Management: Great Expectations - A Reality Check [Pg.1]

MANAGEMENT
Great Expectations
-A Reality Check

As a follow up to the second BT-Stern Stewart ranking of Indian companies' shareholder wealth creation performance, Tejpavan Gandhok and Sanjay Kulkarni of Stern Stewart discuss how the Economic Value Added (EVA)/ Market Value Added (MVA) framework provides a way of understanding future growth expectations embedded in market valuations-an analysis that is useful both for the savvy, long-term investor as a reality check on market valuations, as well as for CEOs in charting their companies' growth plans.

The hypothesis that we put forward in India's Biggest Wealth Creators (BT, March 6, 2001), ''The Indian Capital Markets are as value driven as other leading markets,'' stands vindicated. The Indian stockmarkets in the long run are indeed driven by fundamentals, even though the short-term peaks and troughs may cause the lay investor to think otherwise. With the benefit of hindsight, market valuations during the hey days of March last year did appear to be overly optimistic. Most 'new economy' stocks were clearly overvalued while some of the 'old economy' stocks were taking a beating.

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Take a look at Wipro's valuation: in March 2000, its average share price was about Rs 6,000, and its market value (sum of the market value of its equity and the market value of its debt) was about Rs 1,38,000 crore. This valuation implied less than 1 per cent tangible operating value; in other words 99 per cent of its value came from future growth expectations over and above the existing operating value. To justify this lofty valuation, Wipro, with its annual economic profits (EVA) of around Rs 118 crore, would have to generate growth in EVA of nearly Rs 3,000 crore each year-forever.

To put things in perspective, this would mean generating an EVA growth equal to the annual EVA of a half-a-dozen Hindustan Levers (the highest EVA company in India, with Rs 570 crore) or that of an Oracle (EVA of $600million) every year into perpetuity. Clearly, these were exceedingly optimistic valuations. Indeed, since then the markets, especially TMT stocks, have taken a correction. Wipro's average share price for the month of April 2001, was about Rs 1,230 crore, and its market value about Rs 27,000 crore.

Do we make these observations on mere hindsight or is there any rigorous analysis to help us make a reality check? In this article we propose a framework that can assist investors in doing such a reality check by teasing out the growth expectations embedded in valuations.

New Metrics

We at Stern Stewart developed the EVA/MVA Framework to better guide companies in their shareholder wealth creation efforts. This framework fundamentally rests on the principle that companies are supposed to take financial capital from investors and make it worth more. This premise is as basic as the principle of capitalism can get. However, unfortunately in the real world-especially in the Indian economy-it seems to be forgotten with alarming regularity. Most people tend to focus far too much on size and income/earning-based metrics such as share price, earnings and earnings growth, without taking into account how much additional capital has been poured into the business to generate the income.

To facilitate businesses to achieve an appropriate balance between size and efficiency, we advocate looking at Market Value Added (MVA) and Economic Value Added (EVA). MVA, as the name suggests, is the difference between the capital put into the business and the value of the business today. It reveals how much wealth has been created or destroyed by a company. EVA tells us how much shareholder wealth the business has created or destroyed in a given time period. EVA mimics MVA at a micro level within a company. Simply defined, EVA is the economic profit that remains after deducting the cost of all the capital employed (both debt and equity) in the business to generate the operating profits. (See Defining EVA) The power of EVA comes from the fact that it marries both the income statement and the balancesheet, and reflects the economic reality after eliminating accounting distortions.

EVA analysis provides insight into a company's most recent historical shareholder wealth creation performance. However, for the purpose of assessing the valuation of a company, one would ideally like to know its performance in the future. In the medium to long run, capital markets do get the right linkage between a company's valuation and its fundamental business performance. However, in the short run, the markets swing between optimism and pessimism. Over the past few years, the pendulum seems to have swung too far to either extreme of pessimism and optimism. How can investors spot either extreme? Unfortunately, neither MVA, nor EVA-and for that matter any other known financial measure-can answer that question with absolute certainty. However, we can use the EVA/MVA framework for assessing whether a valuation is half way sensible or absolutely crazy. This type of analysis also has useful implications for the corporate captains to better understand their shareholders' expectations and chart their growth strategies and stretch goals accordingly.

Forecasting The Future

We begin by asking what would a company be worth if it continues to generate the current level of operating economic profits (EVA) forever in the future. That steady stream of future EVAs is discounted back to today's terms at the company's cost of capital (the blended cost for both debt and equity). To this we add the total economic capital employed in the business. This reflects the value from the current operations or the Current Operating Value (COV). For example, if Hindustan Lever could chug along at its EVA of around Rs 570 crore forever, the perpetuity value of its economic profits would be around Rs 3,300 crore (its blended cost of capital is about 17 per cent). The economic book capital is around Rs 3,070 crore. Thus, its Current Operating Value (COV) is Rs 6,370 crore. However, the company is recently valued (based on average share price for the month of April, 2001) at about Rs 47,500 crore. The difference between the Market Value (MV) and the COV is the value that reflects the future growth expectations.

We term this as the Future Growth Value (FGV). The FGV for HLL is Rs 41,130 crore. (See HLL's FGV Analysis). FGV as a percentage of MV (FGV/MV) is a good metric to compare the future growth expectations across companies. In this case it is about 86 per cent.

The FGV/MV metric is better than the traditional PE multiple and market-to-book ratio, as it helps bring out investors' growth expectations embedded in a valuation far more explicitly.

The FGV to MV percentage varies by industry sector and depends on investors' future expectations.

We did an analysis of the Indian companies and our research shows that the IT, FMCG, and the pharmaceuticals sectors have a high FGV/MV, while the consumer durables and automobile sectors have low FGV/MV. (See Sectoral Analysis of FGV/MV).

Conceptually it makes sense that these sectors have high expectations because the market valuations are based on high growth rates for IT companies, enduring brand franchise in the FMCG sector, and the future drug development pipeline for the pharmaceuticals sector.

The sectors with a low FGV/MV still do have future value growth expectations. These capital-intensive sectors have historically had negative EVAs, and the investors are punting on the expectation that their management will be able to eventually make these businesses earn less negative EVAs (show some improvement in performance) as the supply-demand imbalances improve.

This picture of sectoral value growth expectations in India is similar to other economies, except that in the US the pharmaceuticals sector usually has a higher FGV/MV than the FMCG sector. This is because, one, the higher expectations of the Indian FMCG sector due to the promise of increased penetration in the rural segment and two, the Indian pharmaceuticals sector has a relatively smaller new drug pipeline.

We also analysed individual companies in it and the FMCG sector and our research shows some interesting observations.

FMCGs: Touching The Intangible

The FGV/MV metric is considerably high for the Indian FMCG sector. When we dig a little deeper, we find that there is a wide variation of value growth expectations within the sector.

The FGV/MV framework accommodates valuation differences across individual firms within a sector. These differences in investor expectations can be due to a company's superior intangibles such as intellectual property/brand value, the time frames for which a player can hope to achieve superior returns, and the flexibility value of real options that management has up its sleeve to accelerate or abandon investments as the company gains knowledge in previously uncharted waters in the fast paced, uncertain, yet ever changing world. For example, HLL's relative superior ability to foray into new product and service categories is reflected in its higher valuation. A company's operating performance track-record can be another significant factor for valuation differences. The consistent EVA improvement performance of HLL as against the fluctuating performance of Balsara is reflected in their FGV/MV.

Charting The Growth Plans

The COV-FGV framework can help a long-term investor make reality checks about the valuations of companies, but the real power of this tool gets unleashed when companies use it to make strategic plans. If a company is developing strategic plans to achieve a higher share price that is justified through increasing its MVA, not simply by investing more capital in value destroying projects. And it should be. Then, the top management of the company should use this framework to better understand the market expectations embedded in their valuation and make plans to at least meet, ideally beat, these expectations.

Let us illustrate this using the example of Punjab Tractors. Punjab Tractors has been consistently generating positive EVA and more importantly consistently improving its EVA historically. The markets have taken due cognisance of the company's fundamental value creation ability. The recent market value (as of April, 2001) is about Rs 1,210 crore. The company has a COV of Rs 738 crore and this means the company has a FGV of Rs 472 crore. (See FGV Analysis For Punjab Tractors).

What does all of this analysis mean to the management of the firm? One potential interpretation, to justify this valuation is that Punjab Tractors needs to grow its EVA by about Rs 13 crore every year.

The corporate chieftains can use such analysis and chart their growth strategies and stretch goals accordingly. The key drivers to enhance COV are the return on capital employed, capital growth, and the cost of capital. Enhancing FGV involves managing the ''knowledge capital''/intangible assets (such as brands, patents, R&D capability, human capital) and the flexibility value of real options that the organisation can unlock in the future.

The message that we want to deliver is that in order to maximise shareholder wealth it is very important for the company to manage not just its COV but also to take adequate measures to enhance the FGV.

Tejpavan Gandhok is Country Manager, and
Sanjay Kulkarni an Associate with Stern Stewart India. (www.eva.com)
(EVA, COV and FGV are registered trademarks of Stern Stewart & Co.)

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