Sunday, January 25, 2009

EVA, SVA, and the Economy

Shareholder value analysis (SVA) is one of several nontraditional metrics being used in business today. SVA determines the financial value of a company by looking at the returns it gives its stockholders and is based on the view that the objective of company directors is to maximize the wealth of company stockholders.
Shareholder value is calculated by dividing the estimated total net value of a company based on its present and future cash flows by the value of its shares of stock. The resulting figure indicates the company’s value to stockholders.
The underlying principle of shareholder value is that a company adds value for its stockholders only when equity returns exceed equity costs. Once the amount of value has been calculated, targets for improvement can be set and shareholder value can be used as a measure for managing performance.
Before adopting shareholder value as a significant financial objective, you need to understand its implications and the best way for your business to approach it. It can be helpful to first plan the approach with professional advisers such as accountants or consultants who specialize in this area. A company’s value is calculated by subtracting the market value of any debts owed to the company from the total value of the business.
The total value of a business has three main components:
the present value of future cash flows during the planned period;
the residual value of future cash flows from a period beyond the planned period;
the weighted average cost of capital.
Total business value is calculated by adding present value of future cash flows to residual value of future cash flows and dividing it by the weighted average cost of capital.
If the result of this calculation is greater than one, then the company is worth more than the invested capital and added value is being created.
Future cash flows
Future cash flows are affected by growth, returns, and risk. According to Alfred Rappaport in Creating Shareholder Value, these factors can be explained by seven key value drivers that must be managed in order to maximize shareholder value:
sales growth rate
operating profit margin
income tax rate
working capital investment
fixed capital investment
cost of capital
value growth duration
Residual value of future cash flows
The residual value—the price at which a fixed asset is expected to be sold at the end of its useful life—is an important figure that represents cash flows arising after the normal planning period (usually five to ten years). It has been estimated that as much as two-thirds of the value of a business can be attributed to cash flows arising after this planning period. Viewed another way, only one-third of the value of a business results from cash flows arising during the normal planning period.
Weighted average cost of capital (WACC)
The WACC is the cost of equity added to the cost of debt. It represents the return a company needs to earn in order to justify the financial resources it uses. the WACC therefore expresses the opportunity cost of the assets in use. The WACC is entirely market-driven—if the assets cannot earn the required return, investors will withdraw their money from the business.
EVA(Economic Profit)
The Economic Value Added (EVA) is a measure of surplus value created on an investment.
It is a very powerful tool. The analysis is obviously a lot more complex.
This model works nicely in good times. But does it work today? What is it telling us?
I asked the following question:
Cost of Capital is part of the EVA equation. Given the credit crisis, how has this impacted EVA? Is cost of capital going up? If so, what does that mean in terms of where companies should invest then efforts? Or is it going down because the prime rate is so low? What does this mean that from a targeting perspective?
Here are the two responses:
Response #1: On the EVA question, theoretically the Cost of Capital is down given the prime. But actually it’s up given the credit markets — the Libor is a good proxy (the rate at which banks lend to each other). The B2B rates are even worse, hence all the talk about the credit markets freezing up. In terms of targeting Cost of Capital, that’s a tougher question. Most of the action in EVA around the Weighted Average Cost of Capital (WACC) is related to more or less leverage. So targeting it would mean more leverage and there’s not too many companies that want to go in this direction now. In fact, we may have determined a “ceiling” on how far you can push on that lever.
Response #2: From a mathematical perspective, marginal cost of capital is fairly low these days. The availability of capital, however, is the real issue. In the current market it is difficult to raise capital. Therefore if an enterprise can generate excess cash and can identify opportunities with good returns they should certainly invest. It is no different for an individual. Assuming that a major catastrophe is not looming on the horizon and assuming that one has available cash, this is the time to invest. I should hasten to add that the “classical” capital market theories upon which WACC and EVA are based are NOT, in my opinion, quite valid in a tumultuous market where risk free rates are almost zero and people are simply keeping cash “under the mattress.”
Interesting thoughts.
My follow up question is, “Assumiung WACC is up, what is the relative impact of cost reduction versus revenue growth on EVA?”