Analytical Techniques

EVA: An Introduction
FIN 591: Financial Fundamentals/Valuation 2

1/92 1/92 1/92 1/92 1/92 1/92 1/92 1/92 1/92 1/92 1/92 1/92 1/92 1/92 1/92 1/93 1/94 1/95 1/96 1/97 1/98
.7%
3.3%
7.0%
7.56%
7.56%
7.1%
PPI
Experience of a
well - regarded U.S.
manufacturing firm
Cumulative U.S.
Producer Price
Index
A benchmark comparison
of programs to reduce
incoming materials cost
Experience of a
manufacturing firm
Cumulative U.S.
Producer Price
Index
11.4%
1/92 1/92 1/92 1/92 1/92 1/92 1/92 1/92 1/92 1/92 1/92 1/92 1/92 1/92 1/92 1/93 1/94 1/95 1/96 1/97 1/98 1/92 1/93 1/94 1/95 1/96 1/97 1/98
.7%
3.3%
7.0%
7.56%
7.56%
7.1%
PPI
.7%
- .2%
- 3.1%
- 7.9%
- 16%
- 19%
.7%
- 3.1%
- 7.9%
- 16%
- 19%
Experience of a
manufacturing firm
Results from
Honda of America
program
Cumulative U.S.
Producer Price
Index
.7%
- .2%
- 3.1%
- 7.9%
- 16%
- 19%
.7%
- 3.1%
- 7.9%
- 16%
- 19%
Experience of a
manufacturing firm
Results from
Honda of America
program
Cumulative U.S.
Producer Price
Index
11.4%
Honeywells Stock Price
Where to from here?
How Value is Created
Management makes decisions,
hopefully, with benefits exceeding
costs
Benefits may be near or distant future
Costs should include direct investment
costs + cost of capital
True source of value-enhancing
projects
Firms comparative or competitive
advantage.

Comparative Advantage
Advantage one firm has over
another in terms of
Cost of producing or
Distributing goods/services
Example:
Wal-Mart invested in regional warehouses and
distribution system
Reduces the need for retail inventory
Replenish store inventory quickly.

Competitive Advantage
Advantage one firm has over
another because of structure of the
markets in which they operate
Barriers to entry
Patents
Capital requirements
Regulation
Influence over suppliers
Influence over buyers
Must be
sustainable
to be a true
competitive
advantage
Traditional Measures
Fuzzy Finance
Return on Investment
Compare benefits (numerator) with
resources (denominator) affecting
that benefit
Basic earning power ratio
EBIT / Total assets
Return on assets
Net income / Total assets
Return on equity
Net income / Book value of equity
Measured
relative
to what?
Shareholder
value
Profitability
Invested
capital
Revenue
Costs
Working
capital
Fixed
capital
Greater customer service
(higher market share,
increased gross margins).
Greater product availability

Lower cost of goods sold,
transportation, warehousing,
material handling and
distribution management
costs

Lower raw materials and
finished goods inventory
Shorter order-to-cash
cycles

Fewer physical assets (e.g.
trucks, warehouses, material
handling equipment)

Pros & Cons
Benefits of these ratios
Ease of calculation & interpretation
Decompose to reveal sources of changes
Downside of these ratios
Sensitive to choice of accounting method
Accumulation of monetary values from
different periods
Backward looking
Fail to consider risk.
Honeywells Performance
Net
Revenues
Net
Income
Earnings /
Share
$25,023
$23,652
$22,274
'00 '01 '02
$1,659
($99)
($220)
'00 '01 '02
$2.07
($0.12)
($0.27)
'00 '01 '02
EPS: Opiate of the Executive
Suite
EPS is such an unreliable measure
of value that managers often make
dumb decisions to increase it
Prompts managers to misallocate
capital
Treats retained earnings as a free
source of capital
Promotes retaining capital and using it
wastefully.
EPS
Accounting rules discourage EPS-
manic managers from spending
capital on value enhancing
investments in intangibles like
brands, research and training
Why?
GAAP requires outlays to be written off
immediately against earnings.
EPS
EPS focus may cause management
to refrain from issuing equity at
times when the company really
needs it
Fabricate EPS gains by using more
debt than prudent
Both on and off the balance sheet
Accept weak projects that happen
to be financed with debt.
EPS
Earnings manipulation often used
Establish reserves
Invest pension funds in equities
Extreme cases, make up numbers as
you go
Worldcom and HealthSouth.
EPS
Todays market perception:
Management that aims to boost
earnings at the expense of quality will
be more certainly penalized then ever
before with a lower stock price and a
sullied reputation.
Performance vs. Valuation
Performance measurement
Relies on actual results
Historical
GAAP vs. GAP
Valuation
Relies on forecasts
A firms stock price relies on
investors expectations, not
historical performance.

Cash Flows
Statement of Cash Flows
SCF combines balance sheet
and income info
Eliminates the sins of accrual
accounting
SCF consists of:
Operating cash flows
Investing cash flows
Financing cash flows.
Free cash flow
Cash Flow Not the Answer
Cash flow has problems as a valid
performance measure
So long as investments in projects
earn a return higher than shareholders
could earn by investing on their own,
then the more investment a company
makes and the more negative its cash
flow becomes, the higher its share
price will be.
Think Wal-Mart.
Better Than Some
Alternatives
Accounting profits
versus cash operating
profits
Cash flow frequently
defined as:
Net income +
depreciation or as
EBITDA
Poor definition
Honeywells trend...
-500
0
500
1000
1500
2000
2500
3000
'97 '98 '99 '00 '01 '02
NI + depr.
NI
CFFO
Free Cash Flows
Definition:
After-tax operating earnings + non-cash
charges - investments in operating working
capital, PP&E and other assets
It doesnt incorporate financing related
cash flows
Represents cash flow available to service debt
and equity.
When used in capital budgeting
proposals
Based on expectations.
FCF & Capital Budgeting
FCF is the method of choice of most
firms for evaluating capital budgets
Identify incremental
Investment in PP&E + working capital
Revenues
Costs (excluding financing)
Depreciation tax shields.
Common Techniques
Evaluation techniques:
Payback
Accounting rate of return
DCF analysis
Consists of NPV and IRR
DCF analysis is not a problem in theory
Only in practice.

NPV Methodology
Net present value (NPV)
Estimate of change in the value of
equity if the firm invests in the project
Forward looking
If NPV>0
Investment is expected to add value
If NPV<0
Investment is expected to erode value
Decision rule
Invest in projects expected to enhance
value.
A Capital Budgeting Example
Period NOPAT Deprec FCF
0 -200
1 115 10 125
2 110 10 120
3 90 10 100
4 70 10 80
5 60 10 70
6 40 10 50
7 30 10 40
8 20 10 30
9 15 10 25
10 15 10 25
11 15 10 25
12 15 10 25
13 15 10 25
14 15 10 25
15 15 10 25
16 15 10 25
17 15 10 25
18 15 10 25
19 15 10 25
20 15 10 25
NPV $125.86
IRR 50.4%
WACC 25%
Excellent NPV
and IRR
Accept the
project!
NPV(Using FCF) Profile
Free Cash Flow Profile
-250
-200
-150
-100
-50
0
50
100
150
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20
NPV of FCF = $125.86
Significant info revealed?
Internal Rate of Return
Practice is to compare IRR with
weighted average cost of capital
Problem:
IRR fails to measure scale or growth
It sees no difference between earning a
20% return on a $1 million investment
or a $1 billion investment
These two projects are very different with
distinctly different NPVs.
IRR Profiles
(New Example)
($700)
($500)
($300)
($100)
$100
$300
$500
$700
$900
$1,100
0% 16% 50%
Mn
IRR
NE
=19.63%
IRR
ATL
=36.53%

Conflicts: NPV & IRR
Which to Choose?
Discount
rate
Marketing
Campaign
IRR = 16.35%
Product
development
IRR =
13.24%
10.7% 10%
NPV
Select project with higher NPV (product development project)
Value Enhanced?
Once a project is applied, the investment
becomes buried in the balance sheet
How is its contribution measured?
No idea whether project generates value
Accounting measure relied upon
EBITDA and EPS generally increase
Means Bonuses probably will be paid
Motivation:
Get your hands on as much capital as
possible.
Buried in the Balance Sheet
2003 2004
Assets
Cash and short-term investments
Accounts receivable
Inventories
Other

$x,xxx
xxx
xxx
xxx

$x,xxx
xxx
xxx
xxx
Total Assets
$x,xxx $x,xxx
Liabilities
Accounts payable
Accrued compensation
Income taxes payable
Other

$x,xxx
xxx
xxx
xxx

$x,xxx
xxx
xxx
xxx
Total Liabilities
$x,xxx $x,xxx
Shareholders Equity
$x,xxx $x,xxx
Focused Finance & EVA
Focused Finance
EVA & Shareholder Value
What is the best way to measure
shareholder value?
Fortune 500 sales?
Earnings per share?
Business Week survey of market value of
equity?
Stock market share price?
Market value added?
EVA & Other Measures
of Performance
0%
5%
10%
15%
20%
25%
30%
35%
40%
45%
50%
EPS Growth Cash Flow
Growth
ROE EVA
Correlation
with MVA
EVA & Wealth Creation
Warren Buffet:
We feel noble intentions should be checked periodically
against results. We test the wisdom of retaining earnings
by assessing whether retention, over time, delivers
shareholders at least $1 of market value for each $1
retained.
Translation:
Ultimate litmus test of any companys
success lies in increasing its market
value by more than it increases its
capital.
View of the Firm
Value of firm = Value of debt + value of
stock
Market value of a company reflects:
Earning power of invested assets
Present value of current operations
Present value of expected improvement in
operating performance.

Market Valued Balance Sheet
Assets Debt
Equity
What is Required to Focus?
Tie performance methods to capital
budgeting techniques:
Economic value added (EVA)
Market value added (MVA)
Want to gauge managements
performance
Focus on:
Decisions made in the past to help project
the future.
Links to
NPV
What is MVA?
MVA = Market value of capital
- book value of capital
Honeywells MVA = ?
Key elements:
Calculation of market value of capital
Market value of debt + market value of
equity
Calculation of capital invested
Accounting adjustments necessary
MVA Related to EVA.

Market Value Added
Total
market
value
Debt &
equity
capital

Market
value added
Investment
Premium
Also, Market Value Added
Total
market
value
Debt &
equity
capital

Expected
improvement
in EVA
MVA
Current level
of EVA
MVA = Present value of all future EVA
EVA & Market Value
Market value of a company reflects:
Value of invested capital
Value of ongoing operations
Present value of expected future economic
profits
Captures improvement in operating performance
EVA related to market value by:
Measuring all the capital
Seeing what the firm is going to do with
the capital
Turn FCF forecasts into EVA forecasts
Discount EVA.
What is EVA?
EVA = Economic profit
Not the same as accounting profit
Difference between revenues and costs
Costs include not only expenses but also cost of
capital
Economic profit adjusts for distortions caused
by accounting methods
Doesnt have to follow GAAP
R&D, advertising, restructuring costs, ...
Cost of capital accounted for explicitly
Rate of return required by suppliers of a firms debt
and equity capital
Represents minimum acceptable return.

Advantages of EVA
Annual EVA is easy to interpret
Correlations between market value
and various measures:
Standardized EVA 0.50
ROE 0.35
Fortunes Most admired firms 0.24
Cash flow growth 0.22
EPS growth 0.18
Dividend growth 0.16
Sales growth 0.09
50% of change in market value explained
by standardized EVA (Standardized EVA = EVA /
Capital).
Components of EVA
NOPLAT
Net operating profit after tax
Operating capital
Net operating working capital, net
PP&E, goodwill, and other operating
assets
Cost of capital
Weighted average cost of capital %
Capital charge
Cost of capital % * operating capital
Economic value added
NOPLAT less the capital charge.
What is NOPAT?
Net sales 150,000
Cost of sales 135,000
Depreciation 2,000
SG&A 7,000
Net Operating profit 6,000
Taxes @ 40% 2,400
NOPAT 3,600
Excludes financing charges
What is Operating Capital?
Capital: Net operating assets adjusted
for certain accounting distortions
Asset write-downs, restructuring charges,
Net operating assets:
Cash, receivables, inventory, prepaids
Trade payable, accruals, deferred taxes
Net property, plant, and equipment
Exclude non-operating assets:
Marketable securities, investments,...
What is Cost of Capital?
Weighted average cost of capital
consists of:
Cost of debt after taxes
= Market interest rate x (1 tax rate)
Cost of equity
= Risk-free rate + beta x (market risk
premium)
WACC
= Cost of debt after taxes x % debt +
cost of equity x % equity
where % debt + % equity = 100%.
What is the Capital Charge?
Represents a rental charge for the
use of the operating capital
Minimum rate of return the
operating capital should earn
Calculated as the firms weighted
average cost of capital % x invested
capital.
Calculating EVA
NOPAT/Average capital
= Return on invested operating capital (ROIC)
- Weight average cost of capital (WACC)
= Spread (= ROIC - WACC)
* Operating capital
= Economic value added (EVA)
Net operating profit after tax (NOPAT)
- Capital charge (= WACC * Capital)
= Economic value added (EVA)

Whats Affecting EVA?
Sales
- Operating expenses
- Taxes
= NOPAT
- Capital charge
= EVA
COGS, SG&A + other
Net working capital
PP&E
WACC
Evaluate the many assumptions!
Potential govt
actions
Market potential
Forward Looking
Relationship for EVA & MVA
EVA EVA EVA EVA
Year 1 Year 2 Year 3 .... Year n
Market
Value
Market
value
MVA
Capital
=
EVA + EVA + EVA + ... + EVA
1 + r (1 + r)
2
(1 + r)
3
(1 + r)
n
Market value is based on establishing the
economic investment made in the company
(capital), making a best guess about what
economic profits (EVA) will happen in the future,
and discounting those EVAs to the present to get
market value added.
MVA
EVA Drives MVA
Companies that consistently earn
profits in excess of their required
return ...
NOPAT
EVA
Market
Value
Capital
MVA
Charge
are typically valued at premiums to book value.
Fundamental Strategies

Capital * capital of Cost
Capital
NOPAT
EVA

Operate: Improve the
return on existing
operating capital
Build: Invest as long as returns
exceed the cost of capital
Harvest: Re-deploy capital when returns
fail to achieve the cost of capital.
Decrease: WACC
An Example of Drivers
Focus on EVA Improvement
A positive change in EVA is better
than a positive yet unchanging
base level of EVA
Why?
Positive changes in EVA are consistent
with shareholder value added -- whether
from a positive or negative base
Positive changes in EVA are consistent
with the managerial notion of continuous
improvement in performance.
Heres the Point
EVA is the reward from investing in
projects that return above the cost of
capital
EVA = (ROIC - WACC) * Operating Capital
Each projects expected return must
exceed its cost of capital to be
justified
Can this explain all the outsourcing?
Why Use EVA & Not NPV?
Present value of EVA
= Present value of NPV
Provides insight into each period
Is a direct link to performance
More useful for future project
audits.
Investment Schedule
Net Assets
%
WACC
Destroy value
Create value
An Example Revisited
(See Slides 27 & 28)
Asset's
Period NOPAT Deprec FCF CapChg Balance EVA
0 -200 200
1 115 10 125 50.0 190 65.0
2 110 10 120 47.5 180 62.5
3 90 10 100 45.0 170 45.0
4 70 10 80 42.5 160 27.5
5 60 10 70 40.0 150 20.0
6 40 10 50 37.5 140 2.5
7 30 10 40 35.0 130 -5.0
8 20 10 30 32.5 120 -12.5
9 15 10 25 30.0 110 -15.0
10 15 10 25 27.5 100 -12.5
11 15 10 25 25.0 90 -10.0
12 15 10 25 22.5 80 -7.5
13 15 10 25 20.0 70 -5.0
14 15 10 25 17.5 60 -2.5
15 15 10 25 15.0 50 0.0
16 15 10 25 12.5 40 2.5
17 15 10 25 10.0 30 5.0
18 15 10 25 7.5 20 7.5
19 15 10 25 5.0 10 10.0
20 15 10 25 2.5 0 12.5
NPV $125.86 $125.86
IRR 50.4%
WACC 25%
EVA =
NOPAT
WACC * Beginning Balance
= 110 25% * 190
= 110 = 47.5
= 62.5
NPV (Using FCF) & EVA Profiles
FCF vs. EVA
-250
-200
-150
-100
-50
0
50
100
150
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20
FCF
EVA
NPV of FCF = NPV of EVA = $125.86
Significant info revealed?
Some Research Results
Profitability & COGS
-10
0
10
20
30
40
50
60
70
80
Successful Less
Successful
COGS
Other expenses
Profit
McKinsey & Co.s
survey of electronics
companies
Items shown as % of
sales
Major difference
between successful
and unsuccessful
companies is cost of
goods sold
Requires a closer look
at the reasons.
COGS: 13 point differential
Other expenses: 6 point differential
Result: 19 point profit differential
Affect on EVA
Sales
- Operating expenses
- Taxes
= NOPAT
- Capital charge
= EVA
COGS, SG&A + other
Net working capital
PP&E
WACC
How is EVA affected?
Potential govt
actions
Market potential
Reducing COGS
0
5
10
15
20
25
30
35
40
Successful Less So
Undefined
responsibility
Production
Controlling
Mat'ls Mgmt
Board/Committee
Successful
companies
Increase
outsourcing
More competitive
the industry more
important to
outsource activities
that fall short of
world standards
Neutral decision
maker
Board or
committee.

Real Life EVA
The Manitowoc Co. in Manitowoc, Wis., a diversified food service, crane
manufacturing and marine operations company, outsourced a reverse-auction
procurement system to a vendor instead of acquiring a software package itself. A
comparison using Economic Value Added of buying vs. renting would look like this
for the first year (hypothetical numbers):
In-house application
$180,000 in net benefits - ($1 million capital investment x 12% cost of capital) =
$60,000 EVA
Outsourced application
$180,000 in net benefits - ($0 capital investment x 12% cost of capital) - $80,000 in
rental fees = $100,000 EVA
Outsourced application requires no capital investment thus, no capital charge.
Suppose the operating costs to run the system in-house were $50,000 per year.
Most companies only look at the income statement side of the ledger; they wouldn't
outsource this application because it would be exchanging $50,000 of in-house expenses
for the $80,000 rental fee, another kind of expense on the income statement. Yet on an EVA
basis, the company would outsource the system, because doing so would produce more
residual income ($100,000 vs. $60,000) by virtue of the $0 capital charge.
"When you are exposed to the EVA philosophy, you recognize how to better
manage your capital," says Jim Pecquex, Manitowoc's CIO.
Source: Computerworld, February 17, 2003.
Real Life EVA
Consider a recent EVA analysis that Robert Egan, vice president of IT at Boise
Cascade Corp., and his colleagues conducted for a storage investment. The
decision was whether to keep storage assets or replace them with new technology
that has lower maintenance charges.
The example is illustrative. Egan declined to provide real cost figures.
The new storage technology costs $1 million, with maintenance costs of $100,000
per year. The maintenance expense on the old storage technology is $350,000.
For simplicity, we'll assume that the new storage equipment offers no benefits other than
the lower maintenance costs.
Boise's cost of capital is about 16%. Thus, the capital charge for investing in the
new storage is 16% x $1 million = $160,000, which EVA says must be added to the
$100,000 maintenance costs to get the true cost.
The result:
The total cost of the new storage is $260,000, vs. $350,000 for the old storage.
"In this case, have you lowered the operating cost enough to make up for spending the
capital?" asks Egan. Yes -- $90,000 worth.
Boise is constantly reminded of the obvious point that technology isn't free. The
company is also aware of the less obvious fact: neither is the capital to finance it.
Source: Computerworld, February 17, 2003.

Real Life: Walgreens
Performance
Real Life: EVA & MVA
3-year changes in MVA explained by
regression analysis
Summary
Measure Earnings with EVA
Simple to explain and understand
EPS (and NI) ignore cost of equity capital
EVA doesnt
Retained earnings no longer considered free
Benefits:
Reduce cost of capital
Improve operational efficiency
Better management of assets
Profitable growth.

EVA
NOPAT
Invested
capital
Revenue
Costs
Working
capital
Fixed
capital
Greater customer service
(higher market share,
increased gross margins).
Greater product availability

Lower cost of goods sold,
transportation, warehousing,
material handling and
distribution management
costs

Lower raw materials and
finished goods inventory
Shorter order-to-cash
cycles

Fewer physical assets (e.g.
trucks, warehouses, material
handling equipment)

minus
plus
Cost of
capital
times
minus
Customer Satisfaction New Products
Volume Marketing
Product Pricing Growth
Sales
Overhead Compensation
Account Management Training & Development
Manufacturing Costs
Operating Expenses
Acquisitions & Divestitures Working Capital Management
Alliances Accounts Receivable
R&D Decisions Inventory Management
Capital Charge
Improvement in EVA
Manufacturing EVA Drivers
Reduce inventory
Reduce cycle time
Improve yields
Reduce scrap/waste
Maximize labor efficiencies
Improve vendor efficiencies
Process improvements

Staff EVA Drivers
Work group/process simplification
Consistency monitors audit
Centralizing resources/synergies
Best practices benchmarking
Insourcing/outsourcing decisions
Simplify EVA measurements/reporting
Ensure compliance with legislation

Research & Development EVA Drivers
Improve to-market process
Reduce R&D expenses as % of new product sales
Strategic partners for R&D
Stronger links to product marketing
New products via:
- Research
- Formulation
- Development
-Acquisition

Marketing EVA Drivers
Increase market share / revenue
New markets
More focused channel programs
Voice of customer / consumer
Leverage advertising / promotion
Build brand awareness

The End

Analytical Techniques

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Analytical Techniques

Uploaded by

Copyright:

Available Formats

EVA: An Introduction

FIN 591: Financial Fundamentals/Valuation 2

You might also like