Assignment Sapm 4

What is the importance of the following in company analysis? A) Liquidity Ratio B) P/E Ratio C) EVA (Economic Value Added) Liquidity Ratio A class of financial metrics that is used to determine a company's ability to pay off its short-terms debts obligations. Generally, the higher the value of the ratio, the larger the margin of safety that the company possesses to cover short-term debts. Common liquidity ratios include the current ratio, the quick ratio and the operating cash flow ratio. Different analysts consider different assets to be relevant in calculating liquidity. Some analysts will calculate only the sum of cash and equivalents divided by current liabilities because they feel that they are the most liquid assets, and would be the most likely to be used to cover short-term debts in an emergency. A company's ability to turn short-term assets into cash to cover debts is of the utmost importance when creditors are seeking payment. Bankruptcy analysts and mortgage originators frequently use the liquidity ratios to determine whether a company will be able to continue as a going concern. P/E Ratio A valuation ratio of a company's current share price compared to its per-share earnings. Calculated as: = Market value per share / Earning per share For example, if a company is currently trading at $43 a share and earnings over the last 12 months were $1.95 per share, the P/E ratio for the stock would be 22.05 ($43/$1.95). EPS is usually from the last four quarters (trailing P/E), but sometimes it can be taken from the estimates of earnings expected in the next four quarters (projected or forward P/E). A third variation uses the sum of the last two actual quarters and the estimates of the next two quarters. In general, a high P/E suggests that investors are expecting higher earnings growth in the future compared to companies with a lower P/E. However, the P/E ratio doesn't tell us the whole story by itself. It's usually more useful to compare the P/E ratios of one company to other companies in the same industry, to the market in general or against the

company's own historical P/E. It would not be useful for investors using the P/E ratio as a basis for their investment to compare the P/E of a technology company (high P/E) to a utility company (low P/E) as each industry has much different growth prospects.

EVA (Economic Value Added) EVA (Economic Value Added) was developed by a New York Consulting firm, Stern Steward & Co in 1982 to promote value-maximizing behaviour in corporate managers (O'Hanlon. J & Peasnell. K, 1998). It is a single, value-based measure that was intended to evaluate business strategies, capital projects and to maximize long-term shareholders wealth. Value that has been created or destroyed by the firm during the period can be measured by comparing profits with the cost of capital used to produce them. Therefore, managers can decide to withdraw value-destructive activities and invest in projects that are critical to shareholder's wealth. This will lead to an increase in the market value of the company. However, activities that do not increase shareholders value might be critical to customer's satisfaction or social responsibility. For example, acquiring expensive technology to ensure that the environment is not polluted might not be of high value from a shareholder's perspective. Focusing solely on shareholder's wealth might jeopardize a firm reputation and profitability in the long run. EVA sets managerial performance target and links it to reward systems. The single goal of maximizing shareholder value helps to overcome the traditional measure problem, where different measures are used for different purposes with inconsistent standards and goal. Rewards will be given to managers who are able to turn investor's money and capital into profits efficiently. Researches have found that managers are more likely to respond to EVA incentives when making financial, operational and investing decision (Biddle, Gary, Managerial finance 1998), allowing them to be motivated to behave like owners. However this behaviour might lead to some managers pursuing their own goal and shareholder value at the expense of customer satisfaction. Unlike simple traditional budgeting, EVA focuses on ends and not means as it does not state how manager can increase company's value as long as the shareholders wealth are maximised. This allowed managers to have discretion and free range creativity, avoiding any potential dysfunctional short-term behaviour. Rewards such as bonuses from the attainment of EVA target level are usually paid fully at the end of 3 years. This is because workers' performance is monitored and will only be rewarded when this target is maintained consistently. Hence, leading to long-term shareholders' wealth. EVA = Net Operating Profit After Tax (NOPAT) - Cost of Capital EVA is then measured by deducting the company's cost of capital from the NOPAT value. The amount of capital to be used in the EVA calculations is the same under either the operating or financing approach, but is calculated differently. The operating approach starts with assets and builds up to invested capital, including adjustments for economically derived equity equivalent values. The financing approach, on the other hand, starts with debt and adds all equity and equity equivalents to arrive at invested capital. Finally, the weighted average cost of capital, based on the relative values of debt and equity and their respective cost

rates, is used to arrive at the cost of capital which is multiplied by the capital employed and deducted from the NOPAT value. The resulting amount is the current period's EVA.

4 Ms of EVA •

Measurement

•

Management System

•

Motivation

•

Mindset

How Companies Have Used EVA Name

Timeframe Use of EVA

The Coca-Cola Early 1980s Focused business managers on increasing shareholder Co. value AT&T Corp.

1994

Used EVA as the lead indicator of a performance measurement system that included "people value added" and "customer value added"

IBM

1999

Conducted a study with Stern Stewart that indicated that outsourcing IT often led to short-term increases in EVA

Herman Miller Late 1990s Tied EVA measure to senior managers' bonus and Inc. compensation system

Advantages claimed for EVA are: • •

• • •

EVA eliminates economic distortions of GAAP to focus decisions on real economic results EVA provides for better assessment of decisions that affect balance sheet and income statement or tradeoffs between each through the use of the capital charge against NOPAT EVA decouples bonus plans from budgetary targets EVA covers all aspects of the business cycle EVA aligns and speeds decision making, and enhances communication and teamwork

Academic researchers have argued for the following additional benefits: •

• • • • •

Goal congruence of managerial and shareholder goals achieved by tying compensation of managers and other employees to EVA measures (Dierks & Patel, 1997) Better goal congruence than ROI (Brewer, Chandra, & Hock, 1999) Annual performance measured tied to executive compensation Provision of correct incentives for capital allocations (Booth, 1997) Long-term performance that is not compromised in favor of short-term results (Booth, 1997) Provision of significant information value beyond traditional accounting measures of EPS, ROA and ROE (Chen & Dodd, 1997)

Limitations of EVA EVA also has its critics. The biggest limitation is that the only major publicly-available sample evidence on the evidence of EVA adoption on firm performance is an in-house study conducted by Stern Stewart and except that there are only a number of single-firm or industry field studies. Brewer, Chandra & Hock (1999) cite the following limitations to EVA: • • • •

EVA does not control for size differences across plants or divisions EVA is based on financial accounting methods that can be manipulated by managers EVA may focus on immediate results which diminishes innovation EVA provides information that is obvious but offers no solutions in much the same way as historical financial statement do

Also, Chandra (2001) identifies the following two limitations of EVA: •

Given the emphasis of EVA on improving business-unit performance, it does not encourage collaborative relationship between business unit managers

EVA although a better measure than EPS, PAT and RONW is still not a perfect measure