It's easy to forget that every investment decision comes at a price the other ways in which you could have used your money. For example, if you choose to buy shares, then you are sacrificing the chance to put the same money to work in a bank account, a government bond, corporate bond or even at the racetrack.
The fact that few investors pay attention to this 'opportunity cost' allows many company directors to get away with murder. They proudly cite the returns from projects or acquisitions that a firm has undertaken, with no mention of what those cost in terms of the debt and equity capital committed.
The measure 'economic value added' (EVA) tries to correct this. As Jen-Ai Chua and Amar Gill of broker CLSA put it, "companies create positive economic value only if they generate returns on capital in excess of cost of capital". Such firms are "value creators". Companies for whom the reverse is true are "value destroyers". So how is EVAmeasured?
Subscribe to MoneyWeek
Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE
What is EVA?
The best firms are those where the 'return on invested capital' (ROIC), say 10%, exceeds the weighted average cost of its capital (WACC see below), say 5%.
To calculate ROIC, take net operating profit after tax (NOPAT) and divide it by a firm's tangible capital employed (so intangibles such as goodwill are taken out). The bigger the gap, or 'spread', between ROIC and WACC in this case 5% the better. That's fine, but a percentage tells you nothing about scale.
If I borrow £1 at an interest rate of 1% and invest it to earn 20%, ROIC, ignoring tax, exceeds my WACC by a solid 19%. But unless I can repeat the same trick for a much larger sum, it'll be a long time before I am rich.
So another way to measure EVA is to take a firm's NOPAT, say £100m, and deduct a charge to reflect the cost of capital (say £60m) to give an absolute number in this case £40m. Big is better. A small, or negative, figure is bad news.
Another problem with EVA is you need to do some number crunching you won't find the numbers you need in the published accounts. But CLSA reckons it's well worth the effort.
How well does EVA work?
CLSA has tested investment strategies based on buying the top stocks in terms of ROIC, against the results achieved using various other common valuation measures over the last ten years (see the chart). These include the dividend yield, price/book ratio, earnings yield (the p/e ratio flipped on its head), and free cash flow yield (annual cash flow after deducting non-discretionary payments, divided by the share price). The benchmark used was the MSCI Asia ex-Japan index, which managed a compound return of just 2.8%.
The result? Well, as CLSA notes, high ROIC companies, especially when backed by a high EBIT/EV ratio (operating profit divided by the market value of debt and equity), had "the strongest returns of our valuation screens and were also the most consistent outperformers". Indeed, high ROIC firms managed a compound return of around 20% over the past ten years.
So, what to buy?
Despite a heady rise for Asian stockmarkets this year, the gap between ROIC and WACC is still highest in China (6%) and India (also 6%). Indonesia also does well on 5%. Markets to avoid, where EVA is close to zero, or negative, include Hong Kong, Korea and Malaysia. In sector terms, CLSA likes technology- or energy-related stocks. These offer average EVA spreads of 5% or more. Property and transport, on the other hand, are largely duds. Try Australian telecoms firm Telstra (ASX: TLS), Taiwan's Chungwa Telecoms (NYSE: CHT) and China Mobile (HK: 0941).
How to calculate cost of capital
Most firms have two types of capital debt and equity. The cost of debt is fairly simple the interest rate multiplied by (1 minus the firms' corporation tax rate). This adjustment reflects the fact that interest payments are tax deductible. So if the interest rate is 8% and the firm's tax rate 30%, the cost of debt is 5.6% (8% x 0.7). Next, cost of equity. Here analysts start with the risk-free rate available on a five or ten-year government bond on the basis that this is the minimum return an investor should demand. This is then adjusted higher by an equity risk premium. This is the extra return that a shareholder should want given that a firm may not pay a dividend, or could go bust. So, if the risk free rate is 5%, and the equity risk premium 6%, the cost of equity is 11%.
Finally, if a firm is 60% equity funded and 40% debt funded, the weighted average cost of capital is (0.6 x 11%) + (0.4 x 5.6%), which equals 8.84%. If the firm's management can't generate a ROIC that beats this hurdle rate, the firm is a "value destroyer".
Tim graduated with a history degree from Cambridge University in 1989 and, after a year of travelling, joined the financial services firm Ernst and Young in 1990, qualifying as a chartered accountant in 1994.
He then moved into financial markets training, designing and running a variety of courses at graduate level and beyond for a range of organisations including the Securities and Investment Institute and UBS. He joined MoneyWeek in 2007.
10 vinyl records worth up to £10,000 - is one in your collection?
News Vinyl is experiencing a resurgence and collectors will pay up to £10,000 for some albums - is it time to dust off your old records?
By Marc Shoffman Published
FCA: Banks are still short-changing savers
The latest FCA review finds that while public shaming has encouraged providers into offering better deals on savings, many of those with closed accounts are still being shortchanged.
By John Fitzsimons Published