INTRODUCTION
Everyone knows what Economic Value Added is or maybe this term that has been talked about and written about so much is not so well-understood. In this issue of E-Law and the next, we will discuss Economic Value Added and the identical, generic concept – economic profit as well as the concept of Market Value Added. In the process, we will see how these concepts are related to the more familiar valuation concepts of return on equity, price/earnings multiples, and price/book multiples. Then, in a third issue to follow shortly, we will further relate the concepts of Economic Value Added, economic profit, and Market Value Added to our basic valuation theory as it might relate to the value of businesses and business interests at the freely traded and nonmarketable minority interest levels.
ECONOMIC VALUE ADDED
ECONOMIC VALUE ADDED, or EVA, is a registered trademark of Stern-Stewart & Company. EVA has been a subject of discussion at a number of business valuation conferences and has been given regular national prominence by being featured in Fortune magazine and other financial publications.
Each time I have examined the concept of EVA, I have come away with the impression that Messieurs Stern and Stewart have done a remarkable job of packaging and marketing age-old wisdom: firms build value by maximizing the differential between their costs of capital and the actual returns achieved. They have, however, built a performance measurement system, which is different than a valuation methodology, but performance and valuation are necessarily related. And they have built a sizeable consulting business by establishing a vocabulary, a discipline, and compensation systems geared to encourage managers of the largest companies in America to manage them better.
Is maximizing returns what EVA and economic profit are all about? Yes. EVA, economic profit, and the related concept of Market Value Added (the present value of all future EVA or economic profit), essentially boil down to one simple idea:
In fairness to Stern-Stewart, there can be considerable discussion over which RETURN, or how to measure the income stream, and which EQUITY, or what to include in the definition of equity. And there can be even more discussion about how to develop a firm’s cost of capital. But make no mistake; EVA is all about return on equity. It is almost as if this is a little-known secret that no one wants to talk about. For example, a recent book, Foundations Of Economic Value Added, by James L. Grant (Frank J. Fabozzi Associates, New Hope, PA: 1997), that was extolled as a "must read" by G. Bennett Stewart. In that book, the concept of return on equity (ROE) was mentioned only once, at page 26, in a brief observation of an example company’s 15% return on equity.
The Grant book begins:
The analytical tool called EVA, for Economic Value Added, was commercially developed during the 1980s by the corporate advisory team of G. Bennett Stewart III and Joel Stern. This financial metric gained early acceptance from the corporate financial community because of its innovative way of looking at a firm’s real profitability. Unlike traditional measures of corporate profitability – such as net operating profit after tax (NOPAT) and net income – EVA looks at the firm’s "residual profitability," net of both the direct cost of debt capital and the indirect cost of equity capital. In this way, EVA serves as a modern measure of corporate financial success because it is closely aligned with the shareholder wealth-maximization requirement.
While the name Economic Value Added may be registered, the concepts are not. In fact, other consulting firms have developed similar concepts based on the essential idea that firms build value by maximizing their returns on shareholders’ equity.
Business owners, their advisers, and business appraisers can benefit from these insights. There is no magic to building economic value in businesses.
DEFINITIONS
Professor Grant expresses Economic Value Added in general terms as (at page 2):
EVA = NOPAT – $ Cost of Capital
$ Cost of Capital = [Debt Weight x % After-Tax Debt Cost + Equity Weight x % Cost of Equity]
[In a prominent treatise, economic profit is defined as NOPLAT (net operating profit less adjusted taxes) minus a firm’s invested capital (debt plus equity) times its weighted average cost of capital (WACC) – in other words, the same thing as NOPAT in the EVA terminology above. EVA and economic profit are the same concept. See Copeland, Tim, et al., Valuation: Measuring And Managing The Value Of Companies, Third Edition (New York: John Wiley & Sons, Inc., 200), at pp. 143-145.]
NOPAT is a firm’s net operating profit after tax. Since it will be helpful for the discussion that follows, we will assume an equivalency between NOPAT and debt free net income, or DFNI. Cost of capital is traditionally defined.
Professor Grant then expresses Market Value Added as follows (at page 3):
MVA = Firm Value – Total Capital
MVA = [Debt plus Equity Value] – Total Capital
MVA = PV of Expected Future EVA
EVA is a function of the relationship between a firm’s earnings and its cost of capital, and MVA is a function of that firm’s expected future EVA. So market value added is clearly a function of a firm’s earnings. How earnings are defined and what adjustments are appropriate to earnings are age-old questions of securities analysis.
EVA IS A FUNCTION OF RETURN ON EQUITY (ROE)
We can see the relationship between ROE and EVA by working with the definitional equation for EVA. Since EVA is expressed in terms of dollars (in the United States) we will use the notation $EVA, number the equations and offer brief discussion as the development progresses.
1. $EVA = DFNI – Cost of Capital
For ease of notation, we can express Cost of Capital by the expression:
Cost of Capital = KE*BVE + KD*BVD
KE and KD represent the cost of equity and the after-tax cost of debt, respectively. BVE and BVD correspondingly represent the book values of equity and debt.2. $EVA = DFNI – (KE*BVE + KD*BVD) or,
3. $EVA = DFNI – KE*BVE – KD*BVD
Debt-free net income can be broken into its constituent parts, the portion attributable to equity and the portion attributable to debt. This relationship can be expressed as:DFNI = DFNIE + DFNID or,
= DFNIE + KD*BVD But DFNIE = Net Income = NI So,4. $EVA = NI + KD*BVD – KE*BVE – KD*BVD
After canceling out equivalent terms, EVA becomes:
5. $EVA = NI – KE*BVE
So $EVA is a function of a firm’s net income less its cost of equity capital (KE*BVE). This would suggest that $EVA is maximized by maximizing the differential between earnings and the cost of equity capital. Now, we can consider EVA in percentage terms by dividing all parts of Equation 5 by equity, or BVE.6. %EVA = $EVA/ BVE = NI / BVE – (KE*BVE/ BVE) so,
7. %EVA = (NI / BVE) – KE and finally,
8. %EVA = ROE – KESo $EVA is a function of earnings in excess of a firm’s equity cost of capital and %EVA is a function of a firm’s ROE less its percentage equity cost of capital.
Now I’m sure that proponents of EVA might argue that I don’t understand and that EVA is critically dependent upon how one defines the earnings that are used and, for that matter, the equity figure that is used in the calculation of ROE. But we're dealing at a conceptual level here. Clearly:
This analysis of EVA thus far validates the concept that return on equity is an important driver of the value of equity securities. It is pretty basic, but firms maximize value by focusing on returns to their shareholders! Is this accomplished by a slavish devotion to reported earnings per share under the most liberal and allowable interpretations of GAAP? Hardly not. The market sees through such shenanigans (at least over the longer term), and, hopefully, so do business appraisers in valuing privately owned companies.
MARKET VALUE ADDED IS A FUNCTION OF EVA AND ROE
In order to round out our conceptual understanding of EVA, we need to look at the related concept of MVA a bit more closely. Recall that MVA was defined as a firm’s value (equity plus debt) less its capital employed (equity plus debt). We can use nomenclature consistent with the analysis above, substituting market value concepts for book value concepts, and express MVA, in dollar terms, as:
9. $MVA = (MVE + MVD) – (BVE + BVD)
It is fairly common to consider that for many, if not most, firms the market value of debt is approximately equivalent to the book value of their debt. There can, of course, be exceptions to this simplification, but it is generally used in the financial community as a first-blush assumption. Substituting and simplifying yields:
10. $MVA = MVE + BVD – BVE – BVD Therefore,
11. $MVA = MVE – BVE
It is clear from Equation 11 that $MVA is the surplus of the market’s valuation of a firm’s equity over the book value of that equity. In other words, MVA is the value premium over the shareholders’ historical investment in a firm. If a firm is adding economic value by maximizing its return on equity (and its $EVA), the market may reward it with a large $MVA. If that sounds like a firm’s price/book value multiple might be involved, read on as we convert $MVA to %MVA.
12. $MVA/ BVE = %MVA = MVE/ BVE – BVE/ BVE
The market value of a firm’s equity divided by its book value is none other than the price/book value ratio, or multiple. This relationship was also noted by Copeland, et al. in their discussion of MVA at pp. 59-62, although that discussion is framed in terms of total capital rather than just equity. So %MVA can be expressed as:
13. %MVA = Price/Book – 1
In other words, %MVA is the multiple over a firm’s book value of equity that is indicated by the market value of its equity. For example, a price/book multiple of 2.0 would indicate that the market is valuing a firm’s equity at 1x greater than the shareholders’ historical investment. But we haven’t yet found ROE, or have we?
Stated in the terms of our analysis thus far:
Price/Book = MVE/BVE Which can be expanded into,
Price/Book = MVE/NI x NI/BVE
MVE/NI is generally known as the price/earnings ratio, or multiple. And, from above, NI/BVE is identical to ROE. Going back to Equation 13 and substituting, we see that ROE enters into the picture of %MVA (and $MVA) as follows:
14. %MVA = ((Price/Earnings) x ROE) – 1
%MVA is nothing other than the reward (the price/earnings multiple) that the market accords to a firm’s ROE. So %MVA and $MVA are, like %EVA and $EVA, integrally related to a firm’s ROE. Once again, our analysis of MVA affirms the basic idea:
Since %MVA is a function of both the price/earnings multiple and ROE, it is clear that a firm’s value is related to things that management can influence, and things that management cannot influence. Management can influence the aspects of a business that ultimately are reflected in a firm’s ROE. However, management cannot influence overall market or industry trends and the impact that those trends may have on prevailing price/earnings multiples or the pricing of individual securities.
CONCLUSION
We hope that EVA, MVA and economic profit have been demystified a bit in this brief article on the subject. The next issue of E-Law will continue our discussion in an article entitled: "The Economic Effect of NOT Maximizing EVA, Economic Profit, Market Value Added and Return on Equity."
If you have questions or observations about this or other E-Laws, please do not hesitate to call or e-mail us.
(Reprinted from Mercer Capital's E-Law Newsletter 01-04, April 26, 2001)