EVA Issues as a Valuation Framework: Issues Solved By AFG s Economic Margin

Transcription

1 EVA Issues as a Valuation Framework: Issues Solved By AFG s Economic Margin 1

2 EVA as a valuation tool Firm Value = NOPAT + EVA Future * 1 * T c* c* ( 1 + c* ) Existing Assets Future Investments The basic EVA valuation approach is to break a company into two components The value of existing assets and the value of future investments. Furthermore, the EVA approach incorporates the effects of competition through the use of a factor called T which describes how many years into the future the company will generate EVA on its new investments. However, as we look into the structure of this equation it is clear that it does a very poor job modeling reality. For example, the value of existing asset calculation is simply a perpetuity assumption. This assumes that a company will generate its existing level of EVA into perpetuity, which in a competitive environment is unlikely. The second term, which values future investments is simply another form of perpetuity, but it does not begin for T years. So essentially this approach is similar to traditional DCF approaches which rely on terminal values and perpetuities but ultimately do not begin to approach the reality of modeling how the real world tends to work. C* = Company Weighted Average Cost of Capital

3 Why Valuation is under-utilized in Equity Analysis Projects have distinct ending points, Companies do not Modeling the effects of competition is very difficult Perpetuity assumptions drive value

4 Understanding AFG s Valuation Model Joe invests $100 to start a computer business. What is the value of Joe s investment is the business generates $110, $90, and $40 of cash flow over the next three years? $ 110 CF $ 90 CF $ 40 CF 3 Years of cash flow - $ 100 PV CF = $ Computer = $ 100 = $ 105 Note in this traditional discounted cash flow valuation the answer is $105. However, also note that there is no link between the annual performance of the project, and the ultimate value of the project. This decoupling of performance and value leads to numerous potential problems when applying valuation to real world problems. For example if in year 4 Joe can invest another $100 in the business and earn $40 a year for 3 years should he do it? The answer is not very apparent, as traditional DCF does not explicitly link performance and value so we do not know if $40 of annual cash flow creates or destroys value.

5 AFG s Approach: Link Performance to Value Yr 1 Yr 2 Yr 3 + Cash Flow Capital Charge = Economic Profit x PV Factor = Economic Value = 105 Economic Margin = 70% 50% 0% In this example, we see that given an investment with these characteristics, 3 year life, no salvage value, and a 10% required return, the annual cash flow required to generate 0 NPV is $40 a year. Also note, that if you discount the annual economic profit, (cash flow capital charge), the NPV is identical to what we calculated using the traditional DCF approach. AFG s approach is breakthrough in valuation, as it explicitly links how well a firm is performing to what that firm is worth. We can immediately see that $40 is the cash flow that leads to $0 NPV. By linking performance to value, AFG has effectively solved the terminal value (perpetuity), problem that plagues traditional DCF approaches and makes the AFG valuation framework highly effective and useful. Once forecast economic profit equals zero, the value of all future growth is zero, ending unrealistic terminal value assumptions.

6 AFG s Valuation Approach Focuses on Competitive Advantage Periods A cornerstone of AFG s Economic Margin Framework, is realistically incorporating the effects of competition into the valuation process. AFG s research has identified that the market does not pay for perpetuities! After all, a perpetuity is effectively saying that existing relationships and profit levels will remain unchanged forever. Economic Margin AFG has identified four critical company specific factors that have consistently explained the likely time the market will pay for a company s competitive advantage period (CAP). Applying AFG s CAP model results in an outstanding track record explaining the intrinsic value of the majority of publicly traded companies at a given point in time. Rate of Decay DECAY FACTORS Profitability Variability Trend Economic Profit eventually competed away to zero.. Invested Capital Shaded area represents the decrease in the decay factor for firms with greater competitive resistance. Time

7 AFG s Valuation Approach 10% 5% Annual Return Spread for Portfolios based on Under and O ver-valuation versus Entire Universe (3/96-6/03) 8.58% 0% -5% -10% -15% % 25% Under-valued 25% Over-valued Applying AFG s Economic Margin Framework to value companies consistently identifies firms that are trading above and below their true worth. Using this information allows our clients to successfully implement portfolio decisions that outperform the market. Since 1996, model portfolios that consist of the buying the most under valued firms and shorting the most over valued firms has delivered a 2100 basis point spread. Source: AFGView client databases from 4/96 to 06/03 Universe size: 4,000 to 5,500 firms