EVA TM : Economic Value Added

1. EVATM: Economic Value Added Chris Argyrople, CFA Concentric Investments EVATM & Securities Analysis

2. Long Term or Short Term View? • 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)

3. 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

4. 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??

5. 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)

6. 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.

7. 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%)

8. 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 $(1,100,000) million on the loan • Receive $ 1,300,000 from the sale of the stock • P/(L) $ 200,000 Profit

9. 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.

10. Behavior of WACC WACC incorp: Business Risk & Financial Leverage Rd < Re bec: Senior Claim & Tax Benefits WACC Tax Shield Cost of Benefits Financial Distress

11. 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

12. 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.

13. 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.

14. 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 lower (depends on ROIC of the subsidiary)

15. 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 Similar to EVATM

16. 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

17. 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)

18. 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

19. 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

20. 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 + Other Accounts

21. 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 concern) • Deferred Tax Reserve, LIFO Reserve

22. Invested Capital • Remove Excess Cash (from Capital and NOPAT) • Remove Minority Interest (from Capital and NOPAT) because Management can’t totally control.

23. Market Value Added MVA MVA = Market Value - Invested Capital Capital

24. 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

25. 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.

26. 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?

27. 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

28. ROIC < WACC, Rising Stock

29. 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)

30. 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.

31. EVA trend key to Valuation Chg