Stock Market Valuation

Journal of Business Case Studies – March/April 2010 Volume 6, Number 2 Valuing Technology Stocks With EVA™: A Bridge Too Far? Henry I. Silverman, Roosevelt University, USA ABSTRACT The Economic Value Added (EVA™) framework has engendered a great deal of attention from American and European companies, consultants, accounting firms, security analysts, fund managers and the media for its purported utility in accurately valuing public companies. In 1996, for example, Fortune Magazine trumpeted that hundreds of companies had recently “renounced” earnings per share in favour of EVA™ as a means of measuring performance and driving stock prices. During the 1990s, investors witnessed unprecedented growth in US equity prices, particularly for technology firms. This case study critically examines the Economic Value Added EVA™ framework and attempts to rationalize the bull market in technology stocks by employing EVA™ to estimate the intrinsic value of a large proportion of the US technology sector as of 1999 and comparing this figure with contemporaneous market values for the same. We find a marked disparity between EVA™ estimates of Present Value and actual market value for the sector. Keywords: Economic Value Added, EVA, valuation, technology stocks, R&D 1 INTRODUCTION etween January 1990 and March of 2000, the technology-laden NASDAQ Composite Index rose in value by over one-thousand percent.i Evidence now suggests that profits for many technology firms during this period may have been materially inflated and/or overstatedii; however, much of that Bevidence did not come to light until several years after investors had capitalized profits that were, as originally reported, well above trend. A cursory review of these events suggests investors may have been engaged in a rational appraisal of intrinsic value for the technology sector based on information available at the time. In an effort to rationalize the price gains garnered by technology shares in the 1990s and to gain further insight into the ex ante expectations of technology investors during this period, this case study will critically examine the Economic Value Added (EVA™) framework and employ it to estimate the value of a large proportion of the US technology sector as of 1999. This calculated value can then be compared with the equity market value of the sector at the time. 2 LITERATURE Economic Value Added (EVA™) is a proprietary valuation framework developed by the consulting firm Stern Stewart and broadly introduced in G. Bennett Stewart’s book Quest for Value (1991). EVA™ is a derivative of the traditional residual income model (see Bromwich and Walker, 1998) distinguished from the latter principally by the accounting adjustments to profits and capital specified by Stern Stewart. Indeed, Chen and Dodd (1997) note that most of the EVA™ and residual income variables are highly correlated and nearly identical in terms of the association each has to stock returns. EVA™ has engendered a great deal of attention from American and European companies, consultants, accounting firms, security analysts, fund managers, and the media. In 1996 for example, Fortune Magazineiii trumpeted that hundreds of companies had “renounced” earnings per share in favour of EVA™ as a means of measuring performance and driving stock prices. The same article noted investment banks CS First Boston and Goldman Sachs had recently trained their research staffs in EVA™ analysis and several mutual funds had adopted EVA™ as a stock selection tool. 9 Journal of Business Case Studies – March/April 2010 Volume 6, Number 2 Stewart (1991) presents EVA™ as an economic model of valuation; a method to calculate the true intrinsic value of the firm where investors are concerned about the cash generated over the life of the business and the risk of the cash receipts.iv Bromwich and Walker (1998) concur with this assessment, crediting EVA™ as “…a measure of investment performance which is consistent ex ante with [discounted cash flow] analysis, whilst also providing a basis for ex post performance analysis”. EVA™ is computed by taking the spread between the rate of return on capital r and the cost of capital c* and then multiplying by the economic book value of the capital committed to the business. Thus, EVA = (r – c*) x capital (1) which simplifies to net operating profits (after depreciation and taxes) less a charge for the use of capital: EVA = NOPAT – (c* x capital) (2) NOPAT may be calculated from an operating perspective as follows: NOPAT = Sales – Operating Expenses – Taxes (3) where operating expenses include depreciation, and taxes are only the actual cash operating taxes paid during the period. NOPAT may also be calculated from a financing perspective as follows: NOPAT = Income available to Common + Preferred Dividend + (4) Minority Interest Provision + Interest Expense after Taxes To eliminate accounting “distortions”12, the EVA™ calculation calls for any increase in equity equivalents, unusual losses, and R&D outlays to be added back to income. Capital is defined as: Common Equity + Preferred Stock + Minority Interest + All Debt (5) where equity equivalents, unusual losses, and R&D outlays are added back to common equity as they were to income in the NOPAT calculation. The cost of capital c* is the weighted average cost of capital to the firm, computed by adding the proportionate after-tax cost of debt with the proportionate cost of equity: c* = [(1 – t)b x D/Capital] + [y x E/Capital] (6) where t is the marginal corporate income tax rate, b is the firm’s borrowing rate and y is the cost of equity. Stewart’s (1991) examples for calculating the cost of equity propose the use of the Capital Asset Pricing Model (CAPM) for determining equity risk premiums. Taken together, Stewart’s (1991) “EVA™ Valuation Formula” is: Market value = capital + present value of all future EVA (7) EVA™ is grounded in orthodox financial theory which values the firm as a function of its expected, future cash flows and appropriate discount rate. Although such an economic model offers the promise of a better estimate 10 Journal of Business Case Studies – March/April 2010 Volume 6, Number 2 of corporate value than a pure accounting approach that may fail to consider the time value of money and risk, the utility of EVA™ rests entirely upon the accuracy of the future cash flow forecasts and calculation of the cost of capital. In a RoundTable discussion of EVA™ hosted by Johnson and Johnson in 1994v, S. Abraham Ravidvi points out that EVA™ is subject to the same uncertainties in estimating future cash flows as conventional discounted cash flow analysis. This is particularly the case with technology firms where large operating losses early in the product life cycle are often followed by a period of competitive advantage of unpredictable duration (see Black, Wright, and Bachman, 1998; Moore, Johnson, and Kippola, 1999; Damodaran, 2001). Computing the correct weighted average cost of capital (WACC) for the EVA™ valuation is similarly laden with uncertainty. Stewart (1991) recommends use of the CAPM introduced by Sharpe (1964) to derive the returns expected by shareholders, however this single-factor model has been extensively tested and criticised by Douglas (1969), French and Fama (1992), and others for failing to fully explain returns on equity. Moreover, as the greatest portion of EVA™ will be generated, in the majority of cases, well beyond the current operating period (Stewart, 1991), valuing the company requires an accurate calculation of the firm’s forward WACC and therefore, its forward beta coefficient. Although betas for portfolios have been found to be stable over extended periods (Levy, 1971; Blume, 1971; Tole, 1981), the same is not always true for the betas of individual companies (Sharpe and Cooper, 1972). In a critical analysis of their own valuation framework which, like EVA™, requires a capital charge element, Black, Wright, and Bachman (1998) concede the difficulty in estimating future betas and point out that accurately determining the cost of capital requires the ability to forecast future levels of equity and debt on the balance sheet which is “… a less than straightforward task”. EVA™ is subject to criticism for its approach to calculating a company’s capital base, as well. In the 1994 RoundTable discussion of EVA™ discussed earlier, Stewart acknowledges that in total, there are as many as 164 different “performance measurement issues” related to a company’s accounting system which must be considered with the implementation of EVA™. Several of the most common accounting issues and adjustments include: Acquisitions are treated as if they involved cash outlays rather than a pooling of interests Goodwill related to acquisitions is not amortized. Deferred taxes are added back to book equity. R&D expenditures are added back to book equity. Several researchers have suggested that the large number of equity adjustments incorporated in the Stern Stewart system may not be necessary to achieve the level of value-relevance found in the residual income measure (see Chen and Dodd, 1997; O’Hanlon and Peasnell, 1998). Jerold Zimmerman, co-editor of the Journal of Accounting and Economics, argues that capitalization of research and development spending under EVA™ may lead to investment and valuation errors due to the failure of many R&D projects to evolve into cash-generating assets. vii Yet, Zimmerman simultaneously acknowledges that whereas investments in R&D (and other income producing expenditures like advertising) often have future payoffs that are not picked up by pure accounting-based measures of value, these will be appropriately reflected in EVA™. The Boston Consulting Group (BCG) (1996) suggests that EVA™ is distorted in both the early years as well as in the later years following a new investment. The former occurs, according to BCG, when earnings rather than total cash flow are credited against book investment, and the latter occurs due to EVA™’s choice of depreciating book investments rather than the original cash investment.

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