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www.management.mcgill.ca/mic
“To quietly persevere in storing up what is learned, to continue studying without respite, to
instruct others without growing weary – is this not me?”
- Confucius
B
By:
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McGill University
Montréal, Québec, Canada
andrewychan_@hotmail.com
November 2001
The Mechanics of the Economic Model
1
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Introduction
2
The Mechanics of ROIC
3
-
NOPAT
4
- Invested Capital
6
The Mechanics of WACC
8
The Mechanics of EVA & MVA
10
-
EVA
10
-
MVA
11
- Examples
12
Competitive Advantage Period
16
Summary
18
Myths
- Myth #1: Growth Is Good 18
- Myth #2: High Net Profit Margin Equals High Profitability 19
- Myth #3: ROE Is a Good Indicator of Performance 20
- Myth #4: What the Market Wants Is Profits 21
Shortcomings
21
Conclusion
22
Recommended
Readings
24
Appendix
25
- NOPAT, Invested Capital and ROIC
-
EVA Model
-
DCF Model
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.
The Mechanics of the Economic Model
3
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Return on invested capital (ROIC) is one of the most fu
ndamental financial metrics. But despite its importance, it
does not receive the same kind of press coverage as earnings
per share (EPS), return on equity (ROE), and EBITDA,
or operating margin. One reason is prob
ably because you cannot obtai
n ROIC straight out of
financial statements.
When coupled with the weighed average cost of capital (W
ACC), ROIC becomes one of the most important drivers
to value creation. The cost of capital re
presents the minimum rate of return (a
djusted for risk) that a company must
earn to create value for shareholders and debt holders. ROIC
is measured against the cost of capital, which is what
makes it such an important concept.
Definition:
ROIC shows a company’s cash rate of return on
capital (regardless of the capital structure of the
company) it has put to work.
1
It is the true metric to measure the cash-on-cash return of a firm.
Formula:
Capital
Invested
AVG
NOPAT
ROIC
=
or
Capital
Invested
Beg.
NOPAT
ROIC
=
Where NOPAT: Net Opera
ting Profits After-Taxes
Interpretation:
When compared to the weighted average cost
of capital (WACC), ROIC can help determine
whether or not a company creates value
for its shareholders. If the ROIC of
a company is higher than its WACC, it
means that the company is a
value creator. The ROIC-WACC spread is one of the most important metrics to assess
the quality of a company. A higher spread also explai
ns why a company like Coca-Cola will trade at a “premium”
multiple over the rest of the market. In today’s market, ever
ybody talks about growth, but the fact is that growth is
good only if a company is a value cr
eator. Because if a company destroys
value, growing will only make things
worse.
Mechanics:
There are two components in the ROIC formula. The first one is net operating profits after-tax
(NOPAT) and the second one is invested capital (IC). The difficulty in calculating ROIC is that it requires
adjustments to be made from the financial statements. More important than knowing how to make adjustments is to
know why they are being made. The following section addresses these issues.
1
Michael Mauboussin,
Plus Ça Change, Plus C’est Pareil
, CS First Boston, pp 6.
The Mechanics of the Economic Model
4
NOPAT (Net Operating Profits After-Tax)
NOPAT is operating profit free from any e
ffects of the capital structure. NOPAT
is one of the best ways to measure
the cash generated by a company’s operations as it takes away
the effects of n
on-operating items su
ch as investment
income, non-recurring charges and goodwill amortization.
There are two ways to calculate NOPAT: the operating
and the financing approach. In this report, we will focus on
the operating approach because we believe it is the best
perspective for investors to appreciate the factors that affect operating profits.
NOPAT:
1.
Calculate
Net Operating Profit Before Taxes (NOPBT)
Start with:
+
Sales
Minus:
-
Cost of goods sold
-
Selling and marketing expenses
-
General and administrative expenses
-
R&D
-
Depreciation
-
Other operating expenses
-
(Ignore expenses such as non-recurring charges,
amortization of goodwill, stock options, non-cash
items, acquired in-process R&D...)
Add back:
-
Amortization of goodwill (if included in depreciation)
2.
Subtract Operating Taxes
There are two ways to charge
NOBPT with operating taxes:
-
NOPAT = NOPBT x (1-CTR)
Make an assumption: establish a cash tax rate (CTR) equal to the effective tax rate as reported on the
income statement and if the effective tax rate is ar
tificially low, establish a tax rate somewhere between
35%-40%.
-
NOPAT = NOPBT – Cash Operating Taxes
Cash operating taxes can be calculated as follows:
With cash operating taxes, you can calculate the effective CTR:
Cash operating tax paid/NOPBT = Cash tax rate
This cash tax rate can be used as the effective CTR,
unless it is too low compared to the effective tax
rate under GAAP.
+ Provision for income taxes
+ Add change in deferred tax assets
+ Add tax shield from interest expense (Interest Expense x Tax Rate)
- Subtract change in deferred tax liabilities
- Subtract tax paid on investment income (Investment Income x Tax Rate)
=
Cash operating taxes
The Mechanics of the Economic Model
5
Justifications and Calculations:
Non-recurring Costs (or Gains):
Non-recurring costs were
ignored from the calculati
on of NOPAT because they
do not represent operating costs. Non-recurring costs include:
merger and acquisition related costs, litigation costs,
and costs from extraordinary even
ts. Non-recurring gains are also
subtracted from the equation.
Amortization of Goodwill:
Goodwill arises from the accounting for
acquisitions. Goodwill amortization is non-
cash, non-tax deductible and non-operating item, therefore a non-factor when it comes to business operations. To
cancel this effect, goodwill amortization is ignored in
the NOPAT calculation or added back to NOPBT if it is
included in the same line as depreciation.
Cash Tax Rate:
By establishing a cash tax rate or by calculating the actual cash operating taxes, we have removed
from the equation all taxes that were paid on investment income and the tax shield that was provided by the interest
expenses. In some cases, companies may be charged with
a cash operating tax while they have actually never paid
taxes under GAAP due to the tax shield provided by interest expense. However, with NOPAT, our goal is to de-
leverage the company and make no discrimination as to whether or not the company is debt financed or not.
Therefore we charge all companies with positive NOPBT with taxes. The tax shield from debt financing is
incorporated in the weighted aver
age cost of capital as it uses the
after-tax cost of debt
.
Beware, sometimes the cash operating tax paid may be lower than usual (due to timing of deferred taxes). If it is the
case, we suggest that investors choose the most conservative approach (highest tax rate).
Interest Expenses and Tax Shield from Debt:
read above (Cash Tax Rate)
Investment Income and Tax Pa
id on Investment Income:
Investment income (and the related taxes) was ignored
in our NOPAT calculation simply
because it does not represent an operati
ng item. We do not buy a company for its
ability to generate income on its cash balance. This assumpti
on allows us to remove all cash balances from Invested
Capital and keep cash value neutral in the equation.
Conclusion on NOPAT
We are now able to calculate the numer
ator in the ROIC formula. It is very important to mention that the
adjustments made in calculating NOPAT are not limited to those we’ve listed; not included here are: LIFO reserve
and full-cost reserve among others, for a more in-depth analysis, we recommend that you read
The Quest for Value
.
The reason why some adjustments were not included is becau
se we found them to be very counterproductive and it
beats the purpose of the exercise.
It is important to understand that NOPAT calculates the profits generated from the operations of a company. This is
why we’ve taken any debt-related issues, investment income as well as non-recurring costs and goodwill
amortization out of the equation. However, we did not remove depreciation from the picture since it represents a true
economic
expense whereby firms have to replenish their PP&E over time.
The Mechanics of the Economic Model
6
INVESTED CAPITAL (IC)
Invested capital is the amount of all cash that has been invested in the company’s business since its inception. It is
important to note that many of the adjustments we’ve made
to calculate NOPAT will affect invested capital as well.
IC can be calculated in two ways: with the operating appro
ach or the financing approach. Here we use the operating
approach for the same r
eason as for NOPAT:
Invested Capital
equals:
+
Net working capital
+
Net property, plant & equipment
+
Other operating assets
+
Operating L-T investments (unless they ar
e long-term low-risk income securities)
+
Gross goodwill
+
Unrecorded goodwill
+
Cumulative non-recurring costs
Justifications
and Calculations
Net Working Capital (NWC):
NWC is defined as operating assets minus operating liabilities (a.k.a. non-interest
bearing current liabilities or NIBCLs). Note that cash and equivalents and S-T investments are not operating assets.
Any interest bearing debt is not co
nsidered operating liabilities either.
This item should be studied with greater attention as it is
directly related to balance sheet management. In today’s
income statement centric world, investors tend to underestimate the importance of managing operating assets and
liabilities.
NWC will affect ROIC as it is a major component of IC. If
operating assets increase, in
vested capital increases as
well, which in turn lowers the ROIC. However, if ope
rating liabilities increase, ROIC
increases because NWC is
lower. As you can see, investors must overcome the myth th
at assets are a good thing and that liabilities are bad.
That’s why it is important for firms to co
ntrol their inventories and receivables and
to keep them as low as possible.
These things can only be observed when investors focus on
the balance sheet (and the cash flow statement). Tools
such as the flow ratio and the cash conversion cycle m
easure working capital management. Changes in NWC also
affect cash flows in the same way that it affects ROIC.
When operating liabilities increase, it creates a cash inflow.
When operating assets increa
se, there is a cash outflow.
Gross Goodwill
In NOPAT, we’ve ignored amortization of goodwill, howev
er a company can not get away with this so easily.
Therefore, we are
penalizing
the company by keeping goodwill amortization in the books by using gross goodwill
instead of net goodwill in Invested Capital. Anyway, as
companies start applying the new goodwill rule, companies
will start reporting goodwill on the balance sheet on a gro
ss basis, as goodwill amortization will not be required
anymore.
In the past, we’ve had several discussions about whether or not we should include goodwill in Invested Capital or
not. Mathematically, it doesn’t make a difference from valu
ation standpoint. However, if goodwill is not included in
Invested Capital, ROIC will be artificially high, making
your initial assessment of the value creation capability of
the company flawed. We want to be co
nservative in our approach. If a company
overpaid for a company, it has to be
reflected in ROIC.
Unrecorded Goodwill:
This item is a bit more complicated. Unrecord
ed goodwill arises when companies use the
pooling of interests method to account for mergers and ac
quisitions. Under this method
, the cost recognized to
acquire a company is merely its book value. Any premium paid vanishes from the balance sheet. However, the true
cost of the buying company equals the market value of th
e securities issued at the time of the transaction date.