Along with SVA comes another piece of ‘alphabet spaghetti’, EVA, a concept trade- marked by the US consultancy house Stern Stewart (www.sternstewart.com).
Whereas SVA is a forward-looking technique devised for assessing the inherent value of the equity invested in a firm, EVA is backward-looking, i.e. a measure of performance. Like SVA, EVA relies heavily on the concept of the cost of capital. It is used as a device for assessing how much value or wealth a firm actually has creat- ed. Its roots lie in the accounting concept of Residual Income (e.g. see Horngren et al. 1998), which is simply the accounting profit adjusted for the cost of using the capital tied up in an activity.
However, the Stern Stewart version is rather more sophisticated as it attempts to adjust the recorded profit in various ways. The logic of these adjustments is, broadly, to avoid recording as a cost the items that are value-creating and that should perhaps be treated as capital rather than current expenditure. For example, spending on R & D and on product advertising and promotion contributes to wealth-creation in impor- tant ways. In addition, any goodwill that has been written off in relation to previous acquisitions is added back. The general impact of these adjustments – over 150 of these might be required in a full EVA calculation – is to raise the profit measure and also the capital employed.
Forecast data for Year 1 £000 Value drivers
Sales 900 Sales growth
less Operating costs (600)
Pre-tax profit 300 Margin
less Tax paid (100) Tax rate
Net operating profit after tax 200
add Depreciation 75
less Fixed capital investment (125) Capital expenditure less Additional working capital (50) Working capital investment
Free cash flow 100
Calculation of shareholder value:
Forecast cash flows £000
Yr1 Yr2 Yr3 Yr4 Yr5 Terminal Value 100 150 170 230 250
NPV@12% £617,900
PV terminal value £1,418,600 2,500,000
Total NPV £2,036,500 Shareholder Value
Relating this to an all-equity-financed firm, EVA is calculated after making a further adjustment for the opportunity cost incurred by shareholders when entrusting their capital to the firm’s directors. The EVA formula can be written as:
EVA NOPAT (ke invested capital) where:
NOPAT the Net Operating Profit After Tax, and after adjustment for the items mentioned above
ke the rate of return required by shareholders Invested capital Net Assets, or Shareholders’ Funds To illustrate the concept, consider the data in Table 4.4.
Both firms have the same equity capital employed of £100 m, and both make posi- tive accounting profits. However, after adjusting for the cost of the equity capital employed, Firm B has effectively made a loss for investors, i.e. the negative EVA indi- cates that it has destroyed value.
On the face of it, EVA is a simple and powerful tool for assessing performance, explaining why it has been adopted by many firms as an internal performance meas- urement device, e.g. for determining the performance of different operating units.
However, it is by no means problem-free:
1 Few firms have the resources required to compute EVA, division by division, with the same degree of rigour as the full Stern Stewart model with its myriad required adjustments.
2 It is based on book value, rather than market values (necessarily so for business segments).
3 It relies on a fair and reliable way allocating shared overheads across business units, the Holy Grail of management accountants.
4 It is difficult to identify the cost of capital for individual operating units.
5 It may be dysfunctional if managers are paid according to EVA, especially short-term EVA. It is quite possible to encounter investment projects that flatter EVA in the short term by virtue of high initial cash flows but to have a negative NPV. Such projects might be favoured by managers who are paid by EVA. Similarly, some long-term projects that take time and money to develop may lower EVA in the early years but have a positive NPV. These, of course, could be rejected under an EVA regime.
The verdict is yet to be delivered on EVA, but like many other management tools, it is probably inadequate when used alone – it is one way of looking at the picture that should be supplemented by other perspectives.
We have discussed the reasons why financial managers may wish to value their own and other enterprises, the problems likely to be encountered and the main valuation techniques available.
Given the uncertainties involved in valuation, it seems sensible to compare the implications of a number of valuation models and to obtain valuations from a number of sources. A pooled valuation is unlikely to be correct, but armed with a range of
SUMMARY
Table 4.4
Calculation of EVA NOPAT Equity EVA
Firm A £20 m £100 m 15% £20 m £15 m £5 m
Firm B £10 m £100 m 15% £10 m £15 m (£5 m)
ke
valuations, managers should be able to develop a likely consensus valuation. This con- sensus is, after all, what a market value represents, based upon the views of many times more market participants. There should be no stigma attached to obtaining more than one opinion–doctors do not hesitate to call for second opinions when unsure about medical diagnoses.
Key points
■ An understanding of valuation is required to appreciate the likely effect of invest- ment and financial decisions, to value other firms for acquisition, and to organise defences against takeover.
■ Valuation is easier if the company’s shares are quoted. The market value is ‘correct’
if the EMH applies, but managers may have withheld important information.
■ Using published accounts is fraught with dangers, e.g. under-valuation of fixed assets.
■ Some companies attempt to value the brands they control. An efficient capital mar- ket will already have valued these, but not necessarily in a fully informed manner.
■ The economic theory of value tells us that the value of any asset is the sum of the discounted benefits expected to accrue from owning it.
■ A company’s earnings stream can be valued by applying a P:E multiple, based upon a comparable, quoted surrogate company.
■ Some observers like to compare the EBITDA (Earnings Before Interest, Tax Depreciation and Amortisation) with share price for different companies as a cross-check on valuation. Market-based EBITDA multiples can be used as valua- tion tools.
■ Valuing a company on a DCF basis requires us to forecast all future investment cap- ital needs, tax payments and working capital movements.
■ Valuation of unquoted companies is highly subjective. It requires examination of similar quoted companies and applying discounts for lack of marketability.
■ The value of a share can be found by discounting all future expected dividend payments.
■ The retention of earnings for worthwhile investment enhances future earnings, div- idends and, therefore, the current share price.
■ The Dividend Valuation Model must be treated with caution. It embodies many critical assumptions.
■ Economic Value Added (EVA) is the residual profit after allowing for the charge for the firm’s use of investors’ capital.
■ The two main lessons of valuation are: use a variety of methods (or consult a vari- ety of experts) and don’t expect to get it exactly right.
Further reading
Comprehensive treatments of share and company valuation are quite rare: Koller et al. (2004) is probably the best available. A good overview can be found in Chapter 15 (the contribution by Davies) of Firth and Keane (1986).
The brand valuation issue is addressed by Murphy (1989) and Barwise et al. (1989).
Young (1997) provides a practical application of the EVA concept.
Questions witha coloured numberhave solutions in Appendix B on page 693.
1 Amos Ltd has operated as a private limited company for 80 years. The company is facing increased competi- tion and it has been decided to sell the business as a going concern.
The financial situation is as shown on the balance sheet:
QUESTIONS
Balance Sheet as at 30 June 1999
£ £ £
Fixed assets
Premises 500,000
Equipment 125,000
Investments 50,000
675,000 Current assets
Stock 85,000
Debtors 120,000
Bank 25,000
230,000 Creditors: amounts due within one year
Trade creditors (65,000)
Dividends (85,000)
(150,000)
Net current assets 80,000
Total assets less current liabilities 755,000
Creditors: amounts due after one year
Secured loan stock (85,000)
Net assets 670,000
Financed by
Ordinary shares (50p par value) 500,000
Reserves 55,000
Profit and loss account 115,000
Shareholders’ funds 670,000
The current market values of the fixed assets are estimated as:
Premises 780,000
Equipment 50,000
Investments 90,000
Only 90 per cent of the debtors are thought likely to pay.
Required
Prepare valuations per share of Amos Ltd using:
(i)Book value basis (ii)Adjusted book value
2 The Board of Directors of Rundum plc are contemplating a takeover bid for Carbo Ltd, an unquoted compa- ny which operates in both the packaging and building materials industries. If the offer is successful, there are no plans for a radical restructuring or divestment of Carbo’s assets.
£m £m Assets employed
Freehold property 4.0
Plant and equipment 2.0
Current assets:
stocks 1.5
debtors 3.0
cash 0.1 4.6
Total assets 10.6
Creditors payable within one year (3.0)
Total assets less current liabilities 7.6
Creditors payable after one year (1.0)
Net assets 6.6
Financed by
Ordinary share capital (25p par value) 2.5
Revaluation reserve 0.5
Profit and loss account 3.6
Shareholders’ funds 6.6
Sales revenue £500,000
Operating costs (£300,000)
(after depreciation of £50,000)
Operating profit £200,000
Taxation @ 30% (£60,000)
Profit after tax £140,000
Further information:
(a) Carbo’s pre-tax earnings for the year ended 31 December 2005 were £2.0 million.
(b) Corporation Tax is payable at 33 per cent.
(c) Depreciation provisions were £0.5 million. This was exactly equal to the funding required to replace worn-out equipment.
(d) Carbo has recently tried to grow sales by extending more generous trade credit terms. As a result, about a third of its debtors have only a 50 per cent likelihood of paying.
(e) About half of Carbo’s stocks are probably obsolete with a resale value as scrap of only £50,000.
(f) Carbo’s assets were last revalued in 1994.
(g) If the bid succeeds, Rundum will pay off the presently highly overpaid Managing Director of Carbo for
£200,000 and replace him with one of its own ‘high-flyers’. This will generate pre-tax annual savings of
£60,000 p.a.
(h) Carbo’s two divisions are roughly equal in size. The industry P:E ratio is 8:1 for packaging and 12:1 for building materials.
Required
(a)Value Carbo using a net asset valuation approach.
(b)Value Carbo using a price:earnings ratio approach.
3 Lazenby plc has been set up to exploit an opportunity to import a new product from overseas. It has issued two million ordinary shares of par value 25p, sold at a 25 per cent premium. Its projected accounts show the following annual operating figures:
Notes:
(i) Shareholders require a return of 10 per cent p.a.
(ii) Replacement investment is financed out of depreciation provisions and is fully tax-allowable.
(iii)2% of sales should be written off as bad debts.
(iv)Bad debt write-offs are 50 per cent tax-allowable.
Continued Carbo’s Balance Sheet for the year ending 31 December 2005 shows the following:
Required
Value each share in Lazenby:
(a) assuming perpetual life.
(b) over a ten-year horizon.
4 Brosnan plc generates free cash flows of £5 million p.a. after allowing for tax and depreciation, which is used for reinvestment. It has issued 10 million shares. Shareholders require a 12 per cent return.
Required
Value each share:
(i) assuming all free cash flows are distributed as dividend.
(ii) assuming 50 per cent of FCFs are retained, with a return on retained earnings of 15 per cent.
(iii)as for (ii), but assuming 10 per cent return on reinvestment.
(iv)assuming that FCFs grow at 7.5 per cent for each of the first three future years, then at 5 per cent thereafter.
Note: assume all cash flows are perpetuities.
5 Insert the missing values in the following table:
g b R
(i) £8.44 £0.35 ? 8.5% 0.5 17% 13.0 %
(ii) £4.98 £0.20 £0.219 ? 0.6 16% 14.0 %
(iii) ? £0.10 £0.108 8.0 % 0.4 20% 15.0 %
(iv) £2.75 ? £0.220 10.0 % 0.5 20% 18.0 %
(v) £10.20 £0.60 £0.610 2.0 % ? 10% 8.0 %
(vi) £0.60 £0.05 £0.054 8.0 % 0.8 20% ?
(vii) £1.47 £0.12 £0.133 10.5% 0.7 ? 19.5%
Note: answers may have some minor rounding errors.
ke D1
Do
Po
6 Leyburn plc currently generates profits before tax of £10 million, and proposes to pay a dividend of £4 mil- lion out of cash holdings to its shareholders. The rate of Corporation Tax is 30 per cent. Recent dividend growth has averaged 8 per cent p.a. It is considering retaining an extra £1 million in order to finance new strategic investment. This switch in dividend policy will be permanent, as management believe that there will be a stream of highly attractive investments available over the next few years, all offering returns of around 20 per cent after tax. Leyburn’s shares are currently valued ‘cum-dividend’. Shareholders require a return of 14 per cent. Leyburn is wholly equity-financed.
Required
(a) Value the equity of Leyburn assuming no change in retention policy.
(b) What is the impact on the value of equity of adopting the higher level of retentions? (Assume the new payout ratio will persist into the future.)
7 The most recent Balance Sheet for Vadeema plc is given below. Vadeema is a stock market-quoted company that specialises in researching and developing new pharmaceutical compounds. It either sells or licenses its discoveries to larger companies, although it operates a small manufacturing capability of its own, accounting for about half of its turnover:
Balance Sheet as at 30 June 2005
Assets employed £m £m £m
Fixed assets
Tangible 50
Intangible 120 170
Current assets
Stock and work in progress 80
Debtors 20
Bank 5 105
Current liabilities
Trade creditors (10)
Bank overdraft (20) (30)
Net current assets 75
10% loan stock (40)
Net assets 205
Financed by
Ordinary shares capital (25p par value) 100
Share premium account 50
Revenue reserves 55
Shareholders’ funds 205
Obtain the latest annual report and accounts of a company of your choice.* Consult the Balance Sheet and deter- mine the company’s net asset value.
■ What is the composition of the assets, i.e. the relative size of fixed and current assets?
■ What is the relative size of tangible fixed and intangible fixed assets?
■ What proportion of current assets is accounted for by stocks and debtors?
■ What is the company’s policy towards asset revaluation?
■ What is its depreciation policy?
Now consult the financial press to assess the market value of the equity. This is the current share price times the number of ordinary shares issued. (The notes to the accounts will indicate the latter.)
■ What discrepancy do you find between the NAV and the market value?
■ How can you explain this?
■ What is the P:E ratio of your selected company?
■ How does this compare with other companies in the same sector?
■ How can you explain any discrepancies?
■ Do you think your selected company’s shares are under- or over-valued?
* Most large companies post their Annual Reports and Accounts on their websites. The commonest address forms of UK companies are: companyname.co.uk or companyname.com.
Practical assignment
Further information:
1 2004–05, Vadeema made sales of £300 million, with a 25 per cent net operating margin (i.e. after deprecia- tion but before tax and interest).
2 The rate of corporate tax is 33 per cent.
3 Vadeema’s sales are quite volatile, having ranged between £150 million and £350 million over the previ- ous five years.
4 The tangible fixed assets have recently been revalued (by the directors) at £65 million.
5 The intangible assets include a major patent (responsible for 20 per cent of its sales) which is due to expire in April 2006. Its book value is £20 million.
6 50 per cent of stocks and work-in-progress represents development work for which no firm contract has been signed (potential customers have paid for options to purchase the technology developed).
7 The average P:E ratio for quoted drug research companies at present is 22:1 and for pharmaceutical man- ufacturers is 14:1. However, Vadeema’s own P:E ratio is 20:1.
8 Vadeema depreciates tangible fixed assets at the rate of £5 million p.a. and intangibles at the rate of £25 mil- lion p.a.
9 The interest charge on the overdraft was 12 per cent.
10 Annual fixed investment is £5 million, none of which qualifies for capital allowances:
Required
(a) Determine the value of Vadeema using each of the following methods:
(i) net asset value (ii) price:earnings ratio
(iii) discounted cash flow (using a discount rate of 20 per cent) (b) How can you reconcile any discrepancies in your valuations?
(c) To what extent is it possible for the Stock Market to arrive at a ‘correct’ valuation of a company like Vadeema?
Chapters 5 to 7 examine in depth the investment decision and how it is evaluated. The concepts of time-value of money and present value are extensively applied. The available methods for assisting the financial manager to evaluate investment proposals are examined in Chapter 5, both when capital is freely available and when it is in short supply. Methods of appraisal that do not utilise discounting procedures are also examined.
In Chapter 6, investment appraisal procedures are applied to practical situations, incorporating the impact of both taxation and inflation. Consideration is given to identifying the relevant information for project evaluation, particularly for replacement decisions.
Chapter 7 sets the whole project appraisal system in a strategic perspective and explores the wider aspects of the investment appraisal system within companies. It dispels the notion that investment analysis hinges solely on methods of appraisal, and it reveals how companies approach their project evaluations in practice.