Is it Possible to Value Companies by Calculating the Present Value of EVA?
In the realm of financial analysis, valuing companies is a crucial task. While traditional methods like discounted cash flow (DCF) analysis are widely used, an alternative approach involves calculating the present value of Economic Value Added (EVA). This article delves into the feasibility of using EVA for valuation, exploring the necessary hypotheses and comparing its results to DCF analysis.
Understanding EVA and its Relationship to Valuation
EVA, a performance metric developed by Stern Stewart & Co., measures a company’s true economic profit by subtracting its cost of capital from its operating profit. It represents the value created for shareholders after accounting for the opportunity cost of capital. The formula for EVA is:
EVA = Net Operating Profit After Taxes (NOPAT) – (Cost of Capital x Invested Capital)
The concept of EVA is closely tied to valuation because it directly reflects the economic value generated by a company. By discounting the future stream of EVA back to the present, we can arrive at an intrinsic value for the company. This approach assumes that the market value of a company should equal the present value of its future EVA.
Hypotheses for Validating EVA-Based Valuation
For EVA-based valuation to provide results comparable to DCF analysis, several key hypotheses must hold true:
- Stable and Predictable Future EVA: The future stream of EVA must be reasonably predictable and stable over time. This assumption is crucial for accurate discounting.
- Accurate Cost of Capital Estimation: The cost of capital, which reflects the riskiness of the company’s investments, must be accurately determined. Errors in cost of capital estimation can significantly impact the valuation.
- Consistent Accounting Practices: The company’s accounting practices should be consistent over time to ensure that EVA is calculated on a comparable basis. Changes in accounting policies can distort the EVA trend.
- Market Efficiency: The market must be efficient enough to reflect the true economic value of the company. If the market is inefficient, the present value of EVA may not accurately reflect the market price.
Comparing EVA-Based Valuation to DCF Analysis
While both EVA and DCF analysis aim to determine a company’s intrinsic value, they differ in their approaches:
- DCF Analysis: Focuses on discounting future free cash flows to the present. It considers all cash flows generated by the company, including those related to debt financing.
- EVA-Based Valuation: Focuses on discounting future EVA, which represents the value created for shareholders after accounting for the cost of capital. It emphasizes the economic profit generated by the company.
In practice, EVA-based valuation can provide similar results to DCF analysis, especially for companies with stable and predictable cash flows. However, it’s important to note that EVA-based valuation is more sensitive to the accuracy of the cost of capital estimation and the stability of future EVA.
Case Studies and Examples
Several case studies demonstrate the application of EVA-based valuation. For instance, a study by Stern Stewart & Co. analyzed the performance of companies in the S&P 500 index. The study found that companies with higher EVA consistently outperformed those with lower EVA, suggesting a strong correlation between EVA and shareholder value creation.
Another example is the valuation of a technology company with a high growth rate. While DCF analysis might struggle to accurately predict future cash flows, EVA-based valuation can provide a more reliable estimate by focusing on the economic profit generated by the company’s innovative products and services.
Limitations of EVA-Based Valuation
Despite its potential benefits, EVA-based valuation has certain limitations:
- Sensitivity to Cost of Capital: As mentioned earlier, EVA-based valuation is highly sensitive to the accuracy of the cost of capital estimation. Errors in cost of capital can significantly impact the valuation.
- Difficulty in Predicting Future EVA: Predicting future EVA can be challenging, especially for companies operating in dynamic industries with unpredictable growth prospects.
- Accounting Practices: Variations in accounting practices across companies can make it difficult to compare EVA across different firms.
Conclusion
Valuing companies by calculating the present value of EVA can be a valuable tool, especially for companies with stable and predictable cash flows. However, it’s crucial to acknowledge the necessary hypotheses and limitations associated with this approach. EVA-based valuation should be used in conjunction with other valuation methods, such as DCF analysis, to provide a comprehensive assessment of a company’s intrinsic value.
Ultimately, the choice of valuation method depends on the specific characteristics of the company and the objectives of the analysis. By understanding the strengths and weaknesses of different approaches, investors and analysts can make informed decisions about the value of companies.