EVA and Valuation EVA Financial Management, 2018 Konan Chan Does EVA better explain stock returns? Does EVA better motivate managers? Does EVA lead to a better performance? Evidence on EVA Regress stock returns on various value measures Financial Management Konan Chan 3 Financial Management Konan Chan 4 The change after adoption of EVA-based compensation EVA does not dominate traditional accounting earnings in linking stock returns and firm values EVA maybe undo informative accounting accruals EVA may contain little news beyond that in earnings The evidence indicates that managers respond to EVA-based incentives with Better operating efficiency, more sale of assets, investment reduction, more share repurchases EVA is useful for internal incentive purpose Financial Management Konan Chan 5 Financial Management Konan Chan 6
Evidence on EVA (Kleiman, 1999) Evidence on EVA (Kleiman, 1999) Financial Management Konan Chan 7 Financial Management Konan Chan 8 Evidence on EVA (Kleiman, 1999) EVA firms outperform the competitors after adoption of EVA in stock returns, but no difference before using EVA EVA firms improve their operating performance No evidence of cost cutting Better operating profit margin Significant more asset sale EVA adoption motivates managers to take actions to increase EVA DCF Firm valuation Valuation Equity valuation Relative valuation Financial Management Konan Chan 9 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. Discounted Cash Flow Valuation DCF is to estimate the intrinsic value. T Ct PV t t1 (1 r) To compute the intrinsic value, you need to estimate Cash flows Discount rate Growth Financial Management Konan Chan 11 Financial Management Konan Chan 12
DCF Method Estimate terminal value (two-stage model) DCF DCF is popular in evaluating projects (capital budgeting) or valuing companies (merger) DCF can be used for both firm valuation and equity valuation r is the appropriate risk-adjusted discount rate. Financial Management Konan Chan 13 Financial Management Konan Chan 14 DCF for Firm Value When estimate firm value Free cash flow (FCF) is used as the cash flow measure Use WACC as discount rate where r = WACC Free Cash Flows Free cash flows (FCF) 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 = EBIT taxes + depreciation Financial Management Konan Chan 15 Financial Management Konan Chan 16 DCF for Equity Value (1) When FCF is used as the cash flow measure Use FCF to estimate the firm value first Then subtract bond value Use WACC as discount rate... where r = WACC Financial Management Konan Chan 17 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... where r = cost of equity Financial Management Konan Chan 18
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 Financial Management Konan Chan 19 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 Financial Management Konan Chan 20 Relative Valuation The 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/EBITDA Book value: Price/Book, Price/Assets, Tobin s Q Revenues: Price/Sales, Value/Sales Industry Specific Variable (Price/kwh, Price per ton of steel...) Financial Management Konan Chan 21 Price Earnings Ratio PE = Price per Share / Earnings per Share There are a number of variants for PE ratio. They 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 Trailing PE : earnings per share in trailing 12 months Forward PE : forecasted earnings per share next year Financial Management Konan Chan 22 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 Other Multiples PEG = PE / Expected growth rate of earnings Price/Book = MV of Equity/BV of Equity Price/Sales = MV of Equity/Revenues Financial Management Konan Chan 23 Financial Management Konan Chan 24
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) Value/EBITDA Multiple The Classic Definition (Market value of equity + Book value of Debt)/EBITDA The No-Cash Version (MV of equity + BV of Debt - Cash)/EBITDA Financial Management Konan Chan 25 Financial Management Konan Chan 26 Why Value/EBITDA? EBIT 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 EBITDA 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. Financial Management Konan Chan 27 How to Choose Multiple? Recommendation for picking a multiple for a sector Sector Multiple Rationale Cyclical Manufacturing P/E Often with normalized earnings High Tech, 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/EBITDA Focus on operating income Financial Services P/B Book value often marked to market Financial Management Konan Chan 28 How to Choose Multiple? The 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 References in Valuation Details refer to Damodaran website http://pages.stern.nyu.edu/~adamodar/new_ Home_Page/valuation/val.htm Financial Management Konan Chan 29 Financial Management Konan Chan 30