How professional investors use valuation tools
Investment advice has never been a scarce commodity, although sifting through the advice is not easy. Occasionally, one may stumble across a theory or a process that seems to make sense. Perhaps one of these ideas even works, or at least works in more cases than not. Maybe people begin to accept this premise as more than fool's gold.
Portfolio managers and analysts are constantly hunting for just such a tool, an accurate method for evaluating investments. At the same time, the concept that companies should be maximizing shareholder value has become something of a mantra in the US, and the theme has spread across the Atlantic with loud calls for 'value-based management'. Therefore, many investors are seeking new frameworks for evaluating companies based on their ability to create shareholder value. Increasingly, they are turning to valuation models that include economic-based measures of performance.
One of the two most popular economic measures being touted around the world is EVA (economic value added), a trademarked name belonging to Stern Stewart & Co. Another is cash flow return on investment (CFROI). While several firms are offering fairly similar systems, Stern Stewart's EVA and Holt Value Associates' CFROI valuation models are currently the most widely used.
To hear the experts tell it, traditional accouning-based measures of performance are about as reliable as North Korea's economic statistics. And the examples they use to back up their argument are pretty convincing. For instance, earnings can account for a very different percentage of gross cash flow from one company to the next, potentially making it a poor measure of performance. And using EPS as an isolated measure can be misleading if you fail to measure the investment in assets.
Then there is the issue of manipulation. A company can increase its return on equity by simply taking on more debt. Conversely, if a company doesn't grow its assets, it can increase its return on assets. In addition, some companies may use operating leases to keep assets off the balance sheet, or they may stretch out goodwill amortization on acquisitions.
In calculating their CFROI and EVA, Holt and Stern Stewart look at all operating profits belonging to both shareholders and debt holders, and compare the sum with the capital used in the business.
To determine this figure, they make adjustments to companies' reported accounting statements: off-balance sheet assets, such as operating leases, are included; spending on R&D and advertising are both capitalized on the balance sheet as assets. By measuring total cash flow, the measures bypass the accounting irregularities. Both CFROI and EVA are based on discounted cash flow – the idea that companies should look at how their returns exceed the return investors require for the use of their money (cost of capital), though there are different methods for calculating this. Stern Stewart's system is an incentivized program, which allows companies to tie EVA goals to executive compensation. Holt's model is inflation-adjusted and allows for comparisons across company size, time, and national borders.
Putting the models to work
Holt's model is employed by an impressive 1,000 portfolio managers and analysts at over 250 investment firms around the world, including some of the biggest names on the buy-side.
Listening to the proponents of CFROI discuss it is enough to make any investor relations practitioner sit up and take note. Joe Milam, president and owner of Legacy Capital, which invests $100 mn on behalf of high-net-worth individuals, regularly speaks out on the need for corporate managers to embrace value-based management.
'There's an amazing amount of companies out there that don't want to hear about the models,' says Milam. 'Probably 60 percent of companies out there have that opinion. Not because they disagree with the framework, but because they don't like the story the framework is putting forward, which is essentially that there are actions made by management that you can actually track and measure that clearly show if they're making decisions to create shareholder value or not.'
Phyllis Thomas, managing director with NWQ Investment Management, an $8 bn investment advisor, says the level of understanding among corporate executives varies widely. 'When we first started managing the small-cap product,' recalls Thomas, 'I went out to see a number of companies that looked undervalued on the Holt system. But we found that although they had a very nice return on invested capital, they had very high market shares and little growth opportunity. They were constantly trying to do acquisitions and enter new businesses that didn't have the same levels of profitability. They didn't understand the problem with this.'
Thomas says one reason for the lack of understanding on the part of executives is that the stock market has become momentum-driven: investors want to know if the price is moving up or the earnings estimates are being increased, and this influences the thought process in the boardroom. 'You've got a lot of people managing money on pure momentum models. They look at top line growth and earnings momentum irrespective of the relationship of that business's profitability to its cost of capital,' says Thomas. 'I've had companies tell me that I don't know what I'm talking about. Many believe the only thing Wall Street cares about is earnings growth. They say to us, We can deliver earnings growth and so what if the return on invested capital is declining?'
Taking note
Switzerland's Bank J Vontobel, one of Europe's foremost private banks, has been using the CFROI valuation model for over five years. According to Hansjorg Schnyder, the bank's vice president, European companies are only now beginning to embrace shareholder value and take note of the models being used to analyze their performance.
'The global companies, firms like Novartis or Nestle, are completely focusing on shareholder value,' says Schnyder. 'But the smaller companies are sticking to their old methods, their old ways. The problem is many of these smaller companies are privately-owned and the families are still running them. You come across people who may say, This is how my grandfather did it, this is how I'm going to do it as well.'
One major development which may incite more companies to apply value-based management systems is the prevalence of valuation models used by sell-side firms. While Holt mainly works with buy-side firms, Stern Stewart has seen its EVA measure incorporated by several major sell-side organizations, including Goldman Sachs, Salomon Smith Barney, Credit Suisse First Boston and Morgan Stanley Dean Witter. Then there's the giant pension fund, Calpers, which uses EVA to help determine its annual target list of underperforming companies.
Compensation
What makes this trend more unusual is the fact that sell-side analysts are generally compensated based on the accuracy of their earnings estimates, trading volume and transactions. They tend to be more short-term focused, unlike buy-side analysts who are more interested in economic performance and are not transaction-oriented. But today, many of these firms are issuing major reports each year, ranking companies based on their economic performance. Goldman Sachs puts out a hefty overview of companies relying on EVA, and Salomon Smith Barney publishes its own internal EVA handbooks.
'We use EVA for all the companies we look at, and most of them are familiar with it,' says Chip Dickson, MD at Salomon Smith Barney. 'The kind of cash flow analysis we do is what CFROI is based on.'
Al Jackson, managing director of equity research at Credit Suisse First Boston, was one of the first EVA practitioners at a major research firm. Jackson says that corporate executives are increasingly aware of the various valuation models, though he points out that CFROI is less well understood.
'We publish reports based on the EVA model, with rankings done on nearly every company. It's one of the more useful tools we use,' says Jackson. 'Some of the smaller-cap companies may not be as familiar with what we're talking about, but the primary problem is that not every company applies EVA well.'
Common goal
One point all practitioners agree upon is the need for corporate management to begin thinking in terms of shareholder value, regardless of the model or framework they choose to employ. And while momentum investors may not be concerned with cost of capital, a growing number of value and growth investors are pushing the notion that capital is not free, and companies are feeling increased pressure to pay closer attention to shareholder returns.
Legacy Capital's Milam, a strong proponent of Holt's CFROI model, says he is primarily interested in knowing if a company is using some sort of value-based management and measuring shareholder return. 'It doesn't matter what model they're employing internally, because it speaks to a frame of mind in management. If people are working with EVA, I see it in the CFROI numbers,' he says.
However, Stephen Barrow, director of equities for Morgan Grenfell, which uses Holt's model throughout the $165 bn Deutsche Bank-owned investment firm, points out that not everyone can create shareholder value, regardless of their intention.
'The rule has been that 50 percent of capital must underperform, 50 percent must outperform,' says Barrow. 'Companies may say they are looking at shareholder value, but by definition only 50 percent can outperform it at any one time. In addition, not all investors can be successfully looking for shareholder value, since many of them underperform.'
Barrow adds that although valuation models are getting a higher profile, they're not new. 'Ask any CEO or IRO and they'll say they believe in shareholder value. But how many of them understand it or practice it is far less than 100 percent.'
And that's just fine by him. 'We're looking for companies that capture more than their fair share of capital. If companies are not pursuing shareholder value and consequently underperform, by avoiding them we will outperform,' says Barrow.
Next month Ian Sax will be looking at companies' internal use of valuation tools