08 Eva Intro

EVA: An Introduction
How Much Systemic Waste Is There In A Supply Chain?

PPI
Cumulative U.S. US Producer Price Index
11.4% %
7.0% 7.56% 7.56%
Experience of a well -regarded regarded U U.S. S manufacturing firm
7.1%
.7%
1/92 1/92 1/93
3.3% %
1/92 1/94 1/92 1/95 1/92 1/96
1/92 1/97
1/92 1/98
A benchmark comparison of programs to reduce incoming materials cost
FIN 591: Financial Fundamentals/Valuation
A Great Deal More Than Most People Recognize!

PPI
Cumulative U.S. US Producer Price Index
11.4% %
7.0% 7.56% 7.56%
Experience of a well -regarded regarded U U.S. S manufacturing firm
7.1%
.7%
1/92 1/92 1/93
3.3% % .7%
1/92 1/94
-.2%
1/92 1/95
1/92 1/96
1/92 1/97
Results from Honda of America program
1/92 1/98
-3.1% -7.9%
A benchmark comparison of programs to reduce incoming materials cost
-16% -19%
Honeywells Stock Price
Where to from here?
How Value is Created

Management g makes decisions, hopefully, with benefits exceeding costs
Benefits may be near or distant future Costs should include direct investment costs + cost of capital True source of value-enhancing g projects
Firms comparative or competitive advantage. d t
FIN 591: Financial Fundamentals/Valuation 5
Comparative Advantage
Advantage g one firm has over another in terms of
Cost of p producing g or Distributing goods/services
Example:
Wal-Mart invested in regional warehouses and distribution system Reduces the need for retail inventory Replenish store inventory quickly.
Competitive Advantage
Advantage g one firm has over another because of structure of the markets in which they operate
Barriers to entry
Patents Capital C it l requirements i t Regulation
Must be sustainable t i bl to be a true competitive advantage g
Influence over suppliers pp Influence over buyers
Traditional Measures
Fuzzy Finance
Return on Investment
Compare benefits ( (numerator) ) with resources (denominator) affecting that benefit
Basic earning power ratio
EBIT / Total assets
Return on assets
Net income / Total assets
Return on equity
Net income / Book value of equity
Measured relative to what?
10
Effective SCM: Increased Shareholder Value

Revenue Greater customer service (higher market share, increased g gross margins). g ) Greater product availability Lower cost of goods sold, g transportation, warehousing, material handling and distribution management costs Lower raw materials and finished goods inventory Shorter order-to-cash cycles l Fewer physical assets (e.g. trucks warehouses trucks, warehouses, material handling equipment)
11
Profitability Costs
Shareholder
value
Working capital Invested capital Fixed capital
Pros & Cons

Benefits of these ratios
Ease of calculation & interpretation Decompose to reveal sources of changes
Downside of these ratios

Sensitive to choice of accounting method Accumulation A l ti of f monetary t values l f from different periods Backward looking Fail to consider risk.
12
Honeywells Performance
Net Revenues
$25,023
$1,659
Net Income
Earnings / Share
$2.07
$23,652
$22,274
($99) ($220)
($0.12) ($0.27)
'00
'01
'02
'00
'01
'02
'00
'01
'02
13
EPS: Opiate of the Executive Suite

EPS is such an unreliable measure of value that managers often make dumb decisions to increase it Prompts managers to misallocate capital
Treats retained earnings as a free source of capital p Promotes retaining capital and using it wastefully. y
EPS
Accounting g rules discourage g EPSmanic managers from spending capital on value enhancing investments in intangibles like brands, research and training Why?
GAAP requires outlays to be written off immediately against earnings.
15
EPS
EPS focus may y cause management g to refrain from issuing equity at times when the company really needs it Fabricate EPS gains by using more debt than prudent
Both on and off the balance sheet
Accept weak projects that happen to be financed with debt. debt

EPS
Earnings g manipulation often used
Establish reserves Invest p pension funds in equities q Extreme cases, make up numbers as you go y g
Worldcom and HealthSouth.
17
EPS
Today ys market p perception: p
Management that aims to boost earnings at the expense of quality will be more certainly penalized then ever before with a lower stock price and a sullied lli d reputation. t ti
18
Performance vs. Valuation

Performance measurement
Relies on actual results
Historical GAAP vs. GAP
Valuation
Relies on forecasts A firms stock stoc price p ce relies e es on o investors expectations, not historical performance.
Cash Flows
Statement of Cash Flows

SCF combines balance sheet and income info
SCF consists of:

Eliminates the sins of accrual accounting Operating cash flows Investing cash flows Financing cash flows. f
Free cash flow
21
Cash Flow Not the Answer

Cash flow has problems as a valid performance measure
So long g as investments in projects p j earn a return higher than shareholders could earn by investing on their own, th then the th more i investment t t a company makes and the more negative its cash flow becomes, becomes the higher its share price will be.
Think Wal Wal-Mart. Mart.
Better Than Some Alternatives

Accounting profits versus cash h operating ti profits Cash flow frequently defined as:
Net income + depreciation or as EBITDA
Poor definition
3000 2500 2000 000 1500 1000 500 0 -500 500 '97 '98 '99 '00 '01 '02 NI + depr. NI CFFO
Honeywell H lls trend... t d
23
Free Cash Flows

Definition:
After-tax operating earnings + non-cash charges - investments in operating working capital PP&E and other assets capital, It doesnt incorporate financing related cash flows
Represents cash flow available to service debt and equity.
When used in capital budgeting proposals

Based on expectations. p
FCF & Capital Budgeting

FCF is the method of choice of most firms for evaluating capital budgets Identify incremental
Investment in PP&E + working capital Revenues Costs (excluding financing) Depreciation tax shields. shields
25
Common Techniques
Evaluation techniques:
Payback Accounting g rate of return DCF analysis
Consists of NPV and IRR DCF analysis is not a problem in theory
Only in practice.
26
NPV Methodology
Net present value (NPV)
Estimate of change in the value of equity if the firm invests in the project Forward F d looking l ki
If NPV>0 If NPV<0
Investment is expected to add value Investment is expected to erode value
Decision D i i rule l
Invest in projects expected to enhance value.

A Capital Budgeting Example

Period 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 NPV IRR WACC NOPAT 115 110 90 70 60 40 30 20 15 15 15 15 15 15 15 15 15 15 15 15 Deprec 10 10 10 10 10 10 10 10 10 10 10 10 10 10 10 10 10 10 10 10 FCF -200 125 120 100 80 70 50 40 30 25 25 25 25 25 25 25 25 25 25 25 25 $125.86 50.4% 25%
Excellent NPV and IRR Accept the project!
28
NPV(Using FCF) Profile

Free Cash Flow Profile
150 100 50 0 -50 -100
NPV of FCF = $125.86
9 10 11 12 13 14 15 16 17 18 19 20
-150
Significant info revealed?
-200 -250 250
29
Internal Rate of Return

Practice is to compare IRR with weighted average cost of capital Problem:
IRR fails to measure scale or growth It sees no difference between earning a 20% return on a $1 million investment or a $1 billion investment
These two projects are very different with distinctly different NPVs.
30
IRR Profiles
(New ( Example) p )
Mn
$1,100 $900 $700 $ $500 $300 $100 ($100) ($300) ($500) ($700) 0% 16%
IRRATL =36.53%
IRRNE=19.63%
50%
Conflicts: NPV & IRR

Which to Choose?
NPV Marketing Campaign IRR = 16 16.35% 35% Discount rate
10% 10.7% 10 7%
Product development IRR = 13.24%
Select project with higher NPV (product development project)
Value Enhanced?
Once a project is applied, the investment becomes buried in the balance sheet
How is its contribution measured?
No idea whether project generates value

Accounting measure relied upon
EBITDA and EPS generally increase Means Bonuses probably will be paid
Motivation:
Get your hands on as much capital as possible.
Buried in the Balance Sheet

2003 Assets
Cash and short-term investments Accounts receivable Inventories Other $x,xxx xxx xxx xxx $x,xxx $x,xxx xxx xxx xxx $x xxx $x,xxx $x,xxx
2004
$x,xxx xxx xxx xxx $x,xxx $x,xxx xxx xxx xxx $x xxx $x,xxx $x,xxx
34
Total Assets Liabilities

Accounts payable Accrued Accrued compensation Income taxes payable Other
Total Liabilities Shareholders Equity
Focused Finance & EVA
Focused Finance
36
EVA & Shareholder Value

What is the best way to measure shareholder value?

Fortune 500 sales?
E Earnings i per share? h ? Business Week survey of market value of equity? Stock market share price? Market value added?
37
EVA & Other Measures of Performance

50% 45% 40% 35% 30% 25% 20% 15% 10% 5% 0% EPS Growth
Correlation with ith MVA
Cash Flow Growth G ow
ROE
EVA
38
EVA & Wealth Creation

Warren Buffet:
We feel noble intentions should be checked periodically against results. We test the wisdom of retaining earnings b assessing by i whether h th retention, t ti over ti time, d delivers li shareholders at least $1 of market value for each $1 retained.
Translation:
Ultimate litmus test of any companys success lies in increasing its market value by more than it increases its capital. it l
View of the Firm

Market Valued Balance Sheet Assets Debt Equity
Value of firm = Value of debt + value of stock Market value of a company reflects: Earning power of invested assets

Present value of current operations Present value of expected improvement in operating performance. performance
What is Required to Focus?

Tie performance methods to capital budgeting techniques:
Economic value added ( (EVA) ) Market value added (MVA)
Links to NPV
Want to gauge managements performance

Focus on:
Decisions made in the past to help project the future.
What is MVA?
MVA = Market value of capital - book value of capital Honeywells MVA = ? Key elements:
Market value of f debt + market value of f equity Accounting adjustments necessary
Calculation of market value of capital Calculation of capital invested
MVA Related to EVA.
42
Market Value Added
Total market value
Premium
Market value added
Debt & equity capital
Investment
43
Also, Market Value Added

MVA = Present value of all future EVA Expected improvement in EVA
Total market value
MVA
Debt & equity capital
Current level of EVA
44
EVA & Market Value

Market value of a company reflects:

Value V l of fi invested t d capital it l Value of ongoing operations Present value of expected p future economic profits
Captures improvement in operating performance
EVA related to market value by:

Measuring all the capital Seeing g what the firm is g going g to do with the capital Turn FCF forecasts into EVA forecasts Discount EVA. EVA
What is EVA?
EVA = Economic profit
Not the same as accounting profit
Difference between revenues and costs
Economic profit adjusts for distortions caused by accounting methods

Doesnt have to follow GAAP
Costs include not only expenses but also cost of capital
Cost of capital p accounted for explicitly p y
R&D, advertising, restructuring costs, ...
Rate of return required by suppliers of a firms debt and equity capital Represents minimum acceptable return.
Advantages g of EVA
Annual EVA is easy to interpret Correlations between market value and various measures:
Standardized EVA ROE Fortunes Most admired firms Cash flow growth EPS growth Dividend growth Sales growth 0.50 0.35 0 24 0.24 0.22 0.18 0.16 0.09
50% of change in market value explained by standardized EVA (Standardized EVA = EVA /
Capital).
Components of EVA
NOPLAT

Operating capital Cost of capital

Net operating profit after tax Net operating working capital, capital net PP&E, goodwill, and other operating assets Weighted average cost of capital % Cost of capital % * operating capital NOPLAT less the capital charge. charge
Capital p charge g
Economic value added
What is NOPAT?
Net sales Cost of sales D Depreciation i ti SG&A Net Operating profit Taxes @ 40% NOPAT 150,000 150 000 135,000 2 000 2,000 7,000 6,000 2,400 3,600
Excludes financing charges
49
What is Operating Capital?

Capital: Net operating assets adjusted f certain for t i accounting ti di distortions t ti

Net operating assets:
Asset write-downs, restructuring charges, Cash, receivables, inventory, prepaids Trade payable, payable accruals accruals, deferred taxes Net property, plant, and equipment Marketable securities, investments,...
Exclude non-operating p g assets:
50
What is Cost of Capital?

Weighted average cost of capital consists of:
Cost of debt after taxes = Market M k ti interest t t rate t x (1 tax t rate) t ) Cost of equity = Risk-free Risk free rate + beta x (market risk premium) WACC = Cost of debt after taxes x % debt + cost of equity x % equity where h % debt d bt + % equity it = 100% 100%.
What is the Capital Charge?

Represents p a rental charge g for the use of the operating capital Minimum rate of return the operating capital should earn Calculated as the firms weighted average cost of capital % x invested capital.
52
Calculating EVA
NOPAT/Average g capital p = Return on invested operating capital (ROIC) - Weight average cost of capital (WACC) = Spread (= ROIC - WACC) * Operating capital = Economic value added (EVA) Net operating p g profit p after tax ( (NOPAT) ) - Capital charge (= WACC * Capital) (EVA) ) = Economic value added (
Whats Affecting g EVA?

Sales - Operating expenses - Taxes = NOPAT - Capital charge = EVA
Market potential COGS, SG&A + other Potential govt actions Net working capital PP&E WACC
Evaluate the many assumptions!

Forward Looking Relationship p for EVA & MVA

EVA Year 1 EVA Year 2 EVA EVA Year 3 .... Year n
Market Value Market value
MVA EVA + EVA + 1+r (1 + r)2 Capital EVA + ... + EVA (1 + r)3 (1 + r)n
Market M k value l i is based b d on establishing bli hi the h economic investment made in the company (capital), making a best guess about what economic profits (EVA) will happen in the future, and d discounting di i those h EVAs A to the h present to get market value added.
55
EVA Drives MVA

Companies that consistently earn profits fit in i excess of f th their i required i d return ...
NOPAT EVA Charge
are typically valued at premiums to book value.

Market Value Capital
MVA
Fundamental Strategies g
NOPAT EVA = Cost of capital * Capital C it l Capital
Operate: Improve the return on existing operating capital Decrease: WACC Build: Invest as long as returns exceed the cost of capital Harvest: Re Re-deploy deploy capital when returns fail to achieve the cost of capital.
An Example of Drivers
58
Focus on EVA Improvement p

A positive change g in EVA is better than a positive yet unchanging base level of EVA
Why?
Positive changes in EVA are consistent with shareholder value added -- whether from a positive or negative base Positive changes in EVA are consistent with the managerial notion of continuous improvement in performance.
Heres the Point

EVA is the reward from investing g in projects that return above the cost of capital
EVA = (ROIC - WACC) * Operating Capital
Each projects expected return must exceed its cost of capital to be j tifi d justified
Can this explain all the outsourcing?
60
Why y Use EVA & Not NPV?

Present value of EVA = Present value of NPV Provides P id insight i i ht into i t each h period i d Is a direct link to performance More useful for future project audits.
61
Investment Schedule
% Create value WACC Destroy value
N t Assets Net A t
An Example Revisited
(See Slides 27 & 28) ( )
Asset's Balance 200 190 180 170 160 150 140 130 120 110 100 90 80 70 60 50 40 30 20 10 0 Period 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 NPV IRR WACC NOPAT 115 110 90 70 60 40 30 20 15 15 15 15 15 15 15 15 15 15 15 15 Deprec 10 10 10 10 10 10 10 10 10 10 10 10 10 10 10 10 10 10 10 10 FCF -200 125 120 100 80 70 50 40 30 25 25 25 25 25 25 25 25 25 25 25 25 $125.86 50.4% 25% CapChg 50.0 47.5 45.0 42.5 40.0 37 5 37.5 35.0 32.5 30.0 27.5 25.0 22.5 20.0 17.5 15.0 12.5 10 0 10.0 7.5 5.0 2.5 EVA 65.0 62.5 45.0 27.5 20.0 25 2.5 -5.0 -12.5 -15.0 -12.5 -10.0 -7.5 -5.0 -2.5 0.0 2.5 50 5.0 7.5 10.0 12.5 $125.86
EVA = NOPAT WACC * Beginning Balance = 110 25% * 190 = 110 = 47.5 = 62.5
63
NPV
(Using FCF)
& EVA Profiles

FCF vs. EVA
150 100 50 0 -50 -100

NPV of FCF = NPV of EVA = $125.86
10 11 12 13 14 15 16 17 18 19 20
FCF EVA
-150
Significant info revealed?
-200 -250 250
64
Some Research Results
Profitability & COGS

80 COGS 70 Other expenses Profit 60
COGS: 13 point differential

50
40
30
Other expenses: 6 point differential
20
Result: 19 point profit differential

10
-10 Successful Less Successful
McKinsey & Co.s survey of f electronics l t i companies Items shown as % of sales Major difference b t between successful f l and unsuccessful companies p is cost of goods sold Requires a closer look at the reasons. reasons
66
Affect on EVA
Sales - Operating expenses - Taxes = NOPAT - Capital charge = EVA
Market potential COGS, SG&A + other Potential govt actions Net working capital PP&E WACC
How is EVA affected?

Reducing COGS
40
Undefined responsibility
35
Production Controlling
Successful companies i
30
M t'l Mgmt Mat'ls M t

25
Increase outsourcing g
Board/Committee
20
15
10
More competitive the industry more important to outsource t activities ti iti that fall short of world standards Neutral decision maker
Board or committee.
0 Successful Less So
68
Real Life EVA

The Manitowoc Co. in Manitowoc, Wis., a diversified food service, crane manufacturing and marine operations company, outsourced a reverse-auction procurement system to a vendor instead of f acquiring a software f package itself. f A comparison using Economic Value Added of buying vs. renting would look like this for the first year (hypothetical numbers):
In-house application
$180,000 in net benefits - ($1 million capital investment x 12% cost of capital) = $60,000 EVA
Outsourced application
$ $180,000 , in net benefits - ($ ($0 capital p investment x 12% cost of capital) p )-$ $80,000 , in rental fees = $100,000 EVA
Outsourced application requires no capital investment thus, no capital charge. Most companies p only y look at the income statement side of the ledger; g they y wouldn't outsource this application because it would be exchanging $50,000 of in-house expenses for the $80,000 rental fee, another kind of expense on the income statement. Yet on an EVA basis, the company would outsource the system, because doing so would produce more residual income ($100,000 vs. $60,000) by virtue of the $0 capital charge.
Suppose the operating costs to run the system in-house were $50,000 per year.
"When When you are exposed to the EVA philosophy, you recognize how to better manage your capital," says Jim Pecquex, Manitowoc's CIO.
Source: Computerworld, February 17, 2003.
69
Real Life EVA

Consider a recent EVA analysis that Robert Egan, vice president of IT at Boise Cascade Corp., and his colleagues conducted for a storage investment. The decision was whether to keep storage assets or replace them with new technology that has lower maintenance charges.
The example is illustrative. Egan declined to provide real cost figures.
The new storage technology costs $1 million, with maintenance costs of $100,000 per year. The Th maintenance i t expense on th the old ld storage t t technology h l i is $350 $350,000. 000
For simplicity, we'll assume that the new storage equipment offers no benefits other than the lower maintenance costs.
Boise's cost of capital is about 16%. Thus, the capital charge for investing in the new storage is 16% x $1 million = $160 $160,000, 000 which EVA says must be added to the $100,000 maintenance costs to get the true cost. The result:
The total cost of the new storage is $260,000, vs. $350,000 for the old storage. "In In this case case, have you lowered the operating cost enough to make up for spending the capital?" asks Egan. Yes -- $90,000 worth.
Boise is constantly reminded of the obvious point that technology isn't free. The company is also aware of the less obvious fact: neither is the capital to finance it.
Source: Computerworld, February 17, 2003.
70
Real Life: Walgreens Performance e o a ce
71
Real Life: EVA & MVA
3-year changes in MVA explained by regression analysis
72
Summary
Measure Earnings with EVA

Simple to explain and understand EPS (and NI) ignore cost of equity capital
EVA doesnt
Retained earnings no longer considered free
Benefits:
Reduce R d cost t of f capital it l Improve operational efficiency Better management of assets Profitable growth.
74
Effective SCM: Increased Shareholder Value

Revenue NOPAT
minus
Greater customer service (higher market share, increased g gross margins). g ) Greater product availability Lower cost of goods sold, g transportation, warehousing, material handling and distribution management costs Lower raw materials and finished goods inventory Shorter order-to-cash cycles l Fewer physical assets (e.g. trucks warehouses trucks, warehouses, material handling equipment)
75
Costs
minus
EVA Cost of capital

times
Working capital
plus
Invested capital
Fixed capital
Improvement in EVA
Sales
Customer Satisfaction Volume Product Pricing New Products Marketing Growth
Operating Expenses
Overhead Account Management Manufacturing Costs Compensation Training & Development
Capital Charge
Acquisitions & Divestitures Alliances R&D Decisions Working Capital Management Accounts Receivable Inventory Management
Manufacturing EVA Drivers

Reduce inventory Reduce cycle time Improve yields Reduce scrap/waste Maximize labor efficiencies Improve vendor efficiencies Process improvements
Research & Development EVA Drivers

Improve to-market process Reduce R&D expenses as % of new product sales Strategic partners for R&D Stronger links to product marketing New products via: - Research - Formulation - Development -Acquisition
Staff EVA Drivers

Work group/process simplification Consistency monitors audit Centralizing resources/synergies Best practices benchmarking Insourcing/outsourcing decisions Simplify EVA measurements/reporting Ensure compliance with legislation
Marketing EVA Drivers

Increase market share / revenue New markets More focused channel programs Voice of customer / consumer Leverage advertising / promotion Build brand awareness
76
The End
77

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EVA: An Introduction

How Much Systemic Waste Is There In A Supply Chain?

A benchmark comparison of programs to reduce incoming materials cost

FIN 591: Financial Fundamentals/Valuation

A Great Deal More Than Most People Recognize!

A benchmark comparison of programs to reduce incoming materials cost

FIN 591: Financial Fundamentals/Valuation

Honeywells Stock Price

Where to from here?

FIN 591: Financial Fundamentals/Valuation

How Value is Created

FIN 591: Financial Fundamentals/Valuation

Influence over suppliers pp Influence over buyers

FIN 591: Financial Fundamentals/Valuation

FIN 591: Financial Fundamentals/Valuation

Measured relative to what?

Effective SCM: Increased Shareholder Value

FIN 591: Financial Fundamentals/Valuation

Pros & Cons

Downside of these ratios

FIN 591: Financial Fundamentals/Valuation

FIN 591: Financial Fundamentals/Valuation

EPS: Opiate of the Executive Suite

FIN 591: Financial Fundamentals/Valuation

Accept weak projects that happen to be financed with debt. debt

FIN 591: Financial Fundamentals/Valuation

FIN 591: Financial Fundamentals/Valuation

Performance vs. Valuation

Statement of Cash Flows

SCF consists of:

Free cash flow

FIN 591: Financial Fundamentals/Valuation

Cash Flow Not the Answer

Better Than Some Alternatives

Honeywell H lls trend... t d

FIN 591: Financial Fundamentals/Valuation

Free Cash Flows

When used in capital budgeting proposals

FCF & Capital Budgeting

FIN 591: Financial Fundamentals/Valuation

FIN 591: Financial Fundamentals/Valuation

Invest in projects expected to enhance value.

A Capital Budgeting Example

Excellent NPV and IRR Accept the project!

FIN 591: Financial Fundamentals/Valuation

NPV(Using FCF) Profile

-200 -250 250

FIN 591: Financial Fundamentals/Valuation

Internal Rate of Return

FIN 591: Financial Fundamentals/Valuation

Conflicts: NPV & IRR

Product development IRR = 13.24%

Select project with higher NPV (product development project)

No idea whether project generates value

Buried in the Balance Sheet

Total Assets Liabilities

Total Liabilities Shareholders Equity

Focused Finance & EVA

FIN 591: Financial Fundamentals/Valuation

EVA & Shareholder Value

Fortune 500 sales?

FIN 591: Financial Fundamentals/Valuation