Economic Value added

May be you guys want to look at the discussion on Economic Profit Added in the Art of valuation thread
http://forum.valuepickr.com/t/the-art-of-valuation/?source_topic_id=3332

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The most commonly used simplified Capital Employed = Total Assets - Current Liabilities

yes but in EVA capital employed is a bit different .

thanks @akbarkhan … wud have a go through

Wonderful to work as a team

wud be sharing the eva resources that i have

EVA-basic. printed.pdf (484.5 KB)eva (2).pdf (287.1 KB)EVA Example.xls (166.5 KB)EVA_Frank_Pinto.doc (64 KB)
eva.pdf (108.0 KB)evaspres.pdf (42.5 KB)
EVA-basic. printed.pdf (484.5 KB)
eva3.pdf (237.4 KB)EVA-runko32 esitys_e.ppt (1.2 MB)

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HI Saurabh,

Thanks for the links. I had the privilege of studying under Joel Stern a few years back, he taught us Finance in B school. Will share my notes from class soon. Incredibly eye opening stuff! In the process of moving to Tampa from Pittsburgh so please excuse the delay. Thanks again Saurabh, appreciate it!

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Hi,

EVA calculation & correlation with stock price from 2011 to 2015. Its for bharti airtel. It shows low EVA results stagnant stock price. Would be great if similar correlation between EVA & CMP (+ve or -ve) can be sampled across few large/mid/small cap stocks from various sectors.

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Just found this thread while searching for something else. I thought I’d leave my two cents on this.

How would you treat a company with lots of liquid cash in its Balance Sheet? No, not the Operating Cash items (Loans given to employees, Deposits with the Tax Department, Cash blocked for purchase of Inventory etc), but I mean the really liquid cash like Cash/Bank/Bonds and Mutual Fund/Equity Investments.

If the company is prudent with accounting, the gains from these will not show up in the Operating Profits of the company. More often than not, these show up as ‘Other Income’ and so on, which should ideally not be considered while trying to Value a company.

I personally define ‘Capital Invested’ as (Total Fixed Assets + (Current Assets - Cash - Cash Equivalents) - (Current Liabilities - Deferred Tax Liabilities)). In essence, I remove Cash & Cash Equivalents from the “Capital” of the company and add it back separately once I’m done Valuing the company (While being careful not to include the gains/income from these in the profit of the company). This boosts the company’s capital turnover, at the downside of these additional Assets treated at face value and nothing more.

I’d love to hear the thoughts on this from some of the seniors in this forum.

Edit: Found an old blog post from Prof. Damodaran on the topic

Also a paper on the same (Impact of Cash and Cross Holdings on Equity Investors):

https://papers.ssrn.com/sol3/papers.cfm?abstract_id=841485

This will be an interesting discussion.

My view about this is that one should study the track record of the co in deploying cash. In some cases excluding cash is a better way to value the co but in most cases cash is just capital invested earning ok returns for the time being. Keeping excess cash or equivalents for an elongated period of time and piling it up depresses the value of the co. Some cos like thyrocare, goodyear, HMVL etc come to mind.

In India, cos have a tough time scaling up because of our large, ingenious and flexible unorganized sector and often grow upto a point and then stagnate. Its much more difficult to grow a business in india than is commonly thought and after a point cash reserves tend to pile up as opportunities to grow dry up.

India is made up of a lot of small opportunity sizes which can absorb only so much capital and the rest is either destroyed in cyclical turns or sits on the balance sheet or is employed in some non productive fashion by the business. Returning it to the shareholder is the last thought that occurs , if it does at all.

For this reason, i view cash as risk capital until is transferred to the investor.

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Interesting. So do you mean that you will also demand the Required Rate / Cost of Capital on Excess Cash?

Say, the company has Rs. 100 Cr in Cash. In the regular sense, it earns at the RfR (Say 7%) and being liquid, we demand the RfR, so it remains at face value in the Valuation i.e. 100*0.07/0.07.

Do you say that the Rs. 100 Cr earns the RfR, but you demand the Cost of Capital? Does that mean that, if Kc is 12%, you will Value it at Rs. 58 (100*0.07/0.12) Cr?

Yes, the required rate of return is 15% across the entire capital invested stack

Thank you for your inputs. One final thing then… how do you view Mutual Fund / Bond investments? They may already earn close to the Kc. So does it make sense to mark them down or retain them at face value?

Itna kaun dimaag lagayega. Technically one can mark them up or down as you suggest but itna deep i dont go.

From your posts i gather you follow Damodaran closely. He would certainly do something like this and technically he and his students would be correct. I just lagao 15% and if things look good i dig further.

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If the idea is to compare businesses in terms of business quality, I think removing cash makes sense as that will give an accurate picture of business machinations. I did something similar to compare Dr Lal Path labs and Thyrocare. In terms of CoC on cash/investments in mf etc, I agree with @bheeshma that an indicative 15% should do. Going any more precise on that I think is futile due to the law of diminishing returns for practical purposes while it might make sense in an academic exercise if the evaluation depended on it.

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The problem is, I already use 15% Kc for all my Valuations anyway (Regardless of excess cash or not), unless the market-implied Kc is higher.

I agree that this is just nitpicking, but I’m interested in the theory. While theory may not be very useful always, it helps in extreme cases like Apple (As Prof. Damodaran himself had discussed).

Thank you for the feedback again.

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A snapshot form the book “Its earnings that count” by Hewitt Heiserman Jr who introduced the Earning Power Box to evaluate the earning quality of the companies using Defensive Income Statement and Enterprising Income Statement. This table provides how an Enterprising Capital is calculated which is needed in arriving at Enterprising Income Statement. Enterprising income is also referred as EVA as I understand.
In the table shown the excess cash is mentioned and it is defined as any cash above 2% revenue. This is stated in general and might have to be revisited based on the context.

PS: I have started reading this book and have not practically used it much. But book is very interesting and seems to provide a framework to evaluate our portfolio quality and take buy/sell/hold decisions based on how earning quality for the companies is changing.

Br, Sudheendra

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@dineshssairam , @bheeshma Taken this from Pidilite AR . Can you let me know how to evaluate this business through EVA figure ?How to get an idea about the current valuation on EVA Basis?

I have basic idea that EVA is the incremental difference in the rate of return over a company’s cost of capital. It assesses the performance of a company and its management through the idea that a business is only profitable when it creates wealth and returns for shareholders, thus requiring performance above a company’s cost of capital.

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):

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)

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Much Helpful. Really appreciate.

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Excellent Presentation by Pidilite in their AR on Cost of Capital & EVA: