## EVA-Valuation

The purpose of EVA-Valuation is to measure the total value added of a company´s operations, i.e. the net cash generated in excess of claimholders´ return requirements.

This document describes EVA valuation in detail and in our valuation model. If your would like to get an overview of EVA valuation in general or practical examples (numerical and graphical) about it, then you should look at our EVA valuation tutorial.

The computation of EVA is closely related to DCF. Hence, it starts with EBIT and ends with the fair value of the share. The share price potential (which the investors are interested in) is computed by comparing the fair value with the current market price of the share.

#### The basic formulation of EVA valuation is as follows:

- EVA is computed so that the “fair rate of return to invested capital”, i.e. WACC times the invested capital, is subtracted from the Net Operating Profit Less Added Tax (NOPLAT).
- Cumulative discounted EVA is a yearly item in which all the forecast years´ discounted EVAs are summed up. Hence, the first item (current year) is the sum of all forecast years´ EVAs at present value terms.
- Value of equity EVA is divided by the number of shares outstanding to get the fair value of the company´s share.

#### More detailed formulation of Discounted EVA-valuation is as follows:

- Other items include associated companies´ profit/loss (after tax), taxes on goodwill amortization, minorities, extraordinary items and other income statement adjustments.
- Cost of capital means the “fair rate of return to invested capital”, which goes to all claimholders. It is computed by multiplying Capital invested with WACC. Capital invested is computed as follows:

- For all forecast years except terminal year: Total equity + Interest bearing liabilities + Convertibles – Total interest bearing financial assets.
- For terminal year: (NOPLAT – Gross capital expenditure – Change in working capital + Increase in non-interest bearing liabilities – Total depreciation) / (Net sales growth * NOPLAT).

- Present value of future EVAs means the terminal value of all EVAs, i.e. the approximation of EVAs beyond the forecast horizon. It is computed as follows:
- Last forecast year´s EVA / (WACC – Net sales growth rate).

- Present value of capital base change means the discounted capital change in invested capital after the last forecasted year:
- Capital base change = Capital invested (terminal year) – Capital invested (last forecasted year)
- Present value of capital base change = Discount factor (last forecasted year) x Capital base change

- Prolonged capital invested is the capital invested (according to the beginning balance sheet) that is prolonged to today. If as a discount factor were used time at the end of the year (and thus discount factor would always be integer), prolonging would not be necessary here.
- Three items after Prolonged capital invested are added so that DCF- and EVA-valuation would give same result. (In DCF-valuation these items are added so that the calculation gives the value of equity, not value of firm.)

All items except for EBIT and Taxes on EBIT the model calculates automatically. Thus, you can freely change EBIT and Taxes on EBIT (and naturally all the subitems which are blue).

## DCF-Valuation

The purpose of DCF-Valuation is to determine the value of a company in terms of its future cash flows. The cash flows are adjusted with certain items (e.g. those not related to company´s core businesses or those with no cash effect) in order to make sure the flows reflect the actually generated cash as good as possible.

This document describes DCF valuation in detail and in our valuation model. **If you would like to get an overview of valuation in general or practical examples (numerical and graphical) about it, then you should look at our valuation tutorial.** It approaches equity valuation first with EVA instead of DCF but as the tutorial reveals EVA approach is only an another name for the old familiar DCF valuation. Both end up to identical end result i.e. identical equity valuation.

The underlying idea of DCF-Valuation is to compute the fair value of a company i.e. the intrinsinc value of the company´s share. The potential of the share price (which the investors are particularly interested in) is then computed by comparing the fair value with the current market price of the company´s share.

#### The basic formulation of Discounted cash flow valuation is as follows:

- Free cash flow to firm is discounted with WACC to the Year 0 (the forecast year) in order to get the present value of free cash flows.
- Cumulative discounted free cash flow is a yearly item in which all the forecast years´ discounted cash flows are summed up. Hence, the first item is the sum of all forecast years´ free cash flows at present value terms.
- Value of equity FCFF is divided by the number of shares outstanding to get the fair value of the company´s share.

#### More detailed formulation of Discounted cash flow valuation is as follows:

- EBIT is adjusted with with Taxes and Share of associated companies´ profit/loss in order to get Operating cash flow – the figure that reflects the cash actually generated by the company much better than the EBIT (accounting figure).
- Operating cash flow is adjusted with Total depreciation to get Gross cash flow. This has to be done because depreciation has no cash effect and thus does not really reduce the cash generated.
- Gross cash flow includes cash tied up in investments. Hence, Change in working capital and Gross capital expenditure have to be subtracted from it and Increase in non-interest bearing liabilities added to it in order to get Free operating cash flow.
- Change in working capital appears in the calculation as minus-signed if more capital is tied up in the business than in the previous year. Gross capital expenditure in turn is the cash used for investments during the year. Increase in non-interest bearing liabilities is plus-signed, since it has an opposite effect than Net working capital.
- Other items include extraordinary items, which have a cash effect even though they are not important in a operational business sense.
- Interest bearing debt, Cash at bank and Investments’ share price impact are to be added/subtracted from the Cumulative discounted cash flow so that the result of the valuation is Value of equity, not Value of firm.

All items except for EBIT, Share of associated companies´ profit/loss and Taxes on continuing operations the model calculates automatically. Thus, you can freely change EBIT, Share of associated companies´ profit/loss and Taxes on continuing operations (and naturally all the subitems which are blue).

## Fair value is negative in the model

#### Case

The DCF fair value (and EVA as well) are negative even though the estimates are quite positive and thus the cumulative value of cash flows should be much higher than the value of debt. **However, the value of cash flow in terminal year seems to be negative.**

#### Reason

The reason is most likely that your terminal growth rate (net sales growth percentage in the last estimate year) is greater than WACC. The terminal value of cash flows are calculated with the help of so called “Gordon model” and it is both mathematically and practically an unfeasible assumption that the growth rate would be greater – or even close to – WACC.

Gordon has constructed his formula to calculate the value of a firm that pays an infinite stream of dividends (cash flow) when the dividend is growing at certain pace. Gordon model states that value of an eternal cash flow = cash flow / (r – g) , where g = growth rate and r= discount rate. Thereby you cannot of course have g > r as it would produce a negative output. Actually it is not a sensible assumption that your growth rate (g) would be even very close to discount rate (r) as you would get an infinite value. And of course in real life there has not been any case where a company would have increased its dividend/profits with such growth rate even for decades, not to mention eternally.

#### Solution

Drop your terminal growth rate to a more sensible level. The suitable level is discussed separately in section Valuation basics, see instructions “Estimating long-term growth and profitability”.

## Setting fair value and the meaning of DCF

### How to determine fair value of company?

Fair value of company should be determined using different kinds of multiples such as P/E, P/BV and EV/EBITDA, development of sales and profitable and for some part DCF model. Multi-criteria Rankings is an excellent tool for determining fair value of company. Value of company should always be compared among its peers and competitors and also the current level of valuation in overall markets.

#### Reality check using DCF fair value

DCF is at its best when it is used as a reality check as it should be. With DCF you can see what would actually be demanded in certain price – expectations considering growth, profitability and their development. Had this been used in the end of the roaring nineties the outcome could have been different. Still DCF is not an absolute truth and should never be used without other methods.

Anyway the reality check with DCF is strongly recommended. If the difference between DCF fair value and the fair value you determined earlier is acceptable, you can continue to next step. If there is a significant difference between these levels, you should recheck your expectations.

#### Adjusting DCF to support your target price

After the reality check DCF can be modified to support and justify your fair value. Do not modify DCF before you have really thought about realistic fair value of the company and determined your target price – it would be useless and misleading. Adjusting DCF can be done best e.g. by changing parameters such as mid-term growth and profitability: Net Sales growth and Ebit-% estimates. By mid-term we mean e.g years 3-7 from current year. If you slow down the current perhaps rapid growth towards the terminal value or decrease profitability faster than the previous estimates you also decrease fair value. If you increase growth and profitability (or preferably make them decrease in a slower pace towards the terminal value) then you increase terminal value. The terminal values themselves should not be manipulated much.

Most recommended way is to use net sales and EBIT parameters, as all the other estimate parameters should be rather constant: there is not much sense in changing the average depreciation-% or changing the working capital or investments as there are normally only one reasonable level. Also WACC parameters are rather constant so they should not be manipulated much. if you have big problems on adjusting DCF fair value to your fair value, check your estimates once again. Investors (customers) are able to see, as they should be, what your estimates are based on. They can see your growth and profitability estimates easily. Remember this when you are justifying your target price / fair value – and never try to justify something that just is not there.

## WACC – Parameter guidance

### The Importance of WACC

WACC (Weighted Average Cost of Capital) is a key component when DCF fair value is calculated. Even small changes in WACC may cause significant change in DCF. WACC alone is not that important – nobody makes investment decisions based purely on WACC. To some extent you can even modify WACC-parameters to justify your own fair value with DCF. Still remember that this can be done only after you have done reality check with DCF that has not been modified.

### WACC – Parameters

How should you set WACC-parameters? Here are some tips how it should be done:

**Tax rate.** Simply fill out your company’s tax rate. Basically this is your company’s home country’s tax rate for companies. In Finland the tax rate is due to decrease to 26 % (from 29 %).

**Target debt ratio (D/D+E).** In many cases company has stated their target debt ratio. If your company hasn’t, you can think what it could be. Try to stay away from extremes. Depending on company, the debt ratio is normally around 5-60 %. Do not confuse actual debt ratio for the target debt ratio. They are usually two completely different things, but we prefer to calculate WACC with long-term target instead of volatile actual values.

**Cost of debt.** Try to estimate what is the cost of debt of your company. Cost of debt varies according to company and economical situation. Try to estimate your company’s cost of debt, if company doesn’t tell it or it can not be reliably calculated from financial statements (sometimes the company includes such items in interest expences etc. that the calculated values do not tell the whole truth). This such as size, financial situation, profitability and possible credit rating affect the value. Normally cost of debt is about 0.25% – 1.5%-points more than risk free interest rate (for small/unprofitable companies somewhat more than with blue chips). If you have not better way to estimate the value, then you can e.g. assume that it is 0.75%-points more than long-term risk-free interest rate – and it probably is not very far away from truth. So if risk-free rate is 5%, then let cost of debt be 5.75%.

**Equity beta.** Describes what is the relative equity risk concerning your company (normally the risk of its business sector). The average beta is 1 and thus the companies that have about average risk have beta of 1. If the business is more risky (very cyclical, high fixed costs/operational leverage) then the beta is more than 1 (normally 1.1 – 1.5). This kind of businesses are e.g. internet business (high fixed costs, high operational risk), pulp and paper (cyclical and high fixed costs). If the business is less risky (very smooth: not cyclical and not very high operational risk) then the beta is below 1 (normally 0.6 – 0.9). This kind of businesses are real estate and food and beverage retail and production. We have made a table that has different betas for different businesses and it can be found right after this text. There’s also other information about equity beta and its estimation. Normally you get biased betas if you estimate them from market data from illiquid companies or illiquid /not-so-diversified markets. Therefore it is normally better to estimate the beta yourself than to get it from market data. You can estimate them by assessing whether the company is more or less risky than some other industries whose beta you know.

**Market risk premium.** It describes the premium that equity investors tend to expect to get when investing to equity markets compared to return they would get from risk-free investments – long-term government bonds. Normally equity research producers use hereby values between 3.5% – 5%, even though some academic research has suggested also that the premium might be as big as 6%. The problem is that there is no method to get/estimate the value in reality, so we just have to take some reasonable value here. It would also be important that the value would be about the same with every analyst and currently we recommend that this value would be 4.75; So use it until you hear otherwise.

**Liquidity premium.** It is introduced to WACC calculation to explain a difference between two types of financial securities, that have all the same qualities except liquidity. The extra return is demanded as a compensation for holding assets that may be difficult to convert into cash.

**Risk free interest rate.** Input the interest rate of government 10 year bond. For example Finland’s government bond it is currently about 4,3 %. You should use the one of your country/your own currency area. The risk free interest rates varies a bit in different currency areas as the long-term interest rate holds inside the expectation about the future inflation. As the real interest rate (interest what people expect to get from risk free investments after inflation has been deducted) is about 3%, then the long-term risk free interest rate is currently: real interest rate + current long-term inflation expectation = 3% + 1.3% = 4.3%

### Equity Beta

#### What is beta and what does it indicate?

Beta measures the risk of the company (and its stock) relative to the risk of the stock market in general – how risky is the type of business the firm does and how risky is the financial structure or leverage of the firm. With greater risk, as measured by a larger variability of returns (business or operating risk), the company’s should have a larger beta. And with greater leverage (higher debt to value ratio) increasing financial risk, the company’s stock should also have a larger beta.

With a larger beta, an investor should expect a greater return. The beta of an average risk firm in the stock market is 1.00. Normally betas vary between 0,60 – 1,30, although they also can be much higher or lower.

#### Beta values of some businesses

These values are for your guidance, but they are not valid as they are. They should give you some direction of what could your company’s beta be. You might want to use them as a starting point – after that you can consider other significant factors and modify your company’s beta from that of subjective industry. Other important components that should be considered when “fine tuning” beta of your company can be found from the following chapter, beta and risk components.

Business sector | Beta | Unlevered beta |

Internet | 1,51 | 1,50 |

Semiconductor | 1,34 | 1,31 |

Telecom equipment | 1,21 | 1,17 |

Computer software & services | 1,20 | 1,20 |

Air transport | 1,10 | 0,83 |

Drug | 1,06 | 1,04 |

Retail store | 1,05 | 0,95 |

Furniture, home | 0,90 | 0,82 |

Railroad | 0,87 | 0,65 |

Textile | 0,82 | 0,49 |

Beverage | 0,80 | 0,73 |

Food wholesale | 0,80 | 0,66 |

Tobacco | 0,75 | 0,68 |

Real Estate | 0,74 | 0,69 |

Food processing | 0,72 | 0,63 |

Electric utility | 0,60 | 0,40 |

#### Beta and risk components

The following list has some components you might want to consider when you estimate beta of your company. The weight of each component is set to be 20 % – this is just one way to look at risks / beta, not the only or necessary correct way. The most important thing in this table that you recognize also these factors.

#### Some risk components to think about (weight):

Financial leverage | 20 % |

Size | 20 % |

Valuation | 20 % |

Subjective Industry / Business | 20 % |

Subjective Company | 20 % |