Technically Speaking: Poor EVA showing may expose unfixable faults in the economy

Friday 5th May 2000

The ANZ bank's economic valued added (EVA) survey of NZSE-listed companies first publicised in New Zealand last year found of major listings only Telecom added substantial risk-adjusted value for its shareholders.

Oddly enough, Telecom itself did not do much with this recommendation on the PR front. Modesty is not a fault the company has previously been reproached with.

The share price may have responded to the welcome seal of approval on Telecom. Certainly the extreme volatility of Telecom's share price and a suggestion it has more-or-less peaked unless the company can find new ways to grow could have done with trumpeted glad tidings that the firm was an economic value adder (or e-vadder, in new economy parlance).

EVA sounds thrilling as a means of calculating fair value for shares, a real sorter out of sheep from goats. Shares could be priced on the basis of having either good or bad EVA.

However, it may be difficult to relate inherently volatile share prices to complex concepts of underlying company profitability. Traditional accounting measures such as Ebit are intrinsic to a company - they are a matter of contestable fact regardless of the cost of capital - and could be described as independent measures of return as they are not externally based on relativity to other investments. Price/earnings multiples can be derived from earnings information but the latter is either historical and thus old hat or projected and accordingly pie in the sky.

Such calculations can be
relativised to extrinsic bases of measurement by comparing them with average sectoral multiples for similar companies. But a drawback in New Zealand is that there may be few similar NZSE-listed companies to make comparisons with.

Some then chose to compare the company with overseas peer firms - Fletcher Energy has often been treated in this way - but such an approach is subject to the cavil that if the firms operate in different economies the differences may outweigh the similarities.

The problem either way for a small economy like New Zealand's is suitable peer shortage. In any event - and this is the EVA point - even if a company squares up with or betters its peers in internal rate of return on capital, there may still be an unacceptable opportunity cost in holding its shares. New Zealand's forestry stocks give a good example of this position over recent years. They simply have not stacked up as an entire peer group.

EVA relies on relativising company profitability to an extrinsic measure of risk-adjusted opportunity cost. The essential idea is that net operating profit after tax minus risk-adjusted cost of capital should not produce a negative number; otherwise the investment, even if a payer on paper - including by way of dividend cheques - is a loser put against some other choice.

The concept is not strange to commercial property investment, in which a risk premium on rental return is usually demanded against the current yield of a "riskless" investment like government stock, giving some idea of the fair price for the building, but then there is usually predictable leasing income to compare with stock yield.

Companies are more difficult to value because it is not so obvious what they will earn. Share investors are buying a piece of the future that in the shorter term is only as good as the next company report. In theory at least, it should be possible to establish fair value for shares on an EVA basis.

An equilibrium point could be identified at which it was a matter of indifference between buying the company's shares and investing instead its cost of capital.

However, problems are again found in the limitations of historical and projected profitability figures.

Additionally, the devil is in the detail of how best to calculate the weighted average cost of capital (Wacc) - a matter of debatable and perhaps undecidable opinion - which serves as the measure of risk-adjusted opportunity cost.

Above that again, different companies, industries and economies present different and possibly fluctuating risk profiles, and these in turn need to be matched with the risk-and-reward expectations of investors. Once we go down the value relativisation primrose path, it is difficult to know where to stop. Nor does it follow that it is necessarily rational for investors to maximise returns once risk becomes intrinsic to the estimation of value. Risk aversion may counterweigh desire for profit.

It may be that poor EVA showing for New Zealand companies exposes structural faults in the economy that corporate management would be hard-pressed to remedy no matter how hard it was exhorted to embrace the new paradigm.

The effective tax whack, for example, which should include mandatory compliance costs, rates and levies - in other words avaricious central and local governments' respective danegelds - is highly influential on how much net operating profit is left to subtract the other weighted average cost of capital (Wacc ) from.

At the double-whammy whack/Wacc interface there may be little or no feasible employment of productive capital for companies in New Zealand. Small wonder our battered sharemarket appears to be bloodied and out for the count.

Clearly, to improve EVA potential both tax and Wacc should be subject to reduction - a point that could explain our tax-and-spend government's agnostic reaction to the messianic ardour of the ANZ's EVA evangelist, Joseph Healy. "Thanks, Joe. We'll let you know. Don't call us first and just pop your CV in the shredder on the way out," was a predictable reaction. Socialism is anti-EVA.

Not only is there the potential influence of EVA on fiscal policy and the size and role of the state to consider - especially if it were to be applied to the state's own operations - but whether there should be a New Zealand state at all.

That New Zealand is a small, marginal economy obliged to pay higher interest rates than bigger, more populous and diversified economies would have bearing on what weighted average cost of capital totalled domestically and that in turn would dictate whether worthwhile EVA returns are possible here. Our sovereignty may run counter to EVA.

Logically, if a company cannot produce respectable EVA, it should go out of business. Surely though, the same goes for whole industries and entire countries. In the latter case, perhaps we should all head for places like Australia.

Of course, we should wait until the ANZ publishes an EVA analysis on corporate Australia, including itself, before taking the plunge, and even then, maybe we can stay right at home to enjoy the same result.

Perhaps Mr Healy is part of a cunning plan to entice New Zealand to join Australia as a state, as federation law over the Tasman entitles our country to become and we probably wisely should do. Why stop short at a mere common currency?

Historically, this country was declared part of New South Wales in 1839, making Sydney our original capital a bit before what has become a latter-day blank cheque for reverse apartheid was signed.

Wellington is just a dispensable latter-day leech on honest toil, a nest of rentier-bureaucratic threadworms overdue for purgation.

If we want to do an Ireland and revamp our economy into EVA respectability, we need a rich uncle. If not the EU, then why not the land of the deep-pocketed 'roo?

In the meantime, maybe Telecom is not so wild about the EVA spotlight, considering its AAPT purchase, proposed alliance with America Online right on Nasdaq meltdown, and stated desire to become an internet company with telephony rather than a telephone company that does internet.

Telecom's share price (chart 1) is beginning to move perhaps submissively in tandem with that of AAPT (chart 2) and maybe the last thing required right now is an EVA crusade on internet stocks.

Imagine what a dose of salts, or maybe breath of fresh air, EVA would be for all those bloated new economy share prices.

It would be piquant if Mr Healy could come up with an EVA analysis of AAPT and AOL just so we know where we stand if we want to buy E-Telecom.

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