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Friday, June 1, 2007

Take stock of EVA when choosing shares

Most people look at the profits of a company while deciding on whether to buy its shares or not. However, life is not that simple. Despite being profitable, a company may in reality be destroying its shareholder wealth. Let's look at the followin example to understand this, better.

Profit is not everything
Vijay has received Rs 10 lakh from his father. Based on a suggestion from his friend, he opens a small stationery shop near a college.

The business does well and in the first year he earns an income of Rs 5 lakh. After deducting all expenses aggregating to Rs 4.25 lakh, he makes a net profit of Rs 75,000. Assuming a 30 per cent tax, the profit works out to Rs 52,500. Thus Vijay is successful at running a profitable venture.

But, Vijay’s father is not so happy with this gain. If, instead of giving money to his son, he had put this money in a fixed deposit with an 8.5 per cent pa interest rate (and paid 30 per cent tax on the interest income), the earnings would have been Rs.59, 500. Thus, Vijay has lost Rs 7, 000 of his father’s wealth by earning less.

So, if profit is not the true indicator of performance, what is? This is where a factor known as Economic Value Added (EVA), comes into consideration.

What is EVA?
EVA can be broadly understood as the difference between the actual profit and the investor’s minimum profit expectation.

The EVA in the above case is Rs 7,000 (Rs 52,500 – Rs 59,500). We can also deduce that the EVA should be positive if the company has to add to the shareholder’s value.

A negative EVA means that shareholder’s wealth is being destroyed. The concept, therefore, is very simple and logical.

Why EVA?
The profit and loss statement of a company tells only a part of the story. It only indicates whether the company is profitable or not. It, however, fails to say whether this profit is sufficient enough to meet the minimum expectations of the shareholder.

Mathematically, EVA is defined as:

Net Operating Income After Tax (NOPAT) – Weighted Average Cost of Capital (WACC)

NOPAT = Sales – Operating expenses – Depreciation - Tax
And WACC = Cost of Debt*Total Debt + Cost of Equity*Equity Capital

From the above definition, it can be seen that while NOPAT and Cost of Debt (ie interest) are already part of the usual profit and loss statement, the Cost of Equity capital is overlooked.

It is important that a business should typically generate a net income, which is more than sufficient to meet not only the cost of debt but also the cost of equity. So, before you invest in a company, do a comparative analysis of the returns you can earn from various options. Your decision to invest in the company should be because you expect to earn better returns than the other options. This is the cost of equity.

The calculation of true EVA, however, is quite detailed and requires quite a few adjustments in the account statements prepared as per normal accounting practices. Stern Stewart, who developed the concept of EVA, have a trademark over it. Therefore, they too don’t disclose the exact methodology. However, one can get a broad idea whether a company’s EVA is positive or not, by working on the accounting statement numbers itself.

The beauty of EVA
Different people in the company have different goals. The marketing manager works towards increasing sales, the production manager tries to maximise capacity utilisation, the plant manager looks at the increasing margins, etc.

Thus we end-up having a large number of performance criteria such as Sales, EBIDTA, ROI, Production, Operating Margin, Profit Margin, EPS, IRR, NPV, etc. Improving the above metrics need not necessarily always be beneficial to the shareholder.

Logically speaking, higher the sales the better it is! And every sales manager would like to increase sales. Suppose he does so -- but by giving higher credit period. This would mean that the company’s day-to-day working capital borrowing will go up and hence higher interest cost. If this interest cost is more than the profit that the company earns through higher sales, the company is actually losing by increasing sales.

Logically speaking, the less the m/c downtime the better it is! Suppose the maintenance manager achieves this but in the process he has to keep extra spares and manpower. If this cost is more than say keeping the m/c closed for one or two days till he gets the necessary parts, it may be better to keep the m/c closed.

Thus, what may appear to be logically right need not always be true.

This is where EVA proves very useful. All different departments now have to concentrate on one thing – improving EVA. All that they have to do now is to calculate the impact of any decision on the EVA. If the EVA is improving, the solution is acceptable, else it is rejected. Therefore, now the management will not mindlessly increase the sales, if the net effect is reduction in profits. It may keep the m/c shut rather than keep high inventory of spares. Yet in actual scenario decisions are not always taken rationally. Therefore, you will find many profitable companies with negative EVA.

Further, the experience in the US shows that over time companies, which adopt EVA, do well on the stock markets too. A company, which strives to improve the EVA and hence add to the shareholder’s wealth, is a better investing bet, than the others. The potential for the share prices of such companies to outperform over time is much higher.

It may, therefore, be worthwhile to also look at EVA besides the PE, EPS and other numbers, which we usually analyse before investing in a stock.

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