Transcript Capitalizing Rent Expense

EVATM: Economic Value
Added
Chris Argyrople, CFA
Concentric Investments
EVATM & Securities Analysis
1
Long Term or Short Term View?
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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)
2
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
3
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??
4
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. 6
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
– Receive
the stock
– P/(L)
$(1,100,000) million on the loan
$ 1,300,000 from the sale of
$
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
10
Tax Shield
Cost of
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 14
lower (depends on ROIC of the subsidiary)
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
EVATM
Similar to
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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) 17
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
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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
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concern)
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
TEV vs. MVA
Price x
Shares
Other LT
Liabilities
Debt +
Leases
MVA
Equity
Equival.
Common
Equity
Other LT
Liabilities
Debt +
Leases
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 < WACC, Rising Stock
Income Statement
Revenue
COGS
SG&A
Depreciation
Operating Income
Interest Expense/Inc.
Year 1
250.5
(133.7)
(26.0)
(34.1)
56.7
(1.0)
A
Year 2
250.5
(133.7)
(26.0)
(34.1)
Year 3
Year 4
250.5
(133.7)
(26.0)
(34.1)
56.7
56.7
0.5
1.6
PBT
Taxes
NI
55.7
(22.3)
33.4
57.2
(22.9)
34.3
58.3
(23.3)
35.0
Capital Expenditures
(47.0)
(47.0)
(47.0)
20.5
21.4
22.1
10.0
500.0
10.5
520.5
31.9
541.9
54.0
564.0
510.0
510.0
510.0
510.0
NOPAT
34.02
34.02
34.02
-
Invested Capital
650.0
683.4
717.8
Free Cash Flow
Beginning of Year B/S:
Cash
Debt
Stock Market Value
Enterprise Value
ROIC
5.2%
5.0%
4.7%
Stock % Return
4.1%
4.1%
4.1%
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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
1994
10%
ROIC
13%
WACC
-3%
ROIC - WACC
100
Invested Capital
(3.0)
EVA
1997
16%
14%
2%
115
2.3
1996
14%
13%
1%
110
1.1
1995
11%
12%
-1%
105
(1.1)
Company B
1994
16%
ROIC
10%
WACC
6%
ROIC - WACC
100
Invested Capital
6.0
EVA
1996
11%
10%
1%
110
1.1
1997
10%
11%
-1%
115
(1.2)
Firm B: Falling EVA Trend
Firm A: Rising EVA Trend
8%
ROIC - WACC
4%
ROIC - WACC
1995
14%
9%
5%
105
5.3
2%
0%
-2%
-4%
1994
1995
Year
1996
1997
6%
4%
2%
0%
-2%
Year
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