Valuation of Internet Stocks: A risky venture may not always be that way
IN PRINT ARCHIVE CIR Spring 2000
|EVA is a useful tool to determine value of both old and new economy companies|
|by Brian A. Schofield, MBA, CFA|
Have the equity markets truly tossed aside any sense of fundamental share value in favour of a new pricing game that has arrived without rules? Or, given that the market dramatically penalizes or rewards earnings surprises and the pricing response to analyst upgrades or downgrades has never been stronger, is the link between corporate performance and stock price at an all-time high?
Economic Value Added (EVA is a financial concept that cuts away market chaos to focus on a single investment question: Is a company creating or destroying wealth for shareholders? By answering this question, the first step has been made to picking stocks that outperform the market, which is the mission of every investment professional.
Investing is still based on what people are willing to pay today to own claims on future income streams. This is true whether the future income be royalties, coupons on bonds, dividends on stocks or rents on properties. But not all income streams are priced the same, nor are they equally valuable. Growing income streams are worth more than static ones, and reliable income streams are worth more than uncertain ones.
Future income streams are still relevant to investment value, and the need for corporations to deliver this value is as important as it has ever been. It is just getting trickier to measure and understand. It stands to reason that the tools with which we assess value, make comparisons among companies and ultimately relate this value to stock price potential, have to be better.
A New Angle on an Old Idea
EVA is defined as the difference between a company's net operating profits (NOPAT) and its total cost of invested capital over a given time period. This capital charge is necessary to compensate the providers of debt and equity for use of their capital investment at a rate adequate for the risk incurred. If EVA is positive, the company has created value above the minimum return required by investors, and if it is negative, wealth has been destroyed.
EVA = Net Operating Profits After Tax
- Cost of Invested Capital
With the full cost of capital deducted from NOPAT, EVA shows whether capital is being used efficiently in the company, and with further analysis, whether high-return businesses are subsidizing low-return businesses or which geographical regions or business segments of a company's operations add value or destroy value.
The total cost of invested capital is calculated by determining the required rate of return for equity and debt and averaging those rates, based upon the current market weights present in the capital structure, to produce the weighted average cost of capital (WACC). The WACC is then charged against the total invested capital employed by the company to determine the cost of invested capital.
From an operating perspective, invested capital is the sum of assets employed, such as net working capital plus property, plant and equipment (with accumulated depreciation added back) plus goodwill plus any other asset that required a cash investment. There are a number of adjustments to "accounting" capital that must be made to recognize economic reality, such as capitalizing research and development costs and goodwill amortization and adding back write-offs and LIFO inventory reserves.
For the investor EVA offers a unique characteristic: it is unambiguous. EVA is the only reliable continuous-improvement measure of performance, because more EVA is always better than less. This cannot be said of any other known measure. Higher earnings per share, for example, may or may not be better, depending on how much additional capital or risk was necessary to produce the increase.
Investing Using EVA
Market Value Added (MVA) is the difference between the total market capitalization of a company's debt and equity and the total invested capital described above. It represents the market's perception at a point in time of the company's ability to successfully invest its capital in the future. As shown in Figure 1, companies which have demonstrated superior EVA performance are typically accorded a higher MVA, a premium over their current invested capital to recognize the perceived wealth gain potential. Companies which have an eroding EVA may find their MVA languishing or, in fact, negative, reflecting negative sentiments in their stock price.
By comparing a company's EVA track record and its forecasted EVA with the current MVA, we can categorize companies into one of four zones, as depicted in Figure 2.
From the company's perspective, the best category is zone 2, where wealth is being created (high EVA) and the market is rewarding this wealth creation with a high MVA. Growth and momentum investors may find opportunities in this group of companies. From a value investment perspective, however, the most information is found in zones 1 or 4. In zone 1, companies are not creating sufficient wealth to justify their lofty market prices. The market may be anticipating unrealized growth, in which case the market price is at risk of disappointment. In zone 4, companies are creating wealth but have experienced relative weak market performance. These companies may provide the best value investment potential and likelihood of a positive surprise. Companies in zone 3 are destroying wealth and the market has penalized their stock price accordingly. Occasionally zone 3 companies are turnaround candidates. If they can be restructured and move to zone 4 they become excellent, though risky, investment opportunities.
A framework for determining the relative attractiveness of stocks within industry sectors is depicted in Figure 3, which is derived from YMG's database. A comparison is made between a company's MVA and its EVA on either a historic or forecasted basis. The correlation coefficient between these two factors for companies in the database, shown by the trend line in Figure 3, is typically greater than 65% (r2 > 0.65).
The value investor would view companies below the trend line as generating wealth beyond what is being recognized by the market relative to the peer group, thereby highlighting potentially undervalued situations. The growth investor would view companies on the left side of the chart, whether below or above the trend line, as representing opportunity to move to the right toward increasing MVA.
Earn more NOPAT from existing operations: Companies spend a lot of time working on this, most typically by cutting costs, but many companies stop here when substantial improvements can be made with the other three ways.
Reduce capital employed: Big gains can be made in many companies when they begin to factor in the cost of capital employed. Investors should inquire as to the need for capital assets which are being underutilized. For example, CNR reduced its locomotive fleet by 645 over the past two years. Molson has increased market share while reducing beer plants and offices.
Allocate more capital to high returning projects and reduce capital in low returning activities: High EVA growth often comes from this factor alone. New projects must be scrutinized to ensure that the net profits exceed the total cost of new capital. A company can typically generate superior returns in a small number of core areas. Good management must focus investors' capital on these areas and non-core, underachieving assets should be divested.
Lower WACC: A company's capital structure is dynamic. CFO's can add substantial value by prudent use of low cost debt in place of expensive equity. Alternatively, when business risks become elevated, cash flow can be diverted to lowering debt loads, thereby reducing financial risk. In general, Canada's corporations are under-leveraged and are therefore inefficient from a tax perspective, thereby delivering less value to shareholders.
EVA of the New Economy
Figure 4 provides a diagram of the Cash Economics Matrix which shows the cash flow quadrants representing positive or negative NOPAT and positive or negative capital investment. We use capital investment in this matrix to accentuate the impact of balance sheet management; however, as discussed, capital employed is the long-term concern of the EVA analyst.
The "steady-state" cash flow line shown from the upper left-hand corner to the lower right-hand corner indicates that all points along this line have equivalent free cash flow. Companies that sustain their operations above this line are generating shareholder wealth and those operating below it are destroying wealth.
To understand the difference between new and old economy models, consider Amazon.com and Barnes and Noble, a pair of companies competing in the book retailing business. Barnes and Noble has resided in the "Profitable Buildout" quadrant since 1995 by consistently generating cash earnings inflows built upon cash investments. For the 12-month period ending Oct. 31, 1998, the company invested $118 million in book inventory and customer credit, partially offset by $48 million from increased accounts payable. Combined with $172 million invested in new megastores, the total cash investment came to over $240 million.
Barnes and Noble generated almost $150 million in cash earnings over the same period, but with such large capital commitment, the free cash flow was negative $95 million. Notably, Barnes and Noble's operations have not generated positive free cash flow since it has been public.
Amazon's cash economics are completely opposite. As skeptics have highlighted, the company's low prices, high marketing expenses and relatively low sales have produced losses. However, Amazon has generated considerable cash from its balance sheet, placing it in the "Emerging Capital" quadrant of Figure 4. In 1998, for example, Amazon's ship-to-order business required less than $40 million in inventory and customer credit. Simultaneously, the company generated about $120 million by increasing accounts payable and other forms of interest-free cash loans from suppliers, employees and customers. This produced a surplus of $80 million which, when offset by $26 million in capital investment, largely in computer equipment, and $58 million of NOPAT losses, resulted in a very small free cash loss of $4 million.
Amazon's combination of NOPAT outflows and investment inflows is exactly opposite to Barnes and Noble's more traditional combination of NOPAT inflows and investment outflows. It is not surprising that Amazon's high valuation is confusing to investors. Focusing on cash flows unveils the fact that Amazon's near break-even level is far superior to Barnes and Noble's negative cash flow, and that the source of this value is the balance sheet, not the income statement.
Does EVA Investing Really Work?
Seven U.S.-based mutual funds that use EVA outperformed their peer group by an average of 7.8% over a one-year period in 1996. In a paper entitled "The Search for the Best Financial Performance Measure," published by the Financial Analysts Journal (Bacidore et al., 1997), the authors found that their version of the EVA measure picked a portfolio of stocks which outperformed a market average over the 1988-92 period by over 4%.
EVA does have its detractors and admittedly there is some truth to the concerns that have been raised. The most relevant points are that EVA can be complex to calculate, and building large company databases is difficult due to the labour-intensive process. There are approximately 160 adjustments to GAAP-prepared financial statements that can be made to calculate EVA, however, in practice only 20 or so are meaningful. Figure 5 identifies the most important adjustments.
Some skeptics have criticized EVA, and the building-blocks of NOPAT, capital employed and WACC, as having no consistent definitions. However, many common analytic methods such as discounted cash flow or price/earnings multiples have potential for interpretation and judgment. We consider this flexibility an important benefit since it allows opportunity to adapt valuation techniques to the specific case at hand.
The pace of global economic change is almost beyond comprehension and the capital markets are reacting accordingly. The investment professional must succeed in the difficult task of recognizing value in an increasingly murky sea of opportunity and risk. Improved analytic tools to uncover true wealth creators, still the only relevant issue in any investment, are at hand. EVA is one of these tools, applicable to both old and new economy companies, that re-links operational performance to stock price performance.
Biddle, Gary C., Robert M. Bowen and James S. Wallace, "Evidence on EVA," Journal of Applied Corporate Finance, vol. 12, no.2 (Summer 1999).
Jackson, Alfred G., "Using EVA in Equity Analysis," Association for Investment Management and Research, 1997.
Lavallee, Dan, "Equity Analysis Using Economic Value Added (EVA)," Unpublished Union Securities Inc. research report, March 1999.
Northfield, Stephen, 1998. "A new way to measure wealth," The Globe and Mail, June 13, B22.
Schofield, Brian A. and Vic Alboini, Stature's Shareholder Value Review of the 100 Largest Public Companies in Canada, Toronto, Stature Inc., 1995.
Topkis, Maggie, "A New Way To Find Bargains," Fortune, vol.134, no.11 (December 9, 1996), 175-177.
Tully, Shawn, "America's Wealth Creators," Fortune, vol. 140, no. 10 (November 22, 1999), 275-284.
*EVA is a registered trademark of Stern, Stewart & Co.
Brian A. Schofield is Fund Manager to the YMG Sustainable Development Mutual Fund and YMG Sustainable Value Pension Fund.