Economic Value added

[dineshssairam]

In my opinion, EVA is really iffy, mostly because Cost of Capital itself is really iffy. Market-implied, mechanic Cost of Capital can be used by CXOs to evaluate prospective projects, but it is really not suited for the minority investor in the business. More of my views on Cost of Capital here.

I personally use a flat 15% Required Rate for my Valuation purposes (As @bheeshma and @phreakv6 have also indicated). But think about what would happen if every business manager started demanding at least 15% return on their projects. There would be a recession for lack of employment and industrial production. As a business manager, you make decisions for millions of people around the world. An a minority investor, you only think for yourself. So, both these actions are justified.

As far as EVA and Value are concerned, the theory is that:

1. If a company’s Return on Capital is above its Cost of Capital, it creates Value with Growth
2. If a company’s Return on Capital is below its Cost of Capital, it destroys Value with Growth

But do all companies earning Return on Capital above their Cost of Capital make good investments? Of course not. There are also other questions that remain unanswered:

1. What is the return you personally demand on the Value created? Case in point, for every Rs.100 of Cash Flow, the business manager, assuming a 12% cost, may think he created Rs.833 of Value (100/0.12). However, if your personal demand for returns is 15%, you would calculate a Value creation of only Rs.666. You could see how both the approaches could change the expected price of a stock.

2. What is the risk associated with the Value creation process? Are you sure that the company will keep at it continuously? Won’t there be down years or regulatory troubles? You can’t foresee these, of course. But you can allow for a substantial Margin of Safety, thereby providing yourself a cushion. I personally use at least a 30% Margin of Safety on my Valuations.

Finally, BuffetFAQ is a wonderful collection of a lot of things Warren Buffet and Charlier Munger have said about business, valuations and everything else. At the risk of sounding boring, I would suggest that you read thought the website instead of trying to find a correlation between EVA and Stock prices.

The following thread contains the Valuation model I use to judge prospective investment opportunities (Basically an excel version of the answers I gave above):

Numbers and Narratives: A Simple Discounted Cash Flow (DCF) Model for Equity Valuation

I have created a Discounted Cash Flow Excel Model for Valuation of Common Stock. A Stock’s value is nothing but the story behind the stock and the numbers that keep the story grounded in reality. Hence, I have named the model ‘Numbers and Narratives’. The name is also inspired by one of my all-time favorite YouTube videos by Prof. Aswath Damodaran. In fact, the model itself is a spin-off of a larger, more complex Valuation model created by the Professor himself. Do visit his website to access m…

Oh and before I forget, I made a replica of the Pidilite EVA calculation you posted. This could come in handy as a sample model for anyone interested in this thread: Pidilite EVA.xlsx (11.8 KB)