1. Calculate historical economic value added
2. Value company by discounting economic value added by the WACC
3. Establish justified market multiples using assumptions for growth rate, return on capital, and cost of capital
1. Historical Economic Value Added
Economic Value Added (EVA) – also referred to as Economic Profit (EP) – highlights in each year whether a company is generating more income than its cost of capital. This is measured by deducting a capital charge from the company’s after-tax operating profit. The capital charge represents the cost of all of the company’s capital in money terms. This is calculated by multiplying the weighted average cost of capital by the total capital invested.
Companies create (destroy) value by investing capital at rates of return greater (less) than the cost of capital. Whether a company is profitable in an economic sense can therefore be seen by comparing the return on capital (ROC) to the WACC. When a company has negative EVA (or ROC < WACC), shares are expected to sell at a discount to book value.
Net operating profit after tax (NOPAT) is calculated as EBIT(1-T), where T is the effective tax rate. A more accurate measure is net operating profit less adjusted taxes (NOPLAT), which takes into account deferred taxes among other things. This calculation is detailed further in a separate post (here).
NOPLAT = (Revenue – COGS – SG&A – Depreciation – Amortization) – Adjusted taxes
There are two methods for calculating invested capital. The capital-based approach is the book value of debt plus the book value of equity. The slightly more involved asset-based approach is calculated as net operating assets excluding cash, plus property, plant and equipment. Note that invested capital in this context is taken from the beginning of the period rather than the average of the beginning and ending values.
Invested capital = Operating current assets – Operating current liabilities + Net property & equipment – Cash
2. Company Valuation using Economic Value Added
The Economic Value Added (EVA) model can be used for estimating the intrinsic value of a company’s common stock. This is found by discounting expected future economic profits by the WACC and then adding the current book value of invested capital. If a company is assumed to have a constant return on capital and a constant operating profit growth rate through time, it is appropriate to use a single-stage valuation model.
The single-stage model should not be used in situations where ROC is significantly greater than the WACC since this excess is not expected to persist indefinitely. Analysts therefore often model ROC reverting to some mean level or fading toward the WACC. As with other valuation approaches, a multi-stage approach can be used for a certain time horizon and then a terminal value estimate used after the explicit forecasting period. In cases where ROC is assumed to equal the WACC from the last period forward, the terminal value may be treated as zero.
The above model can be slightly adapted by adding a persistence factor to the denominator of the continuing value formula. This factor (ω) would fall somewhere between zero and one. A persistence factor of zero means that economic profit will not continue after the initial forecast horizon. A factor of one implies that future ROC will remain constant. Companies with strong competitive advantages would be expected to have higher persistence factors.
3. Justified Market Multiples
If operating profit growth and returns on capital are assumed to remain constant then a version of the economic profit model can be used to establish justified market multiples. The formulas show that higher growth will generate greater value, but only as long as the return on invested capital is greater than the cost of capital. Expressing a valuation as an implied multiple provides a useful sanity check, forcing you to justify why a multiple is higher or lower in terms of faster growth or higher returns on capital. A helpful feature of the formulas below is that market expectations about a company’s long-term growth can be backed out if the ROC and WACC are already known.
In EVA valuation, the current book value of invested capital captures a significant portion of total value. The terminal value, by contrast, may not be a large component of total value. An important aspect of the EVA model is that value is typically recognized earlier than with other valuation approaches. This practical advantage makes the EVA model most appropriate to use when great uncertainty exists in forecasting distant cash flows. It is less ideal when invested capital and ROC are not predictable.
If a company has significant non-operating assets (liabilities), they should be valued separately and added (subtracted) from the FCFF valuation. Common non-operating assets include holdings in other firms, unutilized assets (e.g. land), overfunded pension funds, and tax loss carryforwards. Frequently encountered non-operating liabilities include unfunded pension obligations, contingent liabilities, minority interests, and deferred tax liabilities. There are separate posts on this blog for valuing non-operating assets (here) and non-operating liabilities (here).
Prague University of Economics. Using the Economic Value Added Model for Valuation of a Company.