4.3 Profitability analysis
4.3.5 Economic Value Added
The reason why I disregard from traditional figures like return on assets or return on equity is that they do not distinguish between operating and non-operating activities. Return on equity mixes operating performance with financial structure, making peer group analysis or trend analysis less focused. The return on total assets is inadequate because it includes a number of inconsistencies between the numerator and the denominator.60
In a valuation perspective distinction of operating and non-operating activities is essential in order to calculate the right value of a company.
In reality there is no such thing as a risk free interest rate, but for the purposes of this thesis, I will use the the rates of 10 years state's bonds. I consider the state's bond as risk free financial instrument. I will use the rates that are accessible on the official web page of the Czech National Bank.62
4.3.5.1.2 Computing cost of equity rE
I will use Capital Asset Pricing Model (CAPM) to determine the cost of equity. The CAPM derives the firm's cost of capital from its covariance with the market return. The CAPM is defined as:
rE=rf[ErM−rf]
where rf is the market risk-free rate of interest, E(rM) is the expected return on the market portfolio, and β is a firm-specific risk. β is defined as:
=Covrstocks, rM VarrM
I will use data obtained from the official web page of PSE for the PX index and the web page penize.cz for historical prices of Philip Morris stock.
Now, when β is computed, I can continue with CAPM. The next step will be Security Market Line (SML). Firstly, I will calculate the classic CAPM, as defined above.
But the classic CAPM uses an SML, which has the basic problem and it is ignoring of taxes, which creates distortion. Therefore, I will use the tax-adjusted SML:
Cost of equity=rf1−TC[ErM−rf1−TC]
The results for for cost of equity of both the tax-adjusted and classic SML are in the following table:
62 http://www.cnb.cz/miranda2/export/sites/www.cnb.cz/cs/financni_trhy/trh_statnich_dluhopisu/sd/download/
AUKCE_SD_HISTORIE.XLS
Source: own computations
To explain meaning of beta, let us have a look at the previous year. Philip Morris ČR β2009=0.45. It means that a 1 percent increase or decrease in the monthly returns of the PX index was accompanied by a 0.45 percent increase or decrease in Philip Morris' returns.
Moreover, I counted Company's α, which shows that irrespective of changes in the PX index, the monthly return on Philip Morris in 2009 was α=-1.97%. On an annual basis, this is 12*(-1.97)=-23.64%. This indicates that Philip Morris had negative performance over the period.
The R2 for 2009 of the regression shows that 12.39% of the variation in the Philip Morris' returns is accounted for by variability in the PX index. It means that around 12% of variation in Philip Morris returns is explicable by the variation in PX index. This number is pretty low, the average R2 for stocks is approximately 30-40%.63
Now, when the cost of equity is known, I can move on to cost of debt.
4.3.5.1.3 Computing cost of debt
In principle, rD is the marginal cost to the firm (before corporate taxes) of borrowing an additional money unit.
We have to consider some points before calculating of cost of debt. The Company has only some short-term borrowings and only with related parties. They are divided into two groups:
● Interest bearing on-demand borrowings
63 Benninga p. 55
Table 13: Cost of Equity
2009 2008 2007 2006 2005
Effective tax rate 21.24% 22.31% 24.68% 25.89% 27.62%
Alpha -0.0197 -0.0231 -0.0185 0.0063 0.0069
Beta
Using SLOPE 0.4464 0.8432 1.1120 0.6822 0.5119 Using COV/VAR 0.4464 0.8432 1.1120 0.6822 0.5119
R-squared 0.1239 0.2159 0.2929 0.2041 0.1682
rf 5.00% 4.00% 4.00% 3.80% 3.80%
rm monthly 0.62% 2.40% 2.32% 2.03% 1.12%
rm annual 7.38% 28.82% 27.84% 24.36% 13.40%
cost of equity (tax adjusted) 5.47% 24.79% 30.63% 17.51% 8.20%
cost of equity 6.06% 24.93% 30.51% 17.83% 8.72%
● Short-term borrowings
The next part of borrowings is bank overdraft, but this counts for a really small fraction of the total sum of borrowings. Moreover, in the year 2006, the Company has no borrowings and in 2009 the borrowings were only CZK 11 million.
Before computing the cost of debt, I have to make few assumptions:
● I will consider liquid assets, such as cash and cash equivalents as a negative debt, therefore I will deduct them from the firm's debt.
● The Company has usually large amount of cash. Therefore in some years, the net debt is negative. I will conclude that during these years the Company has negative leverage.
● I will count cost of debt as interest expense divided by average amount of debt for current and previous year.64
Source: own computations
With the knowledge of rE and rD, I can calculate WACC now.
4.3.5.1.4 WACC final computation
I will count WACC twice, firstly based on classic CAPM and, secondly, based on tax-adjusted CAPM. In both computations I will use interest rate derived from the financial statements.
64 Benninga p. 80
2009 2008 2007 2006 2005
Cash and cash equivalents 5999 1408 2240 3912 6817
Borrowings 11 1742 3764 0 412
Interest expense 24 152 13 25 16
Interest cost 2.74% 5.52% 0.69% 12.14% 7.77%
Debt net of cash -5988 334 1524 -3912 -6405
Source: own computations
Estimated WACC is an average of WACC based on classic CAPM and tax-adjusted CAPM.
Now, when I computed the WACC, I can continue with the Economic Value Added.
4.3.5.2 Economic value added
In this subchapter, I will focus on calculation of value created to shareholders, by applying one of the excess return models, namely Economic Value Added (EVA). EVA measures surplus value created by an investment. It is computed as the product of the excess return made on an investment and the capital invested in that investment.65 If we want to use EVA measure, we have to make one basic assumption – the main objective of any firm is to maximize shareholder value.
The big advantage of EVA is that it is definitely good measure of performance, as it takes into the consideration the cost of capital employed. The EVA conveniently sums up into one single number the value created above and beyond all financial obligations.
The problem with EVA is that it is a historical performance measure, e.g. during the cycles when there is a reversed trend, EVA will not capture this.
65 Damodoran, p. 215
2009 2008 2007 2006 2005
6.06% 24.93% 30.51% 17.83% 8.72%
5.47% 24.79% 30.63% 17.51% 8.20%
2.74% 5.52% 0.69% 12.14% 7.77%
21.24% 22.31% 24.68% 25.89% 27.62%
Shares outstanding 2,745,000 2,745,000 2,745,000 2,745,000 2,745,000
Share price, end year (CZK) 8,849 6,425 7,591 11,528 18,103
Net debt (CZK) -5,988,000,000 334,000,000 1,524,000,000 -3,912,000,000 -6,405,000,000 Equity value (CZK) 24,290,505,000 17,636,625,000 20,837,295,000 31,644,360,000 49,692,735,000
WACC 2009 2008 2007 2006 2005
based on classic CAPM 7.34% 24.55% 28.47% 19.07% 9.17%
WACC 2009 2008 2007 2006 2005
based on tax-adjusted CAPM 6.56% 24.41% 28.57% 18.72% 8.59%
Estimated WACC 6.95% 24.48% 28.52% 18.89% 8.88%
Cost of equity, rE
Cost of tax-adjusted equity, rE Cost of debt, rD
Tax rate, TC
The EVA can be illustrated by the following graphic:
Source: http://i.investopedia.com/inv/articles/site/EVAChap5Fig1.gif Mathematically, EVA is defined as:
EVA=ROIC−WACC∗Capital Invested=NOPAT−WACC∗Capital Invested The EVA results for each year are in the following table:
Source: own computations
Note that EVA is based on the average level of invested capital, to be in accordance with the ROIC measure.
There are big differences from year to year and we can see that the Company did not always created surplus value. During the years 2008 and especially in 2007 the EVA was negative.
This was due to the fact that WACC rose by around 20% from 2005 until 2007 and only slightly declined in 2008, while it went down to only 7% in 2009.