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Glossary
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Value of Profitability: It is the
net present value of a company's future EVA plus the economic
capital employed.
Enterprise Value: This is the
market value of equity combined with debt.
Value of Prospects or Future Growth
Value: This is value of profitability minus the enterprise
value.
Wealthflow: The value of profitability
plus the value of prospects minus the cost of equity yields
wealthflow.
Economic Value Added = Net Operating
Profit after Tax - Average Economic Capital * Weighted Average
Cost of Capital
Net Operating Profit after Tax (NOPAT)
= (Profit after Tax+ Non-Recurring Expenses + Revenue Expenditure
on R&D + Interest Expense+Provision for Taxes) - Non-Recurring
Income - R&D Amortisation - Cash Operating Taxes
Economic Capital = Net Fixed
Assets + Capital Work in Progress + Investments + Current
Assets - Non Interest Bearing Current Liabilities + Miscellaneous
Expenditure Written off+ Cumulative Non Recurring Losses +Capitalised
Expenditure on R&D - Revaluation Reserve - Cumulative
Non-Recurring Items
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What is Wealth Added?
Wealth added measures the total wealth flow
over a given period time (cash flows to the investor through increase
in market value of equity, dividends and share buybacks, net of
new equity issuances) over and above the investor's expected return
on the market value of a company's equity. The most logical proxy
for the expected return is the Cost of Equity, which is a function
of the risk profile of the company.
How do you calculate new equity issues?
While considering new equity issues we have
considered all enhancements to the equity shares of the company
including rights issues, GDRs/ADRs, Private Placement etc. For simplicity,
we have assumed that the increase in equity due to stock-based amalgamations
as equal to the increase in the number of shares multiplied by the
closing market price of the share of the acquiring company on the
date of the amalgamation.
What is Cost of Equity?
The Cost of Equity is the average expected
return relative to the stock's risk profile. If a company's returns
do not exceed the cost of equity, it is obvious that shareholders'
capital could have been better invested elsewhere.
For Wealth Added, the required return is the
cost of equity, calculated using the widely accepted Capital Asset
Pricing Model (CAPM). The CAPM formulates that the expected rate
of return on a company's stock is given by:
Re=Rf+B (Rm - Rf)
Where Rf is the return of the risk-free asset,
Rm - Rf is the difference between risk-free return and the average
market return, and beta is the measure of the stock's performance
versus the market.
Is there a catch?
Estimating beta of the company requires considerable
judgment as well as sophisticated analysis. A naïve regression
over the last 60-month period would considerably distort the measurement
of the non-diversifiable risk, due to the boom and bust of the Information
Technology, Media sectors and the Capital Markets in 2000-01.
By ignoring the "bubble" period (between
April 2000 and August 2001) and taking the monthly returns over
a 60-month period (1998-2001), we have computed betas that better
reflect the relative risk of companies.
For purposes of measuring the cost of equity
for the survey, we have factored only the Business Risk of the sector.
Ideally speaking, the risk should factor in the risk that equity
holders' bear at some long-term gearing or leverage. We have chosen
to exclude the impact of gearing on the cost of equity, since considerable
intuition will be required to make a judgment on the long-term gearing
of companies in the sector.
The Cost of Equity over a time period will
be also influenced by changes in risk-free rate and the Market Risk
Premium.
We have used the average annual yield on the
10-year Government security as the proxy for the risk-free rate.
The Market Risk Premium has been estimated at 10 per cent over and
above the risk-free rate for the period 1999 to 2001 and 8 per cent
over the risk-free rate for the period beyond.
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