EVA: An Introduction

EVA: An IntroductionEVA: An Introduction

FIN 591: Financial Fundamentals/Valuation 2

How Much Systemic Waste Is There In A Supply Chain?

1/92 1/92 1/92 1/92 1/92 1/92 1/921/92 1/92 1/92 1/92 1/92 1/92 1/921/92 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 awell -regarded U.S.manufacturing firm

Cumulative U.S.Producer Price

Index

A benchmark comparisonof programs to reduce

incoming materials cost



Index



11.4%


A Great Deal More Than Most People Recognize!

1/92 1/92 1/92 1/92 1/92 1/92 1/921/92 1/92 1/92 1/92 1/92 1/92 1/921/92 1/93 1/94 1/95 1/96 1/97 1/981/92 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%


Results fromHonda of Americaprogram


Index



.7% -.2%

-3.1%

-7.9%

-16%-19%

.7%

-3.1%

-7.9%

-16%-19%


Results fromHonda of Americaprogram


Index



11.4%


HoneywellHoneywell’’s Stock Prices Stock Price

Where to from here?


How Value is CreatedHow 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

• Firm’s comparative or competitive advantage.


Comparative AdvantageComparative 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 AdvantageCompetitive 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 besustainable to be a truecompetitiveadvantage

Traditional MeasuresTraditional Measures


Fuzzy FinanceFuzzy Finance


Return on InvestmentReturn 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

Measuredrelativeto what?


Shareholdervalue

Profitability

Investedcapital

Revenue

Costs

Workingcapital

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)

Effective SCM:Effective SCM:Increased Shareholder Increased Shareholder

ValueValue


ProPro’’s & Cons & Con’’ss• 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.


HoneywellHoneywell’’s Performances PerformanceNet

RevenuesNet

IncomeEarnings /

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 EPS: Opiate of the Executive SuiteSuite

• 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…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…• 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…EPS…• Earnings manipulation often used

– Establish reserves– Invest pension funds in equities– Extreme cases, make up numbers as you

go• Worldcom and HealthSouth.


EPS…EPS…• Today’s 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. ValuationPerformance vs. Valuation• Performance measurement

– Relies on actual results• Historical• GAAP vs. GAP

• Valuation– Relies on forecasts– A firm’s stock price relies on investors’

expectations, not historical performance.

Cash FlowsCash Flows


Statement of Cash FlowsStatement 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 AnswerCash 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 AlternativesBetter Than Some Alternatives• Accounting profits

versus cash operating profits

• Cash flow frequently defined as:

Net income + depreciation or as EBITDA

• Poor definition• Honeywell’s trend...

-500

0

500

1000

1500

2000

2500

3000

'97 '98 '99 '00 '01 '02

NI + depr.NICFFO


Free Cash FlowsFree Cash Flows• Definition:

– After-tax operating earnings + non-cash charges - investments in operating working capital, PP&E and other assets

– It doesn’t 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 BudgetingFCF & 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 TechniquesCommon 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 MethodologyNPV 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 ExampleA Capital Budgeting ExamplePeriod NOPAT Deprec FCF

0 -2001 115 10 1252 110 10 1203 90 10 1004 70 10 805 60 10 706 40 10 507 30 10 408 20 10 309 15 10 2510 15 10 2511 15 10 2512 15 10 2513 15 10 2514 15 10 2515 15 10 2516 15 10 2517 15 10 2518 15 10 2519 15 10 2520 15 10 25

NPV $125.86IRR 50.4%

WACC 25%

Excellent NPV and IRRAccept the project!


NPVNPV(Using FCF)(Using FCF) Profile ProfileFree 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 ReturnInternal 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 ProfilesIRR Profiles(New Example)(New Example)

($700)

($500)

($300)

($100)

$100

$300

$500

$700

$900

$1,100

0% 16% 50%

Mn

IRRNE=19.63%

IRRATL =36.53%

•

Conflicts: NPV & IRRConflicts: NPV & IRRWhich to Choose?Which to Choose?

Discount rate

Marketing CampaignIRR = 16.35%

Product developmentIRR = 13.24%

10.7%10%

NPV

Select project with higher NPV (product development project)


Value Enhanced?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 SheetBuried in the Balance Sheet2003 2004

Assets–Cash and short-term investments–Accounts receivable–Inventories–Other

$x,xxxxxxxxxxxx

$x,xxxxxxxxxxxx

Total Assets $x,xxx $x,xxx

Liabilities–Accounts payable–Accrued compensation–Income taxes payable–Other

$x,xxxxxxxxxxxx

$x,xxxxxxxxxxxx

Total Liabilities $x,xxx $x,xxx

Shareholder’s Equity $x,xxx $x,xxx

Focused Finance & EVAFocused Finance & EVA


Focused FinanceFocused Finance


EVA & Shareholder ValueEVA & 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 MeasuresEVA & Other Measuresof Performanceof Performance

0%5%

10%15%20%25%30%35%40%45%50%

EPS Growth Cash FlowGrowth

ROE EVA

Correlationwith MVA


EVA & Wealth CreationEVA & 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 company’s success lies in increasing its market value by more than it increases its capital.


View of the FirmView 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 DebtEquity


What is Required to Focus?What is Required to Focus?• Tie performance methods to capital

budgeting techniques:– Economic value added (EVA)– Market value added (MVA)

• Want to gauge management’s performance– Focus on:

• Decisions made in the past to help project the future.

Links to NPV


What is MVA?What is MVA?• MVA = Market value of capital

- book value of capital Honeywell’s 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 AddedMarket Value Added

Total market value Debt &

equitycapital

Marketvalue added

Investment

Premium


Also, Market Value AddedAlso, Market Value Added

Total market value Debt &

equitycapital

Expectedimprovement in EVA

MVA

Current levelof EVA

MVA = Present value of all future EVA


EVA & Market ValueEVA & 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?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• Doesn’t have to follow GAAP

– R&D, advertising, restructuring costs, ...– Cost of capital accounted for explicitly

• Rate of return required by suppliers of a firm’s debt and equity capital

• Represents minimum acceptable return.


Advantages of EVAAdvantages 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 EVAComponents 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?What is NOPAT?

Net sales 150,000Cost of sales 135,000Depreciation 2,000SG&A 7,000Net Operating profit 6,000Taxes @ 40% 2,400NOPAT 3,600

Excludes financing charges


What is Operating Capital?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?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 % equitywhere % debt + % equity = 100%.


What is the Capital Charge?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 firm’s weighted

average cost of capital % x invested capital.


Calculating EVACalculating EVANOPAT/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)


WhatWhat’’s Affecting EVA?s Affecting EVA?Sales

- Operating expenses- Taxes=NOPAT- Capital charge=EVA

COGS, SG&A + other

Net working capitalPP&EWACC

Evaluate the many assumptions!

Potential gov’t actions

Market potential


Forward Looking Relationship Forward Looking Relationship for EVA & MVAfor EVA & MVA

EVA EVA EVA EVAYear 1 Year 2 Year 3 .... Year n

MarketValueMarketvalue

MVA

Capital=

EVA + EVA + EVA + ... + EVA1 + r (1 + r)2 (1 + r)3 (1 + r)n

Market value is based on establishing theeconomic 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 MVAEVA Drives MVACompanies that consistently earn profits

in excess of their required return ...

NOPAT EVA

MarketValue

Capital

MVA

Charge

… are typically valued at premiums to book value.


Fundamental StrategiesFundamental Strategies

Capital * capital ofCost CapitalNOPATEVA

Operate: Improve thereturn on existingoperating 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 DriversAn Example of Drivers


Focus on EVA ImprovementFocus 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.


HereHere’’s the Points the Point• EVA is the reward from investing in

projects that return above the cost of capital

EVA = (ROIC - WACC) * Operating Capital• Each project’s expected return must

exceed its cost of capital to be justified– Can this explain all the outsourcing?


Why Use EVA & Not NPV?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 ScheduleInvestment Schedule

Net Assets

%

WACC Destroy value

Create value


An Example RevisitedAn Example Revisited(See Slides 27 & 28)(See Slides 27 & 28)

Asset'sPeriod NOPAT Deprec FCF CapChg Balance EVA

0 -200 2001 115 10 125 50.0 190 65.02 110 10 120 47.5 180 62.53 90 10 100 45.0 170 45.04 70 10 80 42.5 160 27.55 60 10 70 40.0 150 20.06 40 10 50 37.5 140 2.57 30 10 40 35.0 130 -5.08 20 10 30 32.5 120 -12.59 15 10 25 30.0 110 -15.010 15 10 25 27.5 100 -12.511 15 10 25 25.0 90 -10.012 15 10 25 22.5 80 -7.513 15 10 25 20.0 70 -5.014 15 10 25 17.5 60 -2.515 15 10 25 15.0 50 0.016 15 10 25 12.5 40 2.517 15 10 25 10.0 30 5.018 15 10 25 7.5 20 7.519 15 10 25 5.0 10 10.020 15 10 25 2.5 0 12.5

NPV $125.86 $125.86IRR 50.4%

WACC 25%

EVA =NOPAT – WACC * Beginning Balance= 110 – 25% * 190= 110 = 47.5= 62.5


NPV NPV (Using FCF)(Using FCF) & EVA Profiles & EVA ProfilesFCF 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

EVANPV of FCF = NPV of EVA = $125.86

Significant info revealed?

Some Research ResultsSome Research Results


Profitability & COGSProfitability & COGS

-10

0

10

20

30

40

50

60

70

80

Successful LessSuccessful

COGSOther expensesProfit

• 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 EVAAffect on EVASales

- Operating expenses- Taxes=NOPAT- Capital charge=EVA

COGS, SG&A + other

Net working capitalPP&EWACC

How is EVA affected?

Potential gov’t actions

Market potential


Reducing COGS…Reducing COGS…

0

5

10

15

20

25

30

35

40

Successful Less So

UndefinedresponsibilityProduction

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 EVAReal 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 …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: WalgreenReal Life: Walgreen’’s s PerformancePerformance


Real Life: EVA & MVAReal Life: EVA & MVA

3-year changes in MVA explained byregression analysis

SummarySummary


Measure Earnings with EVAMeasure Earnings with EVA• Simple to explain and understand• EPS (and NI) ignore cost of equity capital

– EVA doesn’t• Retained earnings no longer considered free

• Benefits:– Reduce cost of capital– Improve operational efficiency– Better management of assets– Profitable growth.


EVA

NOPAT

Investedcapital

Revenue

Costs

Workingcapital

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)

Effective SCM:Effective SCM:Increased Shareholder Increased Shareholder

ValueValueminus

plus

Cost ofcapital

times

minus


Custo m er Satis faction N ew P ro ducts

Vo lum e M arketing

P roduct P ricing G row th

S ales

O verhead Co mpensation

Acco unt M an ag em ent T raining & D evelo pm ent

M anufactur ing Co sts

Operating E xpens es

Acqu isitions & Divestitures W o rking Cap ita l M anagem ent

Alliances Acco unts R eceivab le

R & D D ecisio ns I nventory M anagem ent

Capita l C harge

Improvement in EVA

Manufacturing EVA DriversReduce inventoryReduce cycle time

Improve yieldsReduce scrap/waste

Maximize labor efficienciesImprove vendor efficiencies

Process improvements

Staff EVA DriversWork group/process simplification

Consistency “monitors” – auditCentralizing resources/synergies

Best practices benchmarkingInsourcing/outsourcing decisions

Simplify EVA measurements/reportingEnsure compliance with legislation

Research & Development EVA DriversImprove “to-market” process

Reduce R&D expenses as % of new product salesStrategic partners for R&D

Stronger links to product marketingNew products via:

- Research- Formulation

- Development-Acquisition

Marketing EVA DriversIncrease market share / revenue

New marketsMore focused channel programs

Voice of customer / consumerLeverage advertising / promotion

Build brand awareness


The EndThe End

Documents

EVA: An Introduction