt 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 Budgetings 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
  cant answer this question.
• This is a good hint that they dont understand
  the value creation process.

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Behavior of WACC

• WACC incorp Business Risk Financial Leverage
• Rd lt 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
  RD 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
  3marginal 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 PPE
• 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 RD 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 cant totally control.

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Market Value Added MVA

• MVA Market Value - Invested Capital
• Capital

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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 lt WACC, Rising Stock
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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