How Companies Create Value, the EVA Way

If you have been a reader of Prof. Sanjay Bakshi’s blog, you know how he has laid open his classes for non-students like us. He is doing this by way of sharing the transcripts of his lectures at this year’s classes in MDI, Gurgaon.

So in his latest post, he shared the assignment that he has given his students – that of analyzing the business of Relaxo Footwear.

In the initial part of the assignment, he mentions the concept of “economic profit”, which seems like a difficult term to understand for many investors, as we have grown up on a dose of accounting profits – profits that are reported in the financial statements.

In this post, I try to explain the concept of “economic profit” * and its relevance in assessing a company’s true value creation.

* While Prof. Bakshi has indicated that he uses Buffett’s definition of “owner earnings” when he talks about economic profit, what follows below is another way to look at a company’s economic profit, which assesses its true value creation.

Economic Profit
The concept of ‘economic profit’ dates to at least 1890, when economist Alfred Marshall wrote…

“What remains of his (the owner’s or manager’s) profits after deducting interest on his capital at the current rate may be called his earnings of undertaking or management.”

Marshall effectively said that the value created by a company during any time period (its economic earning) must take into account not only the expenses recorded in its accounting records but also the opportunity cost of the capital employed in the business.

Economic profit is a great tool to measure a company’s true performance in any single year, as against free cash flows (FCF) that helps measure the performance over a period of years (and can be negative in a given year due to high spending on fixed assets or working capital).

So a management can improve FCF in a given year at the expense of long-term value creation by simply delaying investments.

In the book Valuation: Measuring and Managing the Value of Companies, the authors write…

Economic profit is an important measure because it combines size and ROIC into a single result. Too often companies focus on either size (often measured by earnings) or ROIC. Focusing on size (say earnings or earnings growth) could destroy value if returns on capital are too low. Conversely, a high ROIC on a low capital base may mean missed opportunities.

How to Calculate Economic Profit
Method 1: Economic profit, which is a generic term synonymous with Stern Stewart’s metric called EVA or Economic Value Added, can be calculated using this formula…

Here, Invested Capital = Equity + Debt – Cash (we reduce cash, because cash just lies in the business but is not invested in the business)

NOPAT = EBIT – Tax = (Sales – Operating Expenses – Depreciation) x (1 – Tax Rate)

WACC or Weighted Average Cost of Capital = (Weightage of Debt x Cost of Debt) + (Weightage of Equity x Cost of Equity)

Now, how is this different from the reported or accounting profit?

While Accounting Net Profit = EBIT – Interest – Tax

Economic Profit = EBIT – Tax – Capital charge

Here, Capital charge = WACC x Invested Capital

Effectively, while accounting profit charges only for the cost of debt (interest), economic profit charges for the use of all capital, including cost of equity.

Let me pull out some numbers from Relaxo’s FY13 balance sheet and calculate its economic profit using the formula shown above (all numbers in Rs million)…

NOPAT = EBIT x (1 – Tax Rate) = 843 x (1 – 34%) = 558

Invested Capital = Equity + Debt – Cash = 1,724 + 1,455 – 10 = 3,169 (I have used the figure as at the beginning of the year, and thus this is FY12’s Invested Capital)

WACC = (Weightage of Debt x Cost of Debt) + (Weightage of Equity x Cost of Equity) = (49% x 9%) + (51% x 15%) = 4.2% + 7.7% = 11.9%

Here…

• Weightage of Debt or WD = Debt / (Equity + Debt) and Weightage of Equity = 1 – WD
• Cost of Debt = Interest Expense / Debt
• Cost of Equity = Assumed at 15%

Finally, Economic Profit = NOPAT – (Invested Capital x WACC)
= 558 – (3,169 x 11.9%) = Rs 181 million

Method 2: Another way to calculate a company’s economic profit is…

Here, ROIC or Return on Invested Capital = NOPAT / Invested Capital
= 558 / 3,169 = 17.6%

Thus, Economic Profit = 3,169 x (17.6% – 11.9%) = Rs 181 million

Effectively, this formula suggests that Relaxo can increase its economic profit in the future using any of these four levers…

1. ROIC increases (very much likely as Relaxo can raise its product prices or cut its opearting costs, while at the same time not growing its invested capital much as it has already spent a lot on capacity expansion over the past few years – as seen from the cash flow)
2. WACC decreases (which is unlikely unless the company can get better terms for raising funds)
3. Invested capital increases (less likely, for Relaxo has already spent a lot on capacity expansion over the past few years)
4. Invested capital decreases (unlikely, as Relaxo makes good profits on existing capital and would not like to decrease this capital)

The reason we use ROIC (return on invested capital) to calculate economic profit is because it gives the clearest picture of exactly how efficiently a company is using its invested capital, and whether or not its competitive positioning allows it to generate strong returns on that capital.

Management guru Peter Drucker has written…

EVA is based on something we have known for a long time: what we generally call profits, the money left to service equity, is usually not profit at all. Until a business returns a profit that is greater than its cost of capital, it operates at a loss.

Buffett on Economic Profit
Here is what Warren Buffett wrote about the importance of economic profit in his 1982 letter to shareholders…

We prefer a concept of “economic” earnings that includes all undistributed earnings, regardless of ownership percentage. In our view, the value to all owners of the retained earnings of a business enterprise is determined by the effectiveness with which those earnings are used – and not by the size of one’s ownership percentage.

If you have owned 1% of Berkshire during the past decade, you have benefited economically in full measure from your share of our retained earnings, no matter what your accounting system. Proportionately, you have done just as well as if you had owned the magic 20%.

But if you have owned 100% of a great many capital‐intensive businesses during the decade, retained earnings that were credited fully and with painstaking precision to you under standard accounting methods have resulted in minor or zero economic value.

This is not a criticism of accounting procedures. We would not like to have the job of designing a better system. It’s simply to say that managers and investors alike must understand that accounting numbers are the beginning, not the end, of business valuation.

In simpler words, what Buffett is saying here is that instead of the quantum of accounting profit or invested capital, what is more important for an investor to assess is the ROIC the company is earning on this invested capital and the economic profit it is generating in the process.

Overall, economic profit is a great tool to measure the true value creation in a company.

This is because it takes into account the total cost of capital (including the opportunity cost of equity capital) and thus corrects the key deficiency of accounting or reported net profit, which does not incorporate the balance sheet.

Effectively, economic profit clearly recognizes that capital is not free and that a company must earn sustainably more than the cost of capital to justify its growth and to create real value for shareholders.

The goal of economic profit is to answer this question: If a company makes an investment, will it generate profits that outweigh the risk, and truly add value?

As far as Relaxo is concerned, the question that needs to be answered is – For all the expansion the company has made over the past few years, will it generate enough economic profit in the future that would outweigh the risk to the business, and truly add value to its shareholders.

As a potential investor in Relaxo, that’s one question you must try to answer.

Note 1: When you compare Relaxo’s economic profit with the FCF or owner’s earnings, the latter is a negative figure and suggests that while the company seems to be burning more cash than it is generating as of now, this investment will show up in a higher economic profit in the future.

Note 2: When asked his view on Economic Value Added, Charlie Munger once said – “It’s obvious that if a company generates high returns on capital and reinvests at high returns, it will do well. But this wouldn’t sell books, so there’s a lot of twaddle and fuzzy concepts that have been introduced that don’t add much — like cost of capital. It’s accepted because some of it is right, but like psychoanalysis, I don’t think it’s an admirable system in its totality.” 🙂

Now, while Munger may be right about his “twaddle” view on EVA, especially when you use a fuzzy concept like ‘beta’ to calculate the WACC, I believe there’s a merit in studying and understanding the concept of ROIC and how its helps in economic value creation at a company.