While looking at earnings growth, one refers to growth in bottomline or net profits. These are also known as accounting profits. While there is no doubt that one needs to look at how earnings have fared over longer periods of time, the bigger question that would be interesting to answer is have these earnings created value?
As a shareholder or potential investor, the primary question on every investor’s mind is – Will the company create value? But what do investors look at or check to see if the company they are invested in or about to invest in creates value?
What do we mean when we say – is a particular company creating value? The answer to that lies in looking at the economic profits or EVA and MVA. We will look at these concepts in detail in this post.
It has been seen in many cases that companies increase their sales and profits, but increasing sales and profits may not necessarily mean that the company is creating value.There are two important aspects that needs to be looked at while analyzing the growth in sales and profits.
Firstly, companies can increase their sales and profits on the back of increased investments in working capital and fixed assets. One should pay special attention to the working capital requirements of a company when there is increase in sales and profits. It may be the case that companies are extending liberal credit terms to increase sales, in this case there is an increase in receivable days. The company may also resort to paying its suppliers late, in this case the suppliers of the company fund the working capital, however paying your suppliers late may hamper the relationship with the vendors in the long term.
The above changes are not captured in the profit and loss statement but answers to these can be found by looking at the cash flow statements. There are many cases where one can see net profits of companies increasing year on year, however on the other hand cash flow from operations (CFO) are negative during this period.
It is always a good practice to compare the cumulative net profits with the cumulative CFOs over long periods of time. This aspect relates to the cash flows and since the focus of this post is not cash flows, we will stop here. Cash flow analysis is a subject on its own and we will try and cover this in detail in the future.
This brings us to the second important aspect of checking if earnings are creating value for its shareholders. A company is said to create value if its return on capital is greater than its cost of capital. It has positive economic profits or EVA in this case. But what are economic profits? And how does one arrive at the same?
Economic Profits or EVA
Resources of organizations should be put to its best use. For instance if a business is set up at a cost of 1 Cr and earns 8%, in this case the 1 Cr of investment is not put to the best use. We can invest that 1 Cr in government bonds and earn 7%, why take additional risk and run a business which only earns 8%? One would expect the business to generate higher returns for the risks and efforts that are put in to set up the business.
Hence there are opportunity costs linked with the resources of the company. These opportunity costs are not recorded in the profit and loss statement. Economic profits factor in these opportunity costs and indicate if the company is making profits after factoring in these costs. In other words there is a charge (required rate of return) on the resources (invested capital) of the firm and these are deducted from the operating profits of the firm to check if there are any economic profits or EVA that the company is generating.
We arrive at the EVA as shown below
Return on invested capital (ROIC) is the return that the company makes on the capital that it has in place and is arrived at as below
ROIC = Ebit * (1- tax rate) / Invested Capital
ROIC indicates for every 1 Re of invested capital what is the after tax operating earnings or EBIT that the company generates. For instance if a companies after tax operating earnings are Rs 150 Cr and it has Rs 1,000 Cr of invested capital, the after tax ROIC is 15% (150/1000). We take operating earnings in the numerator as these are earnings from the operations of the business.
Invested capital are the fixed assets or net block and the working capital ( Inventories + Receivables – Payables) that the company has in place. Fixed assets and working capital are the assets that the company requires to run its daily operations and hence we take these into consideration while arriving at the invested capital.
The weighted average cost of capital (WACC) is arrived at as below
WACC = (After tax cost of debt * Percentage of debt capital) + (Cost of equity * Percentage of equity capital)
The process involves arriving at the cost of debt – larger and stable companies will have to pay less to borrow as compared to smaller companies. While arriving at the cost of equity one needs to look at the risk free rate (government bonds) and add equity risk premium to this to arrive at the cost of equity. Professor Ashwath Damodaran has written extensively on these topics on his website and these can be explored to develop a deeper understanding of these concepts. One needs to look at the capital structure of the company to arrive at the percentage of debt and equity capital.
Another quick way to look at the cost of capital is to assess what returns an investor wants from his investments. For instance one can earn 7-8% by investing in government or AAA corporate bonds, hence one would assume a higher return for investing in equity. We can add 300 – 400 bps to these fixed income products and expect to earn 11-12% from investing in equities over longer periods of time. Hence one can use 11-12% as the cost of capital in this case.
It is however advisable to arrive at the cost of capital by looking at the capital structures of companies, their cost of debt and equity to arrive at the individual companies cost of capital.
Coming back of economic profits or EVA, so for instance if a companies after tax ROIC is 15% and the cost of capital is 11%, the spread (ROIC – Cost of capital) is positive +4% and if it has invested capital of Rs 600 Cr, the EVA in this case is 24 Cr. A faster way to check if a company is creating value is to check the spread. If the spread is positive, which it is in this case then the company is creating value. Positive spread also indicates that the return on capital that the company is making is greater than the cost of capital.
In case the ROIC and the cost of capital are 11%, there is no spread and the company does not create value. The company may continue to grow earnings but will not create value if the spread is not positive.
So looking at the above equation the major driver for EVA is the
- Return on invested capital (ROIC)
Let us look at what drives the ROIC
Operating margins are expressed as a percentage and indicate that for every 1 Rupee of sales what is the operating profits that the company generates. One needs to look at the product mix and how a company is managing its costs to analyze the trend in operating margins. For instance if a company sells more of higher margin products and is able to control its fixed costs then it will enjoy high operating margins. Increase/decrease in raw material (RM) prices also impact operating margins, however most of the companies have to pass on the increase and decrease in RM prices to customers and increase in operating margins is not sustainable on the back of this factor.
Capital turnover is expressed in form of a number. Capital turnover indicates for every 1 Re of capital that the company has in place what are the sales generated. For instance asset light companies have higher capital turnover, the capital required to run these businesses is low.
Product of both these drivers gives us the ROIC. It is very useful to think of these drivers when one is analyzing the ROIC of any company.
Market Value Add (MVA)
Market value add is arrived at as below
MVA = Market value of company – Invested Capital
The market value of the company is the market value of equity and debt. The market value of equity is the market capitalization of the company and the market value of debt is the debt on the books of the company since the company’s debt is not publicly traded. Invested capital as explained earlier is the fixed assets and the net working capital that has been invested in the company.
Higher and positive MVA indicates the companies ability to create shareholder value. The MVA is the residual value after the invested capital has been adjusted or capital providers to the company have been paid off. However one needs to keep in mind that the market capitalization keeps on changing, hence in a bull market the MVA of companies will be higher. One should then look at the MVA over periods of time to check if the company has created shareholder value.
MVA is also closely linked to the EVA. Basically one needs to discount the current EVA by the WACC to arrive at the present value of future EVA.
MVA = EVA/Cost of capital or WACC
For instance if the EVA of the company is Rs 24 Cr and the cost of capital is 12%, the MVA in this case is Rs 200 Cr. This is the present value of the companies invested capital and its current ROIC profile. Basically in this scenario one assumes that the EVA will remain constant and their is no growth in EVA.
Companies can increase MVA by
- Investing in businesses which yield a higher positive spread (ROIC – WACC)
- Improving operations in the current business which result in higher spread
- Restructuring or shutting down businesses which yield negative EVA
Final Thoughts
EVA and MVA measures indicates the capital allocation process of the management. By looking at the EVA and MVA one gets answers to whether the company has been successful in allocating capital and creating shareholder value. It is also not a bad idea to link the rewards of the managers with their ability to create shareholder value.
We hope that our readers have gained immense value after going through the above post.
References
Finance for Executives, managing for value creation – Hawawini and Viallet
The relationship between EVA, MVA and Leverage – JH de Wet and JH Hall
NOTE: Please do not consider this article as a recommendation, It is purely for informative purpose only. Authors may have positions in the stocks mentioned, so consider our analysis biased. There is no commercial relationship between Capitalmind and the companies mentioned in this analysis.
Foot Notes
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