Joe Stern from Stern Stewart constructed a system that claimed to correctly evaluate business performance. This system stressed that a business can only create value for its shareholders while it earns higher return than the cost of invested capital. So Economic Value added is a technique to measure whether a business could create
the general accounting measures like Revenue, Cash flow or Dividends.
To avoid the distortion from GAAP rules, consultants from Stern Stewart & Co.
have given recommendations to add back change in Equity Equivalents.
2. Tully (1993)
EVA correlates with stock price highly. Also there are three ways for business to increase its EVA:
(1) Increase operation profit while keeping the invested capital fixed.
(2) Try to maintain similar level of operation with lower invested capital.
(3) Invest capital to those projects that can earn higher returns than its cost.
3. Lehn & Makhija (1996)
A study using the 241 U.S. public companies’ financial data of 1987, 1988, 1992 and 1993 showed that return on stock has higher correlation with EVA than other conventional performance evaluation indexes like ROA (Return on Asset), ROE (Return on Equity) and ROS (Return on Sales).
4. Chen and Dodd (1997)
A study using the 566 public companies’ financial data of 1983 to 1992 showed that return on stock has higher correlation with EVA than other indexes like EPS (Earning per Share) and ROE (Return on Equity). But the R squared value of EVA is 0.202, is about comparable to that of Residual Income (0.194).
5. 張耿豪 (1997)
86 companies listed in the Taiwan Stock Exchange are used as research sample. The studying periods are from 1993 to 1997. The sample is further divided into several subgroups by their sizes and industries. The regular regression analysis is first applied to examine the explanatory power of each of the variables to the concurrent stock returns. Then the Information Coefficient Method is used to examine the information content of each of the variables. Results from the information coefficient analysis
strongly support the view that the EVA indeed carries more information content than that of CFO, Earnings, and RI. For the overall and every subgroup, the EVA outperforms other measures in predicting the performance of stock returns. However, the results from the regression analysis show that it is inferior to that of RI.
6. Robert Ferguson, Joel Rentzler, Susana Yu (2005)
This article uses event study methodology to investigate whether firms adopt EVA system leads to better stock performance (greater profitability). There is some evidence that EVA adopters experience increased profitability relative to their peers following adoption.
7. Chikashi Tsuji (2006)
EVA is compared with several other valuation measures including cash flow, operating income, and profit after tax from the viewpoint of both levels and changes.
Also two different forms of EVA are examined by using the Weighted Cost of Capital (WACC) from the Capital Asset Pricing Model (CAPM) and the WACC from the Fama-French (1993) model. The results reveal that corporate market values in both levels and changes have stronger linkages with cash flow and other earnings measures than either form of EVA.
8. Wajeeh Elali (2006)
Two commonly used value-based performance metrics - namely, Total Shareholder Return (TSR) and Tobin's Q - were also considered to highlight the value-relevance of EVA vis-a-vis these measures in predicting shareholder wealth. Using a panel sample of about 1000 American firms over the period 1990-2002, the study found compelling evidence consistent with the notion that EVA outperforms other traditional performance measures in explaining shareholder wealth. Value-relevance tests reveal EVA to be more highly associated with shareholder wealth than TSR and Tobin's Q.
largest explanatory power over TSR and Tobin's Q. These results conclusively support the claims made by EVA proponents and further support the potential usefulness of EVA metric for internal and external performance measurement.
9. Ralph Palliam (2006)
108 companies were analyzed with data ranging from 1998 to 2002. Among them 75 are EVA users and 33 are non-EVA users). EVA corporations do not necessarily have superior stock returns. Simple correlation between accounting earnings provides a reasonable reliable guide to the movement of stock prices. Furthermore, the study found minimal evidence of a difference between the market returns of firms that use EVA compared to firms that do not use EVA.
From the review of these articles, it is found that there are some supporters (Tully (1993), Lehn & Makhija (1996), Chen and Dodd (1997), 張耿豪 (1997), Elali (2006)) asserting that EVA is better than other indexes at predicting stock price movement; but there are also some other researchers (Tsuji (2006), Palliam (2006)) found that this is not the case. Also there is study (Ferguson, Rentzler & Yu (2005)) suggesting that the EVA adopters experience increased profitability relative to their peers following adoption.
So although it is remianed argumentative whether EVA is fully proven to be the best measurement of companies’ capability of creating shareholders’ wealth, but it seems that its advocators are gaining better position.
Here are some comments/questions for Tsuji’s and Palliam’s articles. For Tsuji’s, is it possible that Japan’s investment community is less aware of the concept of EVA so that they follow the old ways of investment, which is looking at the performance of conventional performance metrics? So it may be natural that they the conventional metrics can beat EVA. As far as Palliam’s work is concerned, is it possible that it
contains one big incident which is the dot com bubble so that the stock price has deviates too far from the real value it should be?
So the author concludes EVA to be no worse than other measures and that is the reason why it is chosen as the method for this study.
2.3 EVA calculation and its standardization 2.3.1 EVA Calculation
EVA is the difference between the Net Operation Profit After Tax and Weighted Average Cost of Net Capitals used. The Equation used(Stewart) is:
Among them
NOPATt: It is the abbreviation of Net Operating Profit After Taxes.Net means that various kinds of accounting distortion is deducted.
WACC: It is the abbreviation of Weighted Average Cost of Capital.
Invested Capitalt-1: This is the invested capital at the end of term (t-1) or the beginning of term t.
WACC x Invested Capitalt-1:This is the cost of invested capital at the beginning of term t.
ROICt： This is the abbreviation of Return on Invested Capital.
From the equation of EVAt = (ROICt–WACC) x Invested Capitalt-1, we learnt that business can only increase its value under the situation while ROIC is greater than WACC. That is to say, only under the circumstances of positive EVA can company generates excessive return and brings positive value to its shareholders. On
the contrary, negative EVA means that company can not even earn enough retune greater than the cost of its weighted capital, thus it actually brings negative value to its shareholders. In short, EVA provides information about whether the company is creating excessive return for its shareholders. So it is an explicit form of corporate values creation. The primary goal of the management team is to maximize its EVA to create biggest values for the company.
For line managers, since it starts with the familiar operating profits and simply deducts a charge for the capital invested in the company as a whole, in a business unit, or even in a single plant, office or assembly line. By assessing a charge for using capital, EVA makes managers care about managing assets as well as income, and helps them properly assess the tradeoffs between the two. This broader, more complete view of the economics of a business can make dramatic differences.
2.3.2 EVA Standardization
To eliminate the impact of company sizing on EVA value so that we can do a fair comparison between companies, we need to calculate standardized EVA. The equation is as the following:
Standardized EVAt = (ROICt – WACC) x Standardized Invested Capitalt-1
Standardized Invested Capitalt-1 is the standardized invested capital at the end of term(t-1) or the beginning of term t.
Invested Capital0 is the invested capital at term zero.
Standardized EVAt= (ROICt-WACC) x Standardized Invested Capitalt-1
= (ROICt-WACC) x Invested Capitalt-1/ Invested Capital0 x 100 = EVAt/ Invested Capital0 x 100
2.4 EVA constituents and the calculation method 2.4.1 Computation of NOPAT and Invested Capital
From the previous equation derived, EVA could be easily got from the simple equation. But actually NOPAT and Invested Capital are not readily available from the financial reports. From the book “The Quest for Value” by G. Bennett Stewart III, two methods were proposed:
1. Financing Approach
This mainly comes from the Liabilities and Shareholders Equities of the Balance Sheet
2. Operating Approach
This mainly comes from the Assets of the Balance Sheet
The NOPAT and Invested Capital derived from both approaches should be the same. Please refer to Table 2-1 and 2-2 from the details.
Table 2-1: NOPAT and Invested Capital ( from Financing Approach )
NOPAT ( by Financing Approach ) Invested Capiatl ( by Financing Approach )
= GAPP Net Income = Common Equity
+ Change in Equity Equivalents + Equity Equivalents
+ Capitalized R&D Expenses + Net Capitalized R&D Expenses - R&D amortization (Intangible assets)
+Capitalized Marketing expenses +Net Cpaitalized Marketing expenses - Market amortization (Intangible assets)
+Non-Capitalized lease costs +Present Value of Non-capitalized leases + Change in Bad Debt Reserve + Bad Debt Reserve
+Change in LIFO Reserve +LIFO Reserve
+Goodwill Amortization +Cummulative goodwill amortization + Unusual loss (Gain) after tax +Culmulative unusual loss (Gain) after tax +Change in deferred tax liabilities +Deferred tax liabilities
+Dividend on Preferred Stock +Preferred Stock +Minority Interest Provision + Minority Interest -Investment and Interest income + Short-Term Debt +Tax paid on investment and interest income
( effective tax x investment income ) + Current Portion of Long-Term Debt + Interest expense +Long-Term Debt
- Tax shield from interest expense (effective
tax rate x interest expense) - Marketing Securities & Construction in Progress Source: G.Bennett Stewart,III.
Table 2-2: NOPAT (from Operating Approach)
NOPAT (by Operating Approach) Calculation on Cash Operating Tax
= Sales Revenue = Income tax provision
- Cost of Goods Sold - Change in deferred tax laibilities - Depreciation +Tax aving from Net Interest Expense
-Sellinng General & Administration ( effective tax rate x net interest expense)
+ R&D Expenditures
+ Interest Expense on Non-Cpaital Lease
+Change in LIFO Reserve
+ Other Income
--- NOPBT (Net Operatin Profit before Tax)
- Cash Operating Taxes
---
= NOPAT
Source: G.Bennett Stewart,III.
Comparing the Regular Balance Sheet and EVA Balance Sheet below in Figure 2-1, we can find that the main difference between these two is that in EVA’s Invested capital, NIBL (Non-Interest Bearing Liabilities) is not included. These Non-Interest Bearing Liabilities are accounts such as accounts payable and accrued expenses, that arises as spontaneous sources of financing in the nature course of business and which eliminate the need to raise permanent capital. The rationale for excluding them from capital is that the financing costs associated with paying suppliers and employees with some delay are incorporated in the cost of goods sold, and nothing is to be gained by extracting them from earnings.(G. Bennett Stewart, III)
Source: S. David Young, Stephen F. O’Byrne, EVA and Value-Based Management Figure 2-1: Comparing the Regular Balance Sheet and EVA Balance Sheet
WCR ( Working Capital Requirement ) = Receivables + Inventories + Prepayments- Short-Term NIBL
Where Net Asset = Cash +Working Capital Requirement + Fixed Asstes
And Invested Capital = Short-Term Debt + Long Term Debt + Other Long Term Liabilities + Shareholders Equity
RONAt = NOPATt/ NetAssett-1 ROIC= NOPATt/ Invested Capital t-1
RONA=ROIC since Net Asset= Invested Capital
2.4.2 Computation of WACC
WACC (Weighted Average Cost of Capital) is the weighted average cost of all sorts of capitals that were used for a project (or a business). The importance includes the following:
1. It is used as the discount rate for future cash flow of a corporation for the purpose
of its evaluation. For the investors of this corporation including Bondholders and Shareholders, this is a Required Rate of Return that is a compensation for the risk they take for the investment. So naturally, this return rate will be different for different industries, different companies or even different projects within the same companies.
So the cost of an investment is really dependent on the risk level of that project, or more specifically, on where the money is spent, in stead of where the money come from. So the overall cost of a company’s capital is a reflection of the required return of its overall asset. So for a company that uses different sources of capitals that required different levels of return, the cost is computed by using their weighted average of all capitals.
2. The source of capitals
Since there are two forms of capital sources: debt and shreholders’ equity, so the cost of capital is a function of the cost of each capital. The weighted averaged cost of capital (WACC) is thus defined:
WACC= D/(D+E) x Kd (1-Tc) + E/ (D+E) x Ke
Where Tc is the tax rate of the company, so debt has its effect of tax saving
D: the market value of interest baring debt. Usually it is estimated by the book value of the interest baring debt
E: the market value of a company’s equity. E= Outstanding shares x Share price Market Value of a company= E+D
Kd= cost of interest baring debt= interest expense / Average interest baring debt
= (interest expense x2)/ ( interest baring debt at the beginning of a term + intrest baring debt at the end of a term )
Ke= cost of equity= Rf+β( Rm-Rf) = risk free return rate +β x risk premium of the investment
capitals impact a lot to the magnitude of WACC. So the capital structure of a company (equity to debt ratio) is crucial and needs to be optimized for each specific company.
Each company has its own combination of debt, preferred stock and common stocks to get its WACC reaching the lowest and stock price reaching the highest. This combination is called the target capital structure. So a sensible company which is pursuing the maximum value will try to raise the capitals in a way that it won’t deviate from the optimized capital.
2.5 The computation of MVA
The ultimate goal of a corporate operation is to increase its shareholders’ wealth.
This could only be achieved by increase the difference between a corporate’s market value and its cost of capitals. The difference is called Market Value Added (MVA).
MVA= Market Value of a corporate- Total Invested Capital
So the higher the MVA is, the bigger the shareholders’ wealth become. This is all about how to manage the limited resources within a company so that the EVA is optimized.
MVA= Outstanding shares x Stock Price + Market Value of Preferred Stock + Market Value of Debt – Invested Capital
Usually we assume that the market value of Preferred Stock and Debt equal to their book values for the purpose of simplicity. So the above equation becomes:
MVA= Outstanding Shares x Stock Price – Book Value of Equity
MVA per share = Stock Price – Book Value of Equity/ Outstanding Shares
So MVA, Stockholders’ wealth and stock price change at the same direction. When MVA is positive, it means that the company is creating wealth for its shareholders so the stock price will go up. On the contrary, if the MVA is negative, shareholders’
wealth is destroyed and thus the stock price will go down. But since stock price is
investors’ expectation on company’s future performance instead of current performance, so the correlation among these three parameters may not be that trivial in real case.
Stern Stewart & Co. considers EVA as a measure for company’s stock price through empirical study. EVA is for only one term, while MVA is the accumulation of EVA under the assumption of continual operation. So
Expected MVA = Present Value of Future Expected EVAs.
If the EVA of a specific year is positive, it means that the company can continue to create economic profit after the cost of invested capital is deducted. So MVA gets increased also. If the EVA of a specific year is negative, it means that the company destroys economic profit through its operation. So the market value of the company decreases and MVA drops. This is to say that the changes in EVA have a strong correlation with the change of MVA.
2.6 Company Valuation through EVA computation
A company’s value could be calculated by adding the original invested capital to all future EVA together with each term discounted to its present value by a discounted rate of WACC. This could be expressed by the following equation:
Company Value= Invested Capital + Present Value of future Expected EVAs
= Invested Capital +
Under the assumption of continual operation, usually a company can enjoy higher growth rate and profitability at the beginning several years. After this relatively higher speed of growth, the company may enter a more matured stage when the growth rate and the profitability is relatively stable. So we can use this kind of two stage concept for predicting a company’s future EVA which are:
Stage two: After Explicit Forecast Period
Usually the first period lasts for 3 to 5 years, depending on different industry. But of course the duration of this period can also depend on the actual growth rate. For example, a higher growth rate may possibly extend the duration of this period.
Company Value = Invested Capital + Present Value of EVA During Explicit Forecast Period + Present Value after Explicit Forecast Period.
During Explicit Forecast Period
The financial reports like Balance Sheets and Income Statements should be forecasted explicitly and thus EVA of each year could be calculated explicitly. Then WACC could be used as the discounted rate to calculate the present values.
After Explicit Forecast Period
Continuing Value ( CV, or Terminal Value or Residual Value) is firstly computed and then WACC is again used for its present value calculation. From the book Valuation by Copeland (2000), Continuing Value=
(EVAt+1/WACC)+ (NOPATt+1 ( IROIC-WACC) g)/ (( WACC (WACC-g) IROIC)) Where t means the duration of the first stage
EVA t+1 means the EVA of the first term of the 2nd stage.
NOPAT t+1 means the NOPAT of the first term of the 2nd stage.
g: growth rate of NOPAT
IROIC: The expected rate of return on Incremental Invested Capital
So from this we learn that we need the following conditions to have positive EVA in second stage:
1. IROIC-WACC>0 2. IR= g/IROIC>0
Chapter Three: Industry Analysis and Companies introduction
In this chapter, we will first have an introduction to the wafer fabrication equipment industry, and then the basic information, core competency and competitive strategy of the two companies, Lam Research and Applied Materials will be discussed.
3.1 Introduction to wafer fabrication equipment industry
Wafer fabrication equipment industry is an industry that builds tools for semiconductor manufacturing. The targeted customers includes INTEL, IBM, Samsung, TSMC or UMC……..etc.
3.1.1 Current Status of WFE industry and its trend.
The semiconductor and semiconductor equipment industry has enjoyed strong growth since its inception (Bob Johnson, Dean Freeman, 2005). From 1972 through the mid-1990s, the industry enjoyed revenue CAGR of 15 to 17 percent. The industry became a Wall Street darling, with very high price-to-earnings ratios as a result of the potential for strong growth. In the mid-1990s, however, there was an inflection in the growth curve. In the 1994-1995 timeframe, the long-term CAGR for semiconductor revenue dropped to a range of 10 to 12 percent. This has also affected the semiconductor equipment industry. It is found that this drop in revenue growth rate is probably related, in part, to the drop of average selling price of semiconductors.
Several other issues that could also be contributing to this decline include:
• Consumerism;
Over time, and becoming more prevalent in the 1990s, the business environment for electronic products started to saturate and shifted to a market driven by replacement cycles. The industry has migrated from a supply 'push' to a demand 'pull' market, which is responding to an environment of increasing price sensitivity. Thus, the price premium segment of the market is shrinking on a