Value Added Analysis

Aman Khan
Ujwal Pargi
Praveen Kumar
Ansuman Sharma

How Value is Created

Management makes decisions,
hopefully, with benefits exceeding
costs
Benefits may be near or distant future
Costs should include direct investment
costs + cost of capital
True source of value-enhancing
projects
Firms comparative or competitive
advantage.
2

Comparative Advantage
Advantage one firm has over
another in terms of
Cost of producing or
Distributing goods/services
Example:
Wal-Mart invested in regional warehouses and
distribution system
Reduces the need for retail inventory
Replenish store inventory quickly.

Competitive Advantage
Advantage one firm has over
another because of structure of the
markets in which they operate
Barriers to entry
Patents
Capital requirements
Regulation

Influence over suppliers

Influence over buyers

Must be
sustainable
to be a true
competitive
advantage

Traditional Measures

Return on Investment
Compare benefits (numerator) with
resources (denominator) affecting
that benefit
Basic earning power ratio
EBIT / Total assets

Return on assets

Measured
relative
to what?

Net income / Total assets

Return on equity
Net income / Book value of equity
6

Effective SCM:
Increased Shareholder
Value
Revenue

Profitability
Costs

Shareholder

Greater customer service

(higher market share,
increased gross margins).
Greater product availability
Lower cost of goods sold,
transportation, warehousing,
material handling and
distribution management
costs

value
Working
capital
Invested
capital
Fixed
capital

Lower raw materials and

finished goods inventory
Shorter order-to-cash
cycles
Fewer physical assets (e.g.
trucks, warehouses, material
handling equipment)

Pros & Cons

Benefits of these ratios
Ease of calculation & interpretation
Decompose to reveal sources of changes

Downside of these ratios

Sensitive to choice of accounting method
Accumulation of monetary values from
different periods
Backward looking
Fail to consider risk.

EPS: Opiate of the Executive

Suite
EPS is such an unreliable measure
of value that managers often make
dumb decisions to increase it
Prompts managers to misallocate
capital
Treats retained earnings as a free
source of capital
Promotes retaining capital and using it
wastefully.
9

EPS
Accounting rules discourage EPSmanic managers from spending
capital on value enhancing
investments in intangibles like
brands, research and training
Why?
GAAP requires outlays to be written off
immediately against earnings.

10

EPS
EPS focus may cause management
to refrain from issuing equity at
times when the company really
needs it
Fabricate EPS gains by using more
debt than prudent
Both on and off the balance sheet

Accept weak projects that happen

to be financed with debt.
11

EPS
Earnings manipulation often used
Establish reserves
Invest pension funds in equities
Extreme cases, make up numbers as
you go
Worldcom and HealthSouth.

12

EPS
Todays market perception:
Management that aims to boost
earnings at the expense of quality will
be more certainly penalized then ever
before with a lower stock price and a
sullied reputation.

13

Performance vs. Valuation

Performance measurement
Relies on actual results
Historical
GAAP vs. GAP

Valuation
Relies on forecasts
A firms stock price relies on
investors expectations, not
historical performance.
14

Cash Flows

Statement of Cash Flows

SCF combines balance sheet
and income info

Eliminates the sins of accrual

accounting

SCF consists of:

Operating cash flows

Investing cash flows
Financing cash flows.

Free cash flow

16

Cash Flow Not the Answer

Cash flow has problems as a valid
performance measure
So long as investments in projects
earn a return higher than shareholders
could earn by investing on their own,
then the more investment a company
makes and the more negative its cash
flow becomes, the higher its share
price will be.
Think Wal-Mart.
17

Better Than Some

Alternatives
Accounting profits
versus cash operating
profits
Cash flow frequently
defined as:
Net income +
depreciation or as
EBITDA
Poor definition

Honeywells trend...

18

Free Cash Flows

Definition:

After-tax operating earnings + non-cash

charges - investments in operating working
capital, PP&E and other assets
It doesnt incorporate financing related cash
flows
Represents cash flow available to service debt
and equity.

When used in capital budgeting

proposals
Based on expectations.
19

FCF & Capital Budgeting

FCF is the method of choice of most
firms for evaluating capital budgets
Identify incremental

Investment in PP&E + working capital

Revenues
Costs (excluding financing)
Depreciation tax shields.

20

Common Techniques
Evaluation techniques:
Payback
Accounting rate of return
DCF analysis
Consists of NPV and IRR
DCF analysis is not a problem in theory
Only in practice.

21

NPV Methodology
Net present value (NPV)

Estimate of change in the value of

equity if the firm invests in the project
Forward looking
If NPV>0

Investment is expected to add value

If NPV<0

Investment is expected to erode value

Decision rule

Invest in projects expected to enhance

value.
22

Internal Rate of Return

Practice is to compare IRR with
weighted average cost of capital
Problem:
IRR fails to measure scale or growth
It sees no difference between earning a
20% return on a $1 million investment
or a $1 billion investment
These two projects are very different with
distinctly different NPVs.
23

Value Enhanced?
Once a project is applied, the investment
becomes buried in the balance sheet
How is its contribution measured?

No idea whether project generates value

Accounting measure relied upon
EBITDA and EPS generally increase
Means Bonuses probably will be paid

Motivation:
Get your hands on as much capital as
possible.
24

Focused Finance & EVA

Focused Finance

26

EVA & Shareholder Value

What is the best way to measure
shareholder value?

Fortune 500 sales?

Earnings per share?
Business Week survey of market value of
equity?
Stock market share price?
Market value added?

27

EVA & Other Measures

of Performance

28

View of the Firm

Market Valued Balance Sheet
Assets

Debt
Equity

Value of firm = Value of debt + value of

stock
Market value of a company reflects:
Earning power of invested assets

Present value of current operations

Present value of expected improvement in
operating performance.
29

What is Required to Focus?

Tie performance methods to capital
budgeting techniques:
Economic value added (EVA)
Market value added (MVA)

Links to
NPV

Want to gauge managements

performance
Focus on:
Decisions made in the past to help project
the future.
30

What is MVA?
MVA = Market value of capital
- book value of capital
Honeywells MVA = ?
Key elements:

Calculation of market value of capital

Market value of debt + market value of
equity

Calculation of capital invested

Accounting adjustments necessary

MVA Related to EVA.

31

Market Value Added

Total
market
value

Premium
Debt &
equity
capital

Market
value added

Investment

32

Also, Market Value Added

MVA = Present value of all future EVA

Total
market
value

Expected
improvement
in EVA

MVA

Debt &
equity
capital

Current level
of EVA

33

EVA & Market Value

Market value of a company reflects:

Value of invested capital

Value of ongoing operations
Present value of expected future economic profits
Captures improvement in operating performance

EVA related to market value by:

Measuring all the capital

Seeing what the firm is going to do with the
capital
Turn FCF forecasts into EVA forecasts
Discount EVA.

34

What is EVA?
EVA = Economic profit

Not the same as accounting profit

Difference between revenues and costs

Costs include not only expenses but also cost of

capital

Economic profit adjusts for distortions caused

by accounting methods
Doesnt have to follow GAAP

R&D, advertising, restructuring costs, ...

Cost of capital accounted for explicitly

Rate of return required by suppliers of a firms debt

and equity capital
Represents minimum acceptable return.

35

Advantages of EVA
Annual EVA is easy to interpret
Correlations between market value
and various measures:

Standardized EVA0.50
ROE 0.35
Fortunes Most admired firms 0.24
Cash flow growth 0.22
EPS growth
0.18
Dividend growth 0.16
Sales growth
0.09

50% of change in market value explained

by standardized EVA (Standardized EVA = EVA /
Capital).

36

Components of EVA
NOPLAT

Net operating profit after tax

Net operating working capital, net PP&E,

goodwill, and other operating assets

Operating capital
Cost of capital

Weighted average cost of capital %

Cost of capital % * operating capital

NOPLAT less the capital charge.

Capital charge

Economic value added

37

What is NOPAT?
Net sales
Cost of sales
Depreciation
SG&A
Net Operating profit
Taxes @ 40%
NOPAT

Excludes financing charges

150,000
135,000
2,000
7,000
6,000
2,400
3,600

38

What is Operating Capital?

Capital: Net operating assets adjusted
for certain accounting distortions

Asset write-downs, restructuring charges,

Net operating assets:

Cash, receivables, inventory, prepaids

Trade payable, accruals, deferred taxes
Net property, plant, and equipment

Exclude non-operating assets:

Marketable securities, investments,...

39

What is Cost of Capital?

Weighted average cost of capital
consists of:
Cost of debt after taxes
= Market interest rate x (1 tax rate)
Cost of equity
= Risk-free rate + beta x (market risk
premium)
WACC
= Cost of debt after taxes x % debt +
cost of equity x % equity
where % debt + % equity = 100%.
40

What is the Capital Charge?

Represents a rental charge for the
use of the operating capital
Minimum rate of return the
operating capital should earn
Calculated as the firms weighted
average cost of capital % x invested
capital.

41

Calculating EVA
NOPAT/Average capital
= Return on invested operating capital (ROIC)
- Weight average cost of capital (WACC)
= Spread (= ROIC - WACC)
* Operating capital
= Economic value added (EVA)
Net operating profit after tax (NOPAT)
- Capital charge (= WACC * Capital)
= Economic value added (EVA)
42

Whats Affecting EVA?

Sales
- Operating expenses
- Taxes
= NOPAT
- Capital charge
= EVA

Market potential
COGS, SG&A + other
Potential govt actions
Net working
capital
PP&E
WACC

Evaluate the many assumptions!

43

Forward Looking
Relationship for EVA & MVA
EVA
Year 1

Market
Value
Market
value

EVA
Year 2

EVA
EVA
Year 3 .... Year n

MVA
EVA + EVA + EVA + ... + EVA
1+r
(1 + r)2 (1 + r)3
(1 + r)n

=
Capital

Market value is based on establishing the

economic investment made in the company
(capital), making a best guess about what
economic profits (EVA) will happen in the future,
and discounting those EVAs to the present to get
market value added.

44

EVA Drives MVA

Companies that consistently earn
profits in excess of their required
return ...
NOPAT

EVA
Charge

are typically valued at premiums to book value.

MVA

Market
Value
Capital

45

Fundamental Strategies
NOPAT

EVA
Cost of capital * Capital
Capital

Operate: Improve the

return on existing
operating capital

Decrease: WACC
Build: Invest as long as returns
exceed the cost of capital
Harvest: Re-deploy capital when returns
fail to achieve the cost of capital.
46

An Example of Drivers

47

Focus on EVA Improvement

A positive change in EVA is better
than a positive yet unchanging
base level of EVA

Why?
Positive changes in EVA are consistent
with shareholder value added -- whether
from a positive or negative base
Positive changes in EVA are consistent
with the managerial notion of continuous
improvement in performance.
48

Heres the Point

EVA is the reward from investing in
projects that return above the cost of
capital
EVA = (ROIC - WACC) * Operating Capital

Each projects expected return must

exceed its cost of capital to be
justified
Can this explain all the outsourcing?

49

Why Use EVA & Not NPV?

Present value of EVA
= Present value of NPV
Provides insight into each period
Is a direct link to performance
More useful for future project
audits.

50

Investment Schedule
%
Create value
WACC

Destroy value

Net Assets
51

An Example Revisited
(See Slides 27 & 28)

Period
0
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
NPV
IRR
WACC

NOPAT
115
110
90
70
60
40
30
20
15
15
15
15
15
15
15
15
15
15
15
15

Deprec
10
10
10
10
10
10
10
10
10
10
10
10
10
10
10
10
10
10
10
10

FCF
-200
125
120
100
80
70
50
40
30
25
25
25
25
25
25
25
25
25
25
25
25
$125.86
50.4%
25%

CapChg
50.0
47.5
45.0
42.5
40.0
37.5
35.0
32.5
30.0
27.5
25.0
22.5
20.0
17.5
15.0
12.5
10.0
7.5
5.0
2.5

Asset's
Balance
200
190
180
170
160
150
140
130
120
110
100
90
80
70
60
50
40
30
20
10
0

EVA
65.0
62.5
45.0
27.5
20.0
2.5
-5.0
-12.5
-15.0
-12.5
-10.0
-7.5
-5.0
-2.5
0.0
2.5
5.0
7.5
10.0
12.5

EVA =
NOPAT
WACC * Beginning Balance
= 110 25% * 190
= 110 = 47.5
= 62.5

$125.86

52

NPV (Using FCF) & EVA Profiles

FCF vs. EVA
150
100
50
0
-50

10 11 12 13 14 15 16 17 18 19 20

-100
-150

NPV of FCF = NPV of EVA = $125.86

FCF
EVA

Significant info revealed?

-200
-250

53

Summary

Measure Earnings with EVA

Simple to explain and understand
EPS (and NI) ignore cost of equity capital
EVA doesnt
Retained earnings no longer considered free

Benefits:

Reduce cost of capital

Improve operational efficiency
Better management of assets
Profitable growth.

55

Effective SCM:
Increased Shareholder
Value
Revenue

NOPAT

minus

minus

Costs

EVA
Cost of
capital
times

Invested
capital

Working
capital

Greater customer service

(higher market share,
increased gross margins).
Greater product availability
Lower cost of goods sold,
transportation, warehousing,
material handling and
distribution management
costs
Lower raw materials and
finished goods inventory
Shorter order-to-cash
cycles

plus

Fixed
capital

Fewer physical assets (e.g.

trucks, warehouses, material
handling equipment)

56

Im p ro v e m e n t in E V A
S a le s

O p e r a t in g E x p e n s e s

C a p it a l C h a r g e

C u s t o m e r S a t is f a c t i o n

N e w P r o d u c ts

O ve rh e ad

C o m p e n s a tio n

A c q u is i t i o n s & D i v e s t i t u r e s

W o r k in g C a p i t a l M a n a g e m e n t

V o lu m e

M a r k e t in g

Account M an ag em ent

T r a in i n g & D e v e l o p m e n t

A l li a n c e s

A c c o u n t s R e c e iv a b le

P r o d u c t P r i c in g

G r o w th

M a n u f a c t u r in g C o s t s

R & D D e c i s io n s

I n v e n to ry M a n ag e m e n t

Manufacturing
ManufacturingEVA
EVADrivers
Drivers
Reduce
Reduceinventory
inventory
Reduce
cycle
Reduce cycletime
time
Improve yields
Improve yields
Reduce
Reducescrap/waste
scrap/waste
Maximize
Maximizelabor
laborefficiencies
efficiencies
Improve
vendor
efficiencies
Improve vendor efficiencies
Process
Processimprovements
improvements

Staff
StaffEVA
EVADrivers
Drivers

Work
Workgroup/process
group/processsimplification
simplification
Consistency
Consistencymonitors
monitorsaudit
audit
Centralizing
resources/synergies
Centralizing resources/synergies
Best
Bestpractices
practicesbenchmarking
benchmarking
Insourcing/outsourcing
Insourcing/outsourcingdecisions
decisions
Simplify
EVA
measurements/reporting
Simplify EVA measurements/reporting
Ensure
Ensurecompliance
compliancewith
withlegislation
legislation

Research
Research&&Development
DevelopmentEVA
EVADrivers
Drivers
Improve
Improveto-market
to-marketprocess
process
Reduce
R&D
expenses
as
%
of
new
Reduce R&D expenses as % of newproduct
productsales
sales
Strategic partners for R&D
Strategic partners for R&D
Stronger
Strongerlinks
linkstotoproduct
productmarketing
marketing
New
Newproducts
productsvia:
via:
- -Research
Research
- -Formulation
Formulation
- -Development
Development
-Acquisition
-Acquisition

Marketing
MarketingEVA
EVADrivers
Drivers
Increase
Increasemarket
marketshare
share/ /revenue
revenue
New
markets
New markets
More
Morefocused
focusedchannel
channelprograms
programs
Voice
of
customer
/
consumer
Voice of customer / consumer
Leverage
Leverageadvertising
advertising/ /promotion
promotion
Build
brand
awareness
Build brand awareness

57

Thank You

58