Economic Value Added (EVA)

Transcription

1 Economic Value Added (EVA), 2018 Definition Features and problems Computation

2 EVA EVA is promoted by a consulting firm Stern Steward & Co., which was established in 1982 and pioneered the EVA concept in 1989 EVA is a performance measure that captures the true economic profit of an enterprise EVA is used by over 300 successful companies 3 EVA What is EVA? Which concept is involved in EVA? Why use EVA? Where to apply EVA? How to increase EVA? Real cases? 4

3 What is EVA? EVA = after-tax operating profits total costs of capital after-tax operating profits = net income + after-tax interest expenses total costs of capital are the required profits to give a competitive return on the capital employed, i.e, total capital (in $)* WACC If EVA > 0, benefit to shareholders 5 After-ax Operating Profits After-tax operating profits = EBI (1 tax rate) = net income + after-tax interest expenses Sales - Cost of goods sold - Selling, General & Administrative expenses - Depreciation Operating income + Interest income - Interest expense - axes Net income Why add back interest expense to after-tax operating profits? 6

4 EVA and Residual Income EVA is one kind of residual income measure Residual income = net operating profit after tax (NOPA) total cost of capital (CC) = (ROIC WACC) * C = Net income $ amount of cost of equity 7 Is EVA the same as Profits? What s the difference between EVA and net income (accounting profit)? 8

5 EVA Features EVA is not new. It just considers a fact that equity (retained earnings) is costly EVA makes managers earn more than the cost of capital, not just cost of debt. EVA can be applied to divisions and business service firms EVA corrects some distortion in accounting earnings 9 How to Increase EVA? Increase Decrease Choose projects whose 10

6 Why EVA system works? Return idle capital (CSX) Profit center (A&) Increase profits (Coca-Cola) Reduce cost of capital (Coca-Cola) 11 Problems of EVA EVA does not consider future cash flows EVA depends on current level of earnings EVA penalizes projects with longer lives For example, negative EVA in the first few years doesn t mean negative NPV EVA penalizes start-up firms for their low initial profits 12

7 Market Value Added (MVA) Market value book value = MVA MVA is the present value of future EVA MVA = EVA 1 / (WACC g) If MVA is greater than 0, price-to-book ratio (M/B) is greater than 1 13 Example of EVA Information from balance sheet/income statement: Equity $138.6 million Long-term debt $ 96.3 million Income from operations $ 12.3 million Interest income $ 1.1 million Interest expense $ 9.0 million Income taxes $ 1.3 million After-tax income $ 3.1 million Market information: Interest rate: 9.3%, beta:1.0, risk-free rate: 7% 14

8 What s Required Return on Equity? We can estimate required return on equity based on CAPM: r e = r f + b (r m r f ) Generally, we can assume that (r m r f ) is equal to historical market risk premium. Let s use 5.7% from the Best Practice article r e = r f + b (r m r f ) = 7% + 1* 5.7% = 12.7% Alternative approach is based on constant growth dividend discount model: D1 D1 P0 re g r g P e 0 15 What is WACC? WACC = D *(1 D E D = 96.3, E = 138.6, so D/(D+E) = 0.41 EB (earnings before tax) = = 4.4 ax rate = 1.3/4.4 = WACC = 0.41 * ( )* 9.3% + (1-0.41)*12.7% = 10.18% C E ) rd + * re D E 16

9 EVA Computation After-tax operating profits = EBI (1 tax rate) = Net income + after-tax interest expense = 13.4 * ( ) = * ( ) = 9.45 otal cost of capital (in $ amount) = WACC * total capital = 10.18% * ( ) = million EVA= = EVA and Residual Income Why EVA is negative in previous example? EVA = (ROIC WACC) * C ROIC = After-tax operating profits / total capital = 9.45 / = 4.02% < WACC = 10.18% 18

10 Stock Performance 19 Do EVA Work? 20

11 Questions Does EVA better explain stock returns than accounting earnings? Does EVA better motivate managers to increase shareholder wealth? Does EVA lead to a subsequent superior performance? 21 Valuation, 2018

12 DCF Firm valuation Equity valuation Relative valuation Approaches to Valuation Discounted cash flow valuation, discounts future cash flows back to present, and adds these present values together. Relative valuation, uses the multiples, such as price-to-earnings, price-to-cash flows, price-to-book, and price-to-sales, to estimate value. 24

13 Discounted Cash Flow Valuation DCF is to estimate the intrinsic value. PV C t t t1 (1 r) o compute the intrinsic value, you need to estimate Cash flows Discount rate Growth 25 DCF Method Estimate terminal value (two-stage model) C1 C2 PV 2 1 r (1 r) C (1 g) V r g C (1 r) r is the appropriate risk-adjusted discount rate. V (1 r) 26

14 DCF DCF is popular in evaluating projects (capital budgeting) or valuing companies (merger) DCF can be used for both firm valuation and equity valuation 27 DCF for Firm Value When estimate firm value Free cash flow (FCF) is used as the cash flow measure Use WACC as discount rate FCF1 V FCF2 2 1 r (1 r) FCF (1 r) V (1 r) V FCF (1 g) r g where r = WACC 28

15 Free cash flows (FCF) Free Cash Flows Net cash flows from operations after considering investments Cash flows to the firm FCF = OCF capital expenditure change in working capital Operating cash flow (OCF) OCF = EBI taxes + depreciation 29 DCF for Equity Value (1) When FCF is used as the cash flow measure Use FCF to estimate the firm value first hen subtract bond value Use WACC as discount rate FCF V 1 FCF2 FCF 2 1 r (1 r) (1 r) V (1 r) D FCF (1 g) V r g where r = WACC 30

16 DCF for Equity Value (2) When FCFE is used as the cash flow measure Discount FCFE to estimate equity value directly Use cost of equity as discount rate FCFE V 1 r 1 FCFE (1 r) 2 2 FCFE (1 r) V (1 r) V FCFE r (1 g) g where r = cost of equity 31 Free Cash Flows FCF = CF to creditors + CF to equityholders CF to creditors =Interests + debt retirement - new debt issue CF to equityholders (FCFE) = Dividends + stock buyback new equity issue FCFE = FCF - CF to creditors 32

17 Free Cash Flow to Equity Free cash flow to equity (FCFE) = Net Income (Capital Expenditures - Depreciation) Changes in non-cash Working Capital (Debt Repayments - New Debt Issues) FCFE are cash flows available as dividends FCFE are cash flows left over after the firm meeting its financial obligations, including debt payments, and covering its capital expenditure and working capital needs FCFE are potential dividends 33 Relative Valuation he value of an asset is compared to the values assessed by the market for comparable assets. Prices (values) are normalized by variables Earnings: Price/Earnings, Value/EBIDA Book value: Price/Book, Price/Assets, obin s Q Revenues: Price/Sales, Value/Sales Industry Specific Variable (Price/kwh, Price per ton of steel...) 34

18 Price Earnings Ratio PE = Price per Share / Earnings per Share here are a number of variants for PE ratio. hey are based upon how the price and the earnings are defined. Price is usually the current price, but sometimes the average price for the year EPS: Current PE: earnings per share in most recent year railing PE : earnings per share in trailing 12 months Forward PE : forecasted earnings per share next year 35 Compare PE to exp. growth rate If firms within a sector have similar growth rates and risk, picking the lowest PE ratio stock in each sector will yield undervalued stocks Portfolio managers and analysts sometimes compare PE ratios to the expected growth rate In practice, firms with PE ratios less than their expected growth rate are viewed as undervalued 36

19 Other Multiples PEG = PE / Expected growth rate of earnings Price/Book = MV of Equity/BV of Equity Price/Sales = MV of Equity/Revenues 37 PE & PB with Fundamentals In constant growth DDM, P 0 = D 0 (1+g)/(r-g) P 0 /E 0 =Payout ratio*(1+g)/(r-g) PE will be higher for high growth firms, low risk firms, and firms with low reinvestment needs P 0 /B 0 =ROE*Payout ratio*(1+g)/(r-g) P 0 /S 0 =Profit margin*payout ratio*(1+g)/(r-g) 38

20 Value/EBIDA Multiple he Classic Definition (Market value of equity + Book value of Debt)/EBIDA he No-Cash Version (MV of equity + BV of Debt - Cash)/EBIDA 39 Why Value/EBIDA? EBI are usually positive. For industries which require a substantial investment in infrastructure, this multiple is more appropriate than PE. In leveraged buyouts, the key factor is cash prior to all discretionary expenditures, the EBIDA is the measure. By looking at the value of the firm and cash flows to the firm it allows for comparisons across firms with different financial leverage. 40

21 How to Choose Multiple? Recommendation for picking a multiple for a sector Sector Multiple Rationale Cyclical Manufacturing P/E Often with normalized earnings High ech, high growth PE/G Big differences in growth across firms High growth/no earnings P/S, V/S Assume future margins will be good Heavy Infrastructure V/EBIDA Focus on operating income Financial Services P/B Book value often marked to market 41 How to Choose Multiple? he multiple that is used can be chosen in following ways: Use the multiple that best fits your objective. If you want the company to be undervalued, you pick the multiple that yields the highest value. Use the multiple that has the highest R-squared in the regressions. It is weird to use multiples where fundamentals do not explain multiples Use the multiple that seems to make the most sense for that sector 42

22 References in Valuation Details refer to Damodaran website ome_page/valuation/val.htm 43