Valuing Operating Assets in Place and Computing Economic Value Added

By Nancy L. Beneda

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This article illustrates the computation of EVA, ROIC, and MVA for Toll Brothers, Inc., a company in the home-building industry, which is generally characterized as having a high volatility of investment needs. The company is of average size for the industry, with a market capitalization of $1,742 million. Typical of the industry, the company exhibits relatively sporadic growth, but has maintained an average annual revenue growth of 18% over the last five years.

Economic Value Added and Measuring Operating Assets in Place

Economic value added. A body of literature on EVA has emerged over the past decade. EVA is a measure of residual income, which focuses on the concept that a company must earn an adequate risk-adjusted return on its investment in assets. EVA is a measure of the income from a company’s operations that exceeds the risk-adjusted cost of the investment. Thus, if EVA is zero, a company is earning a return from operations just sufficient to pay investors their required return for risk. A negative EVA indicates that a company is not earning a return sufficient to reward investors for the risk. The risk-adjusted required return is the capital charge for both debt and equity. EVA is calculated as follows (Formula 1):

EVA = (NOPAT – WACC) x Operating Assets in Place

NOPAT is the net operating profit after taxes. WACC is the weighted average cost of capital. Operating assets in place represents the amount of capital invested in the company’s existing operating assets.

When estimating EVA, measuring the amount of capital invested in the company’s existing operating assets is often problematic. Operating invested capital represents the company’s investment in operating assets less its operating liabilities. This generally includes cash, accounts receivable, inventory, prepaid expenses, net property plant and equipment, and intangibles, minus accounts payable, accrued expenses, and taxes payable.

Measuring operating assets in place. Investment theory suggests that the acceptable return of an investment project should be greater than the risk-adjusted return required by the investors. Alternatively, the present value of the expected cash flows of the investment project, discounted at the required risk-adjusted return, should be greater than the cost of investing in the project. Investment theory further suggests that the investment in the project should reflect the current value of the assets required to undertake the project. Consistent with investment theory, EVA focuses on the excess value that is created from the company’s operating investments. It would seem that an appropriate measure of operating assets in place would be the current replacement value of those assets. This article assumes that the replacement value equals the amount that the highest-valued user would pay for the asset. This amount might also be called opportunity cost.

The idea that a replacement valuation (i.e., opportunity cost or market value) should be used to measure operating assets for computing EVA can be illustrated with a simple example. Assume a $100 investment in a savings account that earns 8% compounded annually. After five years, the value of the investment should have grown to $146.93. For the investment to continue earning 8% in the sixth year, the return should be based on $146.93, rather than the historical value of $100. The true investment in an asset at the end of a time period should include the increase in value over previous time periods as part of the replacement value.

Put another way, the capital invested in the company’s assets in place represents the capital that would be needed to reacquire those assets. A difference between the replacement value and the book value of operating assets can arise as a result of accretion in value, obsolescence of assets, and depreciation. Accretion in value most commonly occurs with real estate, mineral reserves, and intangible assets such as research and development, patents, and managerial capabilities. Assets that can become obsolete include production lines and employee talent in high-tech industries. Depreciation occurs as the asset’s value declines from use. Thus, it is appropriate to adjust the book value of operating assets to a replacement value to reflect the changes in valuation which can occur over time. The replacement value represents an opportunity cost of the invested funds, because one could conceivably liquidate the assets in place and reinvest the funds in another company or project, and earn a similar return on that investment.

Measuring Book Value

Estimating the replacement value of operating assets in place can be complex, especially for companies with a large quantity of intangible assets, such as patents, research and development, managerial capability, and employee talent. Furthermore, measuring the value of intangible assets can be more complex for firms that are experiencing rapid growth. Many textbook examples rely on book value as a proxy for the replacement value of operating assets, which is not surprising considering the complexity of measuring the value of, or the change in value of, intangible assets.

If the book value of the assets is significantly less than their current replacement value, however, the opportunity cost of the investment in the company’s assets will be significantly understated and EVA will be significantly overstated. Incorrect conclusions may be drawn from these misstated indicators.

The book value of operating assets is relatively easy to determine because accounting guidelines require the use of historical accounting for financial statement reporting. Although additional accounting disclosures and reporting, regarding the replacement (i.e., market) value for certain items (e.g., marketable securities, inventories) is sometimes required, the treatment is not consistent across all reported assets.

Methodology

When addressing the issue of valuing a company’s operating assets in place, it is helpful to envision the components of the total value of the company’s operations. Consistent with finance theory, the total value of a company’s operations is the present value of the firm’s future expected free cash flows from the existing operating assets in place, as well as the net present value of expected future growth.

The first component can be further separated into two elements: the replacement value of assets in place, and the expected future EVA of the existing operating assets in place. This can be restated as follows (Formula 2):

Total Value of Operations = Replacement Value of Operating Assets in Place + Expected Future EVA from Operating Assets in Place + Expected Future EVA from Future Growth

In this formula, the replacement value of operating assets in place is the same value that should be used in the EVA formulation. Expected future EVA comes from both the operating assets in place and future growth.

The current value of expected future EVA depends upon the difference between the expected ROIC and the risk-adjusted return required by the investors. The significance of this is that if ROIC is less than the risk-adjusted required return, taking on new projects will reduce the value of the operating assets in place over time.

Because book value is primarily used as a proxy for the replacement value of operating assets in place in the computation of future EVA, it is helpful to envision how book value fits into this formulation. As discussed above, the replacement value and the book value of operating assets differ as a result of accretion in value, obsolescence of assets, and depreciation. Thus, the expression above can be further restated as follows (Formula 3):

Total Value of Operations = Book Value of Operating Assets in Place + Excess Replacement Value over Book Value of Operating Assets in Place + Expected Future EVA from Operating Assets in Place + Expected Future EVA from Future Growth

The second component in this formula represents the difference between the replacement value of the operating assets in place and their book value.

Case Study

Two years of income statements and balance sheets for Toll Brothers were used and are shown in the Appendix.

Book value of operating assets in place. The book value of operating assets in place is computed for Toll Brothers for 2001 and 2002. Exhibit 1, Panel A, presents the book value of the operating working capital; Panel B presents the book value of operating invested capital, including long-term operating assets. The book value of the company’s total assets, which includes nonoperating assets, is also presented.

VBM requires that operating assets be reported separately from nonoperating assets. This is useful because companies can influence the value of their operating assets, but the value of nonoperating assets may be largely out of their direct control. Assets not used in the company’s operations can include investments in equity securities, idle land, or buildings held for future use. Operating invested capital plus any nonoperating assets represents the total amount invested by the company’s investors.

The new investment in the operating assets in place consists of any after-tax operating income that is reinvested, plus any new external debt or equity funding that is invested in new operating assets. This amount appears on financial statements as the current change in the book values of the operating assets. Current expenditures on research and development might not be reflected in the required reporting of financial statements. New investment in operating assets for the year ended October 31, 2002, is reported in Exhibit 1, Panel C.

Replacement value of operating assets in place. Exhibit 2 presents the book value and excess replacement value over book value for operating assets in place (Formula 3), for the years ended October 31, 2001, and 2002. It is assumed in this example that the excess replacement value over book value is $34 million as of October 31, 2001, and increases to $173 million as of October 31, 2002. The excess replacement value over book value in this case might be attributable to investors’ and market participants’ perception that the value of managerial capability and real estate has increased over the period. Estimating the replacement cost of operating assets in place requires some element of judgment; however, if an analyst has knowledge about industry conditions, a realistic estimate can generally be found.

Economic value added. Exhibit 3 presents the computation of EVA, which assumes that the replacement value of operating assets in place as of October 31, 2001, is $2,009 million. EVA measures how well the company has used investors’ funds and reflects the performance of the company in terms of the opportunity cost of its investment in the assets.

Exhibit 3, Panel B, illustrates how EVA fits in with valuation. The EVA for a specified period is generally reinvested in the company’s operations in the same period earned. Using Formula 3, and assuming no equity dividend payouts, the EVA is a component of the investment in new operating assets in place for the current period.

Total value of firm operations: EVA approach. As illustrated in the development of Formula 3, the total value of a company’s operations consists of the present value of the firm’s future expected free cash flows from the existing operating assets in place and the current value (i.e., NPV) of expected future growth. The expected future EVA from existing operating assets in place (the third component in Formula 3) is presented in Exhibit 4, Panel A. It is calculated from the expected annual EVA from existing assets, discounted at the WACC, less the amount invested. Formula A2-1 from Exhibit 5 is used for the computation. This formula assumes that the periodic EVA on the existing assets is earned in perpetuity.

The expected future EVA from future growth is also presented in Exhibit 4, Panel A. This amount is equal to the expected annual EVA from future growth, discounted in perpetuity at the WACC. Formula A2-2 from Exhibit 5 is used for this computation.

The marginal ROIC is used in formulas A2-1 andA2-2. The marginal ROIC is the return on capital earned on the new investment rather than the average overall return on capital. This concept is important because generally when a company invests in its operations, it accepts the best projects first, followed by increasingly less profitable projects. Theoretically, all projects whose returns are greater than the cost of capital should be accepted, whereupon the marginal ROIC should equal the cost of capital.

To illustrate the significance of marginal ROIC, consider a company with an average return on capital of 18% and a cost of capital of 12%. If the company is earning only 11% on marginal projects, taking on these projects would reduce company wealth. Thus, large increases in reinvestment do not mean a constant return on capital.

The hypothetical rates used for WACC, ROIC, and marginal return on new investments are 11.2%, 12.9%, and 11.9%, respectively. The WACC used is obtained from Damodaran’s industry cost of capital database (www.wiley.com/college/damodaran/). The expected future ROIC of 11.9% is an average of the ROICs computed for the previous two years, 2001 and 2002. In this example, 11.9% is assumed for the marginal return on invested capital. The marginal return from future investments should be expected to be lower than the marginal return on new investments.

Total value of firm operations: Stock valuation approach. Exhibit 4, Panel B, presents the total value of the company’s operations for the two years ending October 31, 2001, and 2002. Book value of debt is used as a proxy for stock-market value of debt. Stock prices per share as of October 31, 2001, and 2002, are multiplied by the number of shares outstanding on these dates to compute the market values of equity. Nonoperating assets are subtracted from total firm value for each year to compute the total value of the company’s operations on these dates.

ROIC and MVA. VBM typically includes computations of ROIC and MVA, in addition to the computation of EVA. Exhibit 6 presents the computation of ROIC (Panel A) and MVA (Panel B). ROIC is computed as after-tax operating income divided by the beginning replacement value of operating assets in place (as of October 31, 2001).

MVA focuses on the difference between the book value of operating assets in place and the total value of the firm’s operations. In analyzing MVA, it is helpful to examine how it is different from EVA and ROIC. EVA and ROIC focus on measuring the creation of value from operations as part of the periodic change in the value of operating invested assets in place. MVA, however, is a measure of the difference between the book value of a company’s assets in place and the overall value of the firm’s operations. When using MVA, therefore, one is interested in a measure of expected future EVA from existing assets and future growth, as well as the value of the assets in place.

When computing changes to the value of operating assets in place, the value of future growth is excluded from the analysis. Valuing just the company’s operating assets in place does not include valuing future growth potential. If the focus is on the periodic incremental value to the company’s operations overall, then a valuation of future growth is required, as well as a valuation of assets in place.