Download - 26.Segmental Reporting and EVA-2010-Bw
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Session 26 -Segmental Reporting and
Economic Value Added (EVA)
Segmental Reporting
Economic Value Added (EVA )
In Valuation
As a Performance Measure
Calculations
Pepsi
Interpretation
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Segmental Disclosures
Advantages to disclosing information about segments?
Costs?
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Segmental Disclosures
Advantages to disclosing information about segments?
Different operating segments of a company may be
very different in terms of level of profitability, growthand risk
Costs?
Release of proprietary information to competitors (orunions)
Accounting classification/allocation problems
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SFAS 131 --What is a segment? A distinct revenue-producing component of an enterprise
Use the management approach to define segments
Use the same definition that management uses internally to make
operating decision and assess performance (but even if you dontdo this internally, you still have to define segments for external
reports)
Segments can be defined based on
type of product or service,
geographic area,
by legal entity, or
by type of customer
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Ten Percent Tests - A segment must be
reported separately if it meets one ofthese 3 tests
10 % of combined revenues (include intersegmental sales)
10 % of combined profits (of segments reporting profits)
or 10% of combined losses (of segments reporting losses)
10% of combined assets
try to preserve comparability and consistency in the
definition of segments over time
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Assuming the 10% test is met
Add up the total unaffiliated revenue of the reportable
segments
If this is not at least 75% of total unaffiliated revenues,go back and define more segments
Room for Discretion
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Mandated Disclosure about Segments
General Descriptive Information
Information about profit or loss
Information about identifiable assets why not also liabilities?
Reconcile segment information with the enterprise
numbers
Restate previously reported segmental data if the definitionof segments has changed
Information about Major Customers
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Information about Profits
Companies do NOT have to disclose segmental earnings in
accordance with GAAP
They can pick any profit-like performance measure theywant
In principle, they are suppose to disclose the performance
measure they most pay attention to internally
Obviously, consistency over time and across firms is a bigproblem here
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Dividend Discount models can also be expressed in
term of Accounting numbers
Firms Equity value is equal to itsBook Value plus
Present Value of the expected future Abnormal Earnings
Another term for the abnormal earnings is Economic Value Added
The Market Value Added (MVA) by the Firm (the excess of what the net
assets are worth compared to the amounts invested plus profits re-
invested) is the Present Value of the Future EVAs
t t 10 0 t
t 1 e
(E rB )P B
(1 r )
g
!
!
t t 10 0 t
t 1 e
(E rB )
Market Value Added P B (1 r )
g
!
! !
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Another way to express equity value
Equity value depends on your ability to
Grow your capital base (net assets or shareholders equity)
Earn an Excess ROE on that capital base
t t 1 t t 1
0 0 0t tt 1 t 1e e
(ROE r) (ROE r)G{1 }
(1 r ) (1 r )
g g
! !
! !
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Abnormal EarningsEt - r Bt-1 = Net Incomet - re Book Value of Share Equityt-1
Interpretations
Earnings minus normal earnings Earnings minus charge for equity capital (note that the charge for
debt capital is already included in the earnings number)
Other names for it
Residual Income Economic Value Added (EVA)
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EVA as a Performance Measure
"EVA is easily today's leading idea in corporate finance
and one of the most talked about in business. Simply
stated, EVA is just a way of measuring an operations' real
profitability. It allows you to look at almost any business
operation and see immediately whether it was becomingmore valuable or less. What makes it so revealing is that it
takes into account a factor no conventional measure
includes: the total cost of the operations' capital. Managers
who run their business according to the precepts of EVA
have hugely increased the value of their companies (CSX,
Briggs and Stratton, Coca-Cola, etc.)" S. Tully, "The Real
Key to Creating Wealth," Fortune, September 20, 1993
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What is EVA? EVA is net operating profit minus an appropriate charge
for the opportunity cost of all capital invested in an
enterprise.
As such, EVA is an estimate of true "economic" profit, or
the amount by which earnings exceed or fall short of the
required minimum rate of return that shareholders and
lenders could get by investing in other securities of
comparable risk.
Stern, Stewart
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Why a Charge for Capital?
The capital charge is the most distinctive and important
aspect of EVA. Under conventional accounting, most
companies appear profitable but many in fact are not.
"Until a business returns a profit that is greater than its costof capital, it operates at a loss. Never mind that it pays
taxes as if it had a genuine profit. The enterprise still
returns less to the economy than it devours in resources
Until then it does not create wealth; it destroys it."Peter Drucker, Harvard Business Review article
Equity capital (new investments or retained earnings) is
not free
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There are Many Equivalent Ways of
Calculating EVA
All start with some measure of profitability and then
subtract a charge for capital
It is important that the profitability measure, the measure
of capital, and the charge for capital be consistent with
each other
The profit number is usually some variant of accountingnet income (I.e., accounting income with adjustments
number.
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T
hree equivalent versions of EVA
Net Income - r e Shareholders Equityt-1
NOPAT - WACC Assetst-1
NOPAT - WACC* (Assets - Non Int Bearing Debt)t-1
In the last version, the capital basis can be viewed as
Working Capital + Long Term Assets
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EVA - Pepsi
Calculation
What profitability measure is available?
Is this number before or after tax?
Has a charge for any type of capital already beendeducted?
Weighted Average Cost of Capital
Pre-tax rate on debt
Tax rate
Equity cost of capital
Interpretation
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Does a Negative EVA in a period
mean that shareholder wealth was
destroyed (reduced)?
Refer back to Investment Example from last time
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Pepsi - Subsequent Events1996
New CEO - stated they had been trying too hard
sometimes, overreached, got in front of their headlights
in their quest for growth Began to sell back restaurants to franchisees
1997
Left the restaurant business entirely
Spun off KFC, Pizza Hut, Taco Bell into a separatecompany called Tricon Global restaurants and gave to
shareholders
Sold the smaller businesses to outside investors
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Pepsis Current Segments (2002 AR)
By Product type
Beverages - Pepsi Cola (NA and Intl); Gatorade
Snacks -- Frito-Lay (NA and Intl)
Foods Quaker Oats
By Geographic Area
North America (US and Canada)
International
Merger with Quaker Oats this was added as a segment
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Desirable Features of EVA
The present value of EVA is equal to the present value of
cash flows
This holds for any accounting method!!!! (as long as it satisfiesclean surplus this means that The Change in Book Value of the
Firm = Net Investment + Net Income
The market value of an asset (or the firm) is equal to the
book value plus the present value of the remaining EVA -
this also holds for any accounting method!!!
What makes a good accounting method then?
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The Accounting Methods Used to Calculate
the Profit and Capital Measures Matter if...
In a valuation context, you can only forecast over a finite
horizon
In a Performance Measurement Perspective Always
In these situations, the TIME PATTERN of when the EVA
occurs matters (the same would be true for whatever
performance measure you were looking at)
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Limitations to Simple EVA
It is not the same as economic income (which is the change
in the present value of all future cash flows)
EVA is no more forward looking that the operating income
number that it started with
Negative Incentive Effects of Evaluating Managers on the
Basis of EVA
If the Profitability measure is conservative - I.e., if it
treats investments that generate economic assets as an
expense, then EVA will make managers even more
short sighted than conventional accounting measures
Refer back to Example from last time
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Accounting Adjustments Made to
Profitability and Capital Measures
The nature of these adjustments are often things you would
want to do as a part of any good financial analysis
These adjustments are intended to undo "biases" in GAAP
accounting numbers.
These adjustments are sometimes intended to undo some
of management's discretionary accrual decisions bysubstituting your own (or the EVA consultant's)
is this always a good idea?
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Common "Accounting Adjustments"
Made in Calculating EVA
Non-recurring events
Research and Development - Capitalized and amortizedwith any expected benefits
Intangible Assets - Brands, etc
Property, Plant, and Equipment - adjusted for inflation and
other factors LIFO Reserves - added to invested capital
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More Adjustments
Non-Cancelable Operating Leases - treated as "debt
equivalents"
Pooling of Interest - where possible, convert to "purchaseaccounting"
Deferred Taxes - Treated as Equity, Not Debt
Note - if adjustments are made to the balance sheet, thecorresponding adjustments should also be made to the
income statement.
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Limitations to these Adjustments
They often do capitalize some economic assets
but they generally do not look forward and measure the
PV of their inflows they merely capitalizes the historical cost outflow
If the accounting adjustments undo accrual decisions made
by managers, are the new ones really better?