Price-Earnings-Ratio (PER) is a simple and familiar method of valuing a stock among investors. However, there are many other ways to value a stock that can be quite complicated and require a technical expertise. It’s impossible to say that any one method is better than others. Therefore, it’s common for analysts to use several valuation methods and come up with different fair values.
Recently, the Economic Valued Added method has gained attention worldwide. This method is intuitively appealing and measures profitability in the way shareholders define it.
Economic Value Added calculates the actual dollar amount of a business’s wealth created or destroyed in each reporting period. It takes into account the opportunity cost (the minimum acceptable compensation for investing in a risky asset as opposed to a less risky market instrument like government bonds) of the company’s capital investment and measures the excess returns over this charge.
A positive Economic Value Added indicates that value is being created; so adding to the intrinsic value of the company by that amount. A negative Economic Value Added, on the other hand, indicates that value is eroded and the company is now worth less than the initial capital employed.
There are eight steps involve in applying Economic Value Added to value a company:
Step 1: Determining a period of financial projection. To calculate returns on capital employed, we first need to estimate the company’s earnings; for instance, in the next five years to 2011. The earnings projection is based on a set of assumptions for future volume sales growth, finished product prices, government duties and inflation.
Step 2: Net operating profit after tax (Nopat) Net operating profit after tax is equivalent to the after tax earnings generated by the company (excluding interest expense). The financing of asset (interest expense) is assumed to be independent of operating results and is instead reflected in the company’s cost of capital.
Step 3: Initial capital employed The total capital employed at the beginning of each year is the assets base from which earnings for the year are generated.
Capital employed = Net fixed assets + Working capital
Step 4: Return on capital employed (ROCE) The yearly returns on capital employed are determined by dividing Nopat by capital employed at the beginning of each year.
ROCE = Nopat ÷ Capital employed
Step 5: Weighted average cost of capital (WACC) After calculating the Returns On Investment (ROI), match them to the cost of capital. The most commonly used cost of capital is the WACC, which is based on the company’s debt equity capital structure.
WACC = Weighted cost of equity + Weighted after tax cost of debt
After tax cost of debt = [Interest payment x (1-tax rate)] ÷ Total borrowings
How big a risk premium required for investing in a company is dependent on how risky the stock is relative to the broad market; which known as correlation beta. A high beta implies the stock price is more volatile than the broad market. Therefore, an investor should require a higher than market average return to compensate for the additional risks.
Conversely, a low beta implies that the stock returns will lag a market rally but will be more resilient during a sell down.
Step 6: Excess returns over cost of capital
Excess returns (ER) = ROCE – WACC
Step 7: Economic Value Added and Market Value Added (MVA)
Economic Value Added = ER x Capital employed
Beyond the projected period of 2011, you impute a terminal value (perpetuity); on the basis that the company is an ongoing business concern (for the stream of future Economic Value Added, assuming a constant yearly growth of 1%).
The stream of Economic Value Added is then discounted back to present day values using the WACC calculated previously, the sum of which is the positive value created by the company’s business operations.
MVA = Sum of present value of Economic Value Added stream.
Step 8: Intrinsic value and shareholder value The intrinsic value for the company is its initial capital employed enhanced by the positive value created.
Intrinsic market value = Initial capital employed + MVA
Shareholder value = Intrinsic market value – Net debt
Fair value per share = Shareholders’ value ÷ Number of shares
The company’s primary objective would be to maximize Economic Value Added; which is not necessarily the same as maximizing profits. If the return on an investment is below its cost of capital, then the company prefers not to make the investment at all (even if the absolute magnitude of profit is increased).