1Advanced Valuation MethodsEconomic Profit Model2Economic Profit (aka EVA)n EVA represents economic value addedn Reorders cash flows to allow shareholders to relate company operating performance directly to shareholder valuen Adjusts capital to eliminate distortionsn Financing perspectiveCapital = Debt + equityn Operating perspectiveCapital = Fixed assets + working capital.23Components of EVAn NOPLATn Net operating profit after taxn Capitaln Net working capital, net PP&E, goodwill, and other assetsn Cost of capitaln Weighted average cost of capitaln Capital chargen Cost of capital * capitaln Economic value addedn NOPLAT less the capital charge.4What is NOPLAT?Net sales 150,000Cost of sales 135,000Depreciation 2,000SG&A 7,000Net Operating profit 6,000Taxes @ 40% 2,400NOPLAT 3,600Excludes financing charges35What is Capital?n Capital: Net operating assets adjusted for certain accounting distortionsn Asset write-downs, restructuring charges, …n Net operating assets:n Cash, receivables, inventory, prepaidsn Trade payable, accruals, deferred taxesn Net property, plant, and equipmentn Non-operating assets:n Marketable securities, investments,...6What is the Capital Charge?n Represents a rental charge for the use of the operating capitaln Minimum rate of return the operating capital should earnn Calculated as the firm’s weighted average cost of capital.47Calculating EVAn Two methods lead to the same answern Method 1:n EVA = (ROIC% - WACC%) * Invested operating capitaln Profitability captured by the spread: ROIC% - WACC%n Growth captured by the invested operating capitaln ROIC = NOPLAT / net operating invested capitaln Method 2:n EVA = Operating profits after taxes -(WACC% * Invested operating capital)n Similar to the economist’s definition of profit.8Calculating EVA: An Operating ApproachNet operating profit after tax (NOPLAT)- Capital charge (= WACC * Capital)= Economic value added (EVA)59Calculating EVA:A Financing ApproachNOPLAT/Average capital= Return on invested operating capital (ROIC)- Weight average cost of capital (WACC)= Spread (ROIC - WACC)* Capital= Economic value added (EVA)10What’s Affecting EVA?Sales- Operating expenses- Taxes= NOPLAT- Capital charge= EVACost of goods soldSG&A + otherNet working capitalPP&EWACCEvaluate the many assumptions!Potential gov’t actionsMarket potential611Valuation Textn Look at Exhibits 8.9 & 8.11n Pages 141 and 145 of text.12EVA & Shareholder Valuen What is the best way to measure shareholder value?n Fortune 500 sales?n Earnings per share?n Business Week survey of market value of equity?n Stock market share price?n Market value added?713Defining Shareholder ValueTotal market valueDebt &equitycapitalMarketvalue addedInvestmentPremium14Defining Shareholder ValueTotal market valueDebt &equitycapitalExpectedimprovement in EVAMVACurrent levelof EVAMVA = Present value of all future EVA815EVA & Market Valuen Market value of a company reflects:n Value of invested capitaln Value of ongoing operationsn Present value of expected future economic profitsn Captures improvement in operating performance n EVA related to market value by:n Measuring all the capitaln Seeing what the firm is going to do with the capitaln Turn those free cash flow forecasts into EVA forecastsn Discount EVA.16RelationshipBetween EVA & MVAEVA EVA EVA EVAYear 1 Year 2 Year 3 .... Year nMarketValueMarketvalueMVACapital=EVA + EVA + EVA + ... + EVA1 + r (1 + r)2(1 + r)3(1 + r)nMarket 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 thoseEVAs to the present to get market value added.MVA917EVA Drives MVACompanies that consistently earn profits in excess of their required return ...NOPLATEVAMarketValueCapitalMVACharge… are typically valued at premiums to book value.18GrowthROIC - WACCGrowth00Growth:A double edgedswordQuadrant 2:Diminish valueQuadrant 3:ProtectvalueQuadrant 1:Create valueQuadrant 4:Limit value1019Management Implicationsn Quadrant 1: Create valuen NPVs > 0, but require investment that may payoff in the distant futuren Quadrant 2: Diminish valuen NPVs < 0. These businesses consume investment funds. Priority: decrease investmentn Quadrant 3: Protect valuen NPVs < 0. These business address the problem by shrinking their asset base. Priority: increase returnsn Quadrant 4: Limit valuen NPVs > 0. These businesses decrease investment. Priority: increase investment while maintaining returns.20Top-Down, Bottom-UpROIC - WACCGrowth00Diminish valueProtectvalueCreate valueLimit valueROICCash flow InvestmentRevenue Expenses Cap. expend. Working capitalTop DownSetDirection& GoalsManagethe BusinessBottom Up1121Advantages of EVAn Annual EVA is easy to interpretn Correlations between market value and various measures:n Standardized EVA 0.50n ROE 0.35n Fortunes “Most admired firms” 0.24n Cash flow growth 0.22n EPS growth 0.18n Dividend growth 0.16n Sales growth 0.09n 50% of change in market value explained by standardized EVA (Standardized EVA = EVA / Capital).22Uses of EVAn Capital of the company + PV of expected EVAsn The sum equals total firm valuen Capital budgetingn EVA streams = NPV of a projectn Performance reviewn Common language for communicating performance & goals.1223EVA & Other Measuresof Performance0%5%10%15%20%25%30%35%40%45%50%EPS Growth Cash FlowGrowthROE EVACorrelationwith MVA24Four Fundamental StrategiesCapital * capital ofCost CapitalNOPLATEVA−=Operate: Improve thereturn on existing capitalBuild: Invest as long as returnsexceed the cost of capitalHarvest: Redeploycapital when returns fail to achieve the cost of capital.Decrease:WACC1325Focus on theImprovement in EVAn A positive change in EVA is better than a positive yet unchanging base level of EVAn Why?n Positive changes in EVA are consistent with shareholder value added -- whether from a positive or negative basen Positive changes in EVA are consistent with the managerial notion of continuous improvement in performance.26EVA & Capital Budgetingn EVA is the reward from investing in projects that return above the cost of capitalEVA = (ROIC -WACC) * Operating Capitaln Each project’s expected return must exceed its cost of capital to be justified.1427Investment ScheduleNet Assets%WACC Destroy valueCreate value28Why Use EVA & Not NPV?n Present value of EVA =