GREG ROBERTS’ ON THE MONEY: ‘Economic value added’ stock analysis

  • Posted: Sunday, May 26, 2013 9:08 a.m.

I was perusing the latest edition of Fortune Magazine, checking out the latest Fortune 500 listings, when I stumbled across a terrific article by Scott Cendrowski.

This article centered around a different take on stock analysis: Economic Value Added.

This technique examines the market value of a company, defined as the total value of the firm’s debt and equity capital at market prices. Or simply stated, it is what it would cost to buy the business, debt and rent free, and free of excess cash.

Next this method examines the business’ capital, which is defined as the corresponding investment in the firm’s net business assets, including rented assets – covering working capital, net PP&E, investments in intangibles, investments at equity and cost, goodwill and miscellaneous assets – but net of excess cash, so that the measures correspond.

The Market Value Added is simply the difference between the two.

To increase MVA and add to owner wealth, the firm’s market value must increase by more than the additional capital that is contributed to the business or retained by the business.

Going one step further, the economic value added calibrates economic profit after deducting a full cost of capital charge on the firm’s net business assets (and after correcting accounting distortions).

It does not begin to count profit until shareholders have earned a minimum risk-adjusted return.

It increases when wasteful costs are cut, when assets turn faster and capital is freed, and when management invests in growth above the cost of the capital.

It measures all the ways in which performance can be improved and wealth created.

According to this article, this methodology is the purest analytical tool for determining a company’s effectiveness in turning a dollar of capital into a dollar of profit.

Over the past five years, the company that led the EVA rankings was Apple, which rang up an EVA growth of 22.1 percent, based on 2007 sales.

Contrast that performance with a median EVA growth rate of 0.3 percent over the same period for the entire Fortune 500.

Interestingly enough, the travel site Priceline.com came in second, while Google was also in the top ten.

If there is a shortcoming with this sort of analysis, it is that with interest rates being so depressed, the cost of capital for every company is at all-time lows, and this phenomenon dilutes the effectiveness of the EVA method.

If and when interest rates rise, the cost of capital for the best companies will be less than it will for lighter weight companies and the value of the method will be enhanced.

You might want to take a look at the website www.evadimensions.com, and you can plug in your favorite stock to see how it stacks up under the scrutiny of this technique.

Craig Sterling, the head of EVA Dimensions global equity research recently stated that his firm is recommending Starwood Hotels.

Sterling believes that this company is a much better value compared to other hotel operators.

Deere is another of their favorites, since the stock price has not risen in synch with the company’s profit potential, and Sterling feels that the profit cycle for machinery manufacturers is still robust.

One of the demographic groups that will be called upon to shoulder a disproportionate share of the cost of The Affordable Care Act (Obamacare) going forward is those individuals who are under age 30 and not covered by their parents’ plan.

Their response, certainly through 2016, will undoubtedly be to not purchase any health care coverage at all, opting instead to pay the annual penalty which will go up to only $695 in 2016.

This penalty will be thousands less than the cost of medical coverage, and if I were a member of this group, I would opt for the penalty and pay any health care costs out of my own pocket.

Got a financial planning question for Greg? You may email him at greg@lifesolutionsonline.net.

Greg Roberts is a certified financial planner with 35 years of financial and estate planning experience.

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