- Economic Value Added or EVA is the value created in excess of the required return of the company's investors.
- Return on invested capital or ROIC, weighted average cost of capital or WACC are important parameters in calculating EVA.
- While EVA is a good measure for checking investment worthiness, it cannot be used as the only filter.
We, at Amigobulls, believe that identifying value stocks is the core of stock analysis. One of the most important tools for a value investor is economic value added (EVA), a term widely used but rarely understood.
Following our recent articles on WACC (weighted average cost of capital) and ROIC (return on invested capital), we shall focus on ‘Economic value added (EVA)’ and its implications for an investor.
The term ‘value’ could hold a different meaning for different stakeholders. While an equity investor derives value from increase in stock price and dividends received, bond holders derive value from the consistent interest receipts and eventual payback of principal amount. The various stakeholders derive value only when the firm generates value in an equitable manner, considering the interests of all stakeholders.
While every company claims all its actions are aimed at creating value for its stakeholders, in the absence of any quantitative measure of value, we are often left wondering what really creates value and how do we measure it. Stern Stewart and co. nailed this problem by developing the concept of EVA (Economic Value Added), which attempts to measure the economic value created by a firm.
EVA is defined as the residual value of a firm’s wealth (profits), which is left after deducting the cost of capital employed by the firm. In short,
EVA (Economic value added) = ROIC (Return on invested capital) – WACC (Weighted average cost of capital)
Having read our previous articles on return on invested capital or ROIC, and weighted average cost of capital or WACC, we hope the concept of EVA will be easy to understand. We would prefer you read our preceding articles on the above topics in order to effectively understand the EVA.
Implications of EVA
Once we have the ROIC as well as the WACC, the calculation of the EVA is pretty straightforward. However it is the interpretation of the calculated numbers, which is significant. There can be three possible scenarios when comparing the ROIC and WACC:
ROIC > WACC
In case of ROIC > WACC, the firm is creating value and growth would imply better than expected future returns, hence reinvestment into the firm will create more wealth than returning money to shareholders.
ROIC = WACC
In case of ROIC = WACC, growth or no growth does not make any difference to the shareholder’s as their Cost of Capital is equal to the company’s ROIC and as there will be no EV added, the company will not be able to generate wealth over time.
ROIC < WACC
The third case of ROIC < WACC is a dangerous case which, if accompanied by a good rate of growth leads to substantial loss of wealth and losses for stakeholders in the long term. The faster the growth rate, the faster is the destruction of wealth.
Therefore an investor would do well to compare the ROIC of a firm against its WACC and make investments into firms with the highest EVA and avoid firms with negative EVA. EVA is by far the most accurate measure of a firm’s ability to generate wealth and create value over time. The internet bubble of 1999 was a case of fast growing internet companies which sadly had little or no returns, resulting in destruction of investor wealth.
Priceline EVA calculation
Now we calculate the EVA of Priceline (PCLN) using the formula discussed above. We shall calculate the ROIC and WACC for the company before calculating its EVA.
Table below shows Priceline’s ROIC calculation.
|In millions of $, except percentages||2012-12||2013-03||2013-06||2013-09|
|Cash & Cash Equivalents||5183.2||5181.6||5945.1||6583.6|
|Non-Interest bearing Current Liabilities||941.38||1079.11||1239.23||1287.58|
|Income after Tax||289.59||244.29||437.44||832.99|
|ROIC or Return on Invested Capital||119%|
It can be seen that Priceline has a highly efficient business model, which is reflected in its ROIC of 119%. Let’s now calculate Priceline’s WACC.
|Cost of Debt (Interest/Debt)||4.1%|
|After Cost of Debt [Cost of Debt*(1 - Tax Rate)]||3.38%|
|Risk free rate of return (10 year US treasury bond yield)||2.99%|
|Market rate of return (10 year Nasdaq returns)||7.73%|
|Cost of Equity||8.77%|
According to our calculation, the WACC for Priceline comes to 7.35%. This compares against the ROIC of 119% and hence the firm creates significant wealth for its stakeholders. The EVA rate is 111.65% (119% - 7.35%). The dollar value of EVA is equal to $ 1757.71 (EVA rate * Invested capital) million on an invested capital base of $1574.3 million over the last twelve months. The high ROIC of the firm coupled with the value created has also resulted in consistently high returns to the shareholders of Priceline. This is reflected in the fast appreciating stock price of the company with year-to-date gains of 85.8%.
EVA is a significant number to determine good investments, but it cannot be the only filter for your financing decisions and investors will do well to compare EVA against the other fundamental metrics of a firm before making an investment decision. We evaluate stocks through more than 50 fundamental checkpoints to arrive at our top stock picks.
To see Priceline’s latest stock price movement, click here Priceline (PCLN)