2.3 EVA calculation and standardization
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
relative basis, ASPs are declining, and the long-term revenue growth trend is slowing.
• Increased competition;
In the early 1990s there was a significant increase in the number of fabless companies in the marketplace. The rise of the foundry model, with manufacturing capabilities less than a generation behind that of the IDMs (Integrated Device Manufactures), made it very simple for a company to design and then produce devices for the semiconductor market. This rapid rise of the fabless firms, along with a significant increase in the number of DRAM suppliers, led to increased competition in the marketplace, which in turn led to pricing wars for market-share dominance.
• Capital markets;
Much recent historical growth in the semiconductor market has resulted from new entrants -- mainly memory or foundry companies -- funded by offerings in the public capital markets or government incentives. However, the long down cycle has reduced the attraction of semiconductor ventures to capital markets.
Thus, there probably will be few new major entrants into the industry.
• Fewer buying centers
As the industry continues to grow and mature, there are few buying centers that are available for semiconductor equipment manufactures to sell into.
Foundries, the move to 300 mm, alliances and research consortiums have all led to fewer locations where semiconductor equipment can be tested out and then sold to
the market. 'Copy exact' or 'copy smartly' policies have created an environment where one toolset is sold not just to one company, but to any company associated with that consortium. Overall, these factors have in some ways made it easier to sell into the industry but have limited the number of opportunities to become a tool of record.
• The shift of semiconductor manufacturing to Asia
Since the 1980s the semiconductor manufacturing centers have been shifting.
Cheap capital as a result of government incentives saw the industry move from the Americas and Europe to Japan, then Korea and Taiwan. Asia-Pacific market share based on location of production has increased dramatically, from nearly 5 percent in 1990 to approximately 30 percent in 2003.
• The pace of technology.
The pace of technology change seems to increase every year. The technology cycle moved from a three-year cycle to a two-year cycle. This has increased the pace at which the semiconductor equipment manufacturer must develop products and has extended the time period that a semiconductor equipment manufacturer must support its equipment. The industry now has 45 nm in development, 65 nm in pilot line production, 90 nm ramping, 130 nm ramping, 180 nm still running at full volume, and some capacity is still being added. Thus, an equipment manufacturer may need to support up to five different generations simultaneously with resources once needed to support only three generations of technology. This can be a significant drain on company resources.
Along with the faster-paced roadmap, semiconductor equipment manufactures are dealing with a significant number of material changes. Low-k, hi-k and metal gates along with new substrates are a few of the more significant challenges ahead.
This process and product development will take a significant amount of resources to implement into the semiconductor process flow. Equipment firms will need to form alliances with the material suppliers as well as work closely with the semiconductor manufactures to succeed. Firms failing to get in on the leading edge at key semiconductor manufacturers or consortiums will fall farther behind on the technology curve.
Over the past five years the industry has been suffering from an overall lack of profitability, both for chip manufacturers and equipment manufactures. Data about net profit as a percentage of sales for the past 10 years for 32 semi-equipment makers (see Figure 3-1) shows that the industry has run a slight deficit of 1.8 percent. The total dollars picture is a bit brighter, with the industry running a slight profit of 3.3 percent from 1994 to 2003, but the industry has struggled since 1997, with 2000 being the only year with significant profits since 1997. The semiconductor equipment industry also needs to examine how to regain and then maintain profitability in the years to come.
Figure 3-1: Semiconductor Equipment Companies Net Income (Bob Johnson)
As far as the revenue trend forecast, Dataquest has reported a study in Dec., 2006 for the worldwide semiconductor capital and equipment spending forecasts (See Table 3-1 below).
Table 3-1 Semiconductor Capital Spending Forecast. (Dataquest, Dec., 2006)
It clearly showed that Wafer Fab Equipment (WFE) is around 60% of the Semiconductor Capital Expense and almost 80% of the Capital Equipment expenditures (See Table 3-2). From this we can derive that the CAGR (compound annual growth rate) of WFE from 2005 to 2011 is 8.1% (see Figure 3-2), this is a further drops from the 10 to 12 percent in the past 10 years.
Table 3-2 Weighting of WFE expenditure as compared to total semiconductor capital Spending and Equipment Spending.
Year 2005 2006 2007 2008 2009 2010 2011
Figure 3-2 WFE expenditure forecast and the linear fitting curve
So combining the two trends of decreasing profitability and slower annual growth, unfortunately we need to face the fact that this industry may not be as lucrative as before, which should be about right since this industry is around 35 years old as of today.
One other thing that worth noticing is the cyclical nature of this industry (see Figure 3-3 below). The swing of equipment booking and shipping is way bigger than that of semiconductor shipment and the peak to valley ratio can be as high as 8. So we can still conclude that this industry will continue to be exciting and risky. Proper forecasting must be made to survive this cyclical nature.
Source: Dan Tracy, SEMI Equipment and Materials Outlook, Sept. 2006 Figure 3-3: Worldwide Fab Equipment Trend
3.1.2 Targeted markets, shares and geographical distributions
The semiconductor equipment industry obviously has a global market. Worldwide billings totaled $40.47 billion in 2006(7), compared to $32.88 billion in sales posted
in 2005. "The worldwide semiconductor equipment industry resumed strong growth in 2006 as the robust memory chip market and continued transition to 300mm wafers fueled sales of manufacturing technology," said Stanley T. Myers, president and CEO of SEMI. "With double-digit gains in all market regions, the equipment industry posted annual sales second only to the extraordinary levels in 2000."
For the third year in a row, the Japanese market region spent the most on semiconductor equipment, growing almost 13 percent over 2005 to reach US$9.20 billion. N. America reclaimed the number two spot with $7.32 in equipment sales.
Following closely behind N. America were the regions of Taiwan and S. Korea with spending of $7.31 billion and $7.01 billion respectively. After experiencing negative growth in 2005, the China market region grew the most in 2006, rising over 74 percent to US$2.3 billion. The Rest of World region, which aggregates Singapore, Malaysia, Philippines, other areas of Southeast Asia and smaller global markets, increased almost 30 percent. The equipment market in Europe increased 10 in 2006.
The global wafer processing equipment market segment increased 26 percent; the assembly and packaging segment grew 14 percent, the total test equipment sales increased 21 percent.
Table 3-3 2005-2006 Semiconductor Capital Equipment Market by World Region
2005-2006 Semiconductor Capital Equipment Market by World Region (Dollars in U.S. Millions; Percentage Year-over-Year)
Region 2005 2006 % Change
China 1,327 2,315 74.4
Europe 3,262 3,595 10.2
Japan 8,183 9,209 12.5
Korea 5,826 7,014 20.4
North America 5,702 7,324 28.4
Taiwan 5,722 7,308 27.7
Rest of World 2,862 3,709 29.6 Total Regions 32,884 40,474 23.1
Source: SEMI-SEAJ
3.1.3 WFE segments
The business of WFE market could be divided into different segments including new leading edge fab, new non-leading edge fab, new specialty fab, upgrades and end of life.(See Figure 3-4)
Figure 3-4 WFE market segmentation (David Anderson, International SEMATECH, Global Economic Symposium)
Among them, we can further break down the tools by into different production
Among them, we can further break down the tools by into different production