The Mechanics of the Economic Model
2
INTRODUCTION
Prior to 2001 so-called momentum investors, tech investors and Internet investors have enjoyed enormous gains and
many received some very good press
about their performances. Now that th
e bubble has burst, many portfolio
managers, analysts and individual investors have been as
ked to question themselves about their beliefs about the
market and the fundamentals of Secur
ity Analysis. Ironically, the one who has
received the worst press during that
period, Warren Buffett, is yet again the one left standing and having the last laugh. Investors who have barely
survived the dot.com er
a have three choices:
1.
Capitulate (for individual investors, that would mean
switch to index funds, fixed income securities or
invest in mutual funds)
2.
Stick to your beliefs, remain in denial, and continue hoping for another comeback, which would be either
very courageous or very stupid, depending on who you ask
3.
Change your investment philosophy and continue to learn
Personally, I don’t like the first one, that’d be the easy way out. The second one would be... well let’s put it that
way, the worst thing that an investor can do at this point would be to show that s/he has learned nothing from his/her
mistakes, an attitude that we wouldn’t call a sign of intellige
nce. The last one, which seems to be the hardest, is in
fact the simplest one: “Get Back to
Basics: How Do You Value a Stock?†For
those who want an answer to this
question, this is what this report outlines.
There are two classic ways to value a stock. The most co
mmonly used model is probably the one in which investors
project next year’s EPS (or cash flows,
EBITDA, free cash flow, or sales) and assign a multiple to that number. The
second one is the good old Discounted Cash Flow (DCF) model. Finally, there is a more recent one, the Economic
Model or Economic Value Added model (EVA
TM
(EVA
TM
and MVA
TM
are trademarks of the consulting firm Stern
Stewart)).
After studying the practicality of each
model, we’ve come to the conclusion
that the Economic Model is the
valuation model that provides the best answers. Using mu
ltiples to value stocks is tricky since multiples are the
consequence (as oppose to being a value
driver or the measure of a value drive
r) of a sum of factors that affect the
intrinsic value of a stock. It is an indirect way to perform a DCF or and EVA model, without actually evaluating
each value drivers. This method can be
applied quite successfully, however it
takes a great deal of knowledge and
experience to be good at it.
As for the DCF model, we should point that both EVA a
nd DCF will yield the same answer if performed properly.
The reason why we choose the EVA model over the DCF is
because the value drivers ar
e much easier to identify.
For example, using a DCF alone is hard to evaluate whethe
r or not a company creates va
lue. In addition, there is
more value attributed to the terminal value in a DCF model than in an EVA model, which is one of the most
criticized aspects of the DCF model. It should be pointed
out that the Economic Model (and DCF) takes into account
three of the most basic concepts of Security Analysis:
1.
Risk
: The opportunity cost of an investor
and/or a company adjusted for risk.
2.
Capital Requirements
: The capital requirements represent how much capital must be invested in order to
generate profits.
3.
Time Value of Money
: The time value of money simply states that one dollar today is worth more than
one dollar tomorrow because of investment opportunities.
None of these concepts are explicitly
taken into account in EPS, P/E ratio,
PEG ratio or growth. In the Economic
Model however, risk is taken into account by the cost
of capital, capital requireme
nts are accounted for in the
denominator of the ROIC formula, and the time value of money is considered when economic profits are discounted
to calculate the market value added (MVA).
In this report, we will outline the basic concepts of
the Economic Model: ROIC, WACC, EVA, MVA and CAP. We
believe that knowing how to calculate these figures is just
as important as knowing how to calculate the P/E ratio of
a company.