hi i'm jimmy in this video we're looking
at a great way
to look at the genuine profitability of
a company
beyond the typical earnings per share
this is called economic value added
you might hear you might see the
shortened to eva or you might even hear
it called something like economic profit
so we're gonna look quickly at the
formula for economic value added
and then we're gonna look at some
examples some real life examples to see
how we can apply
this method okay let's jump right in so
this is the formula for economic value
added
and it may look like a lot but we'll
break it down step by step
so economic value added so eva
is simply the net operating profit
after tax oftentimes you'll see that
shortened to no pat
we take that and we subtract the
invested capital times the weighted
average cost of capital
this is abbreviated to whack wacc now
just to clean this up a bit
this is how the formula will typically
look if you ever google it
so let's start with notepad notepad is
net operating profit after tax
net operating profit you might hear this
called ebit or
earnings before interest and taxes so
all we do is we take
ebit and we adjust it for taxes so to
adjust ebit by the tax rate all we have
to do is look up the company's tax rate
they'll list that in either their
quarterly report or their annual report
we take their tax rate and we multiply
that we do one minus the tax rate
multiply that by ebit
so if their tax rate is 20 it would be
one minus twenty percent so point eight
times their ebit that would give us net
operating profit after tax
now the reason i ran us through this
particular example
is because the purpose of economic value
added
is to determine how much the company is
returning
after accounting for the cost of capital
interest expense is the cost of capital
so all
notepad is doing for us is eliminating
the interest expense
basically we want to isolate the profit
excluding any interest expense
okay now we move on to invested capital
so to calculate
there's a few ways to calculate uh
invested capital but i think the
simplest way
is to take the equity from the balance
sheet which represents sort of the stock
portion of the invested capital and then
we add any interest-bearing debt
so basically how much bond how many uh
what are the amount of bonds that they
the company has out there
add that to equity and that is the
invested capital within the company
and then we have the weighted average
cost of capital now the i actually did a
video on how to calculate the weighted
average cost of capital
and basically it's the cost of debt and
the cost of equity
so the cost of the stock to the company
and then let's say they have 80
equity and 20 debt well you have to
weight
the overall cost of capital if you're
curious how to do that calculation
you should probably go see that video
that takes a little bit longer to
describe
but basically this is how much the
interest rate that a company
pays essentially sort of pays for
capital so again i'll leave a link to
that video in the description below
but here's a quick example of why this
is important
so let's imagine that there was a
company that was starting a it's a brand
new company they're just starting out
and they borrow let's say a million
dollars
and the in borrowing a million dollars
so now they have a million dollars maybe
they get a loan from bank maybe they do
it via bonds
whatever it is but let's pretend that
that million dollars is costing them
five percent per year so they go out and
they start building their widgets they
sell their widgets
and let's imagine that they return on
their million dollars invested capital
they return
five percent what have they added
profitability it's very possible that
they're profitable
so the company may look profitable and
the
untrained investor might look at that
and be like oh good they're giving us a
return
but what economic value essentially
tells us is because
their cost of capital is the same as
what they are earning
well they're not really they're not
bringing back any economic return
they're not giving us
anything on top of their cost of capital
that's what economic value
added is trying to give us it's trying
to tell us how much
in a dollars in from a dollar's
perspective how much has that company
returned
on top of their cost of capital so the
advantage of economic value added
is that it gives us a much cleaner look
at
how the company is truly performing okay
now
let's look at some examples of how we
can take economic value added and apply
it to real-life investment research
to see how companies that we own or that
we want to own are
truly performing for us so this is the
chart
of 3m's economic value added going all
the way back to 2002.
now i've done videos on 3m in the past
so for curious to learn more about that
company i'll leave a link
to that video in the description below
but the numbers on the left-hand side
here these are
in billions of dollars and we can see
that this number has been consistently
pro it can
has been consistently part of positive
which tells us
that the 3m as a business as management
of 3m well they've done a good job
of consistently adding value to the
business
to the stockhold for the stockholder so
whatever that overall capital is costing
them both debt
and equity whatever that capital is
costing them is ultimately they are
ultimately outperforming that so that's
a good thing now another example is
jonathan and johnson
again johnson johnson going all the way
back to 2002 and we could see that
they have been again consistently
profitable except for
2017 where and i said profitable i meant
consistently positive economic value
added
but they've except for 2017. now
if we were just if we were curious about
investing in johnson johnson
this would be a good thing to look at
what happened in 2017.
now i actually went back and looked at
this and it turns out that with the tax
changes that were happening in the u.s
back then well there was a big offset in
taxes for that year
so this that was one of the reasons this
was a one-off a negative year
it was enough for me to dismiss it
because their no pat net operating
profit after tax was still a fairly
significant number
but there were just their adjustments in
there so hence the reason it came up
with a negative number that year but
it's not something that worried me but
we only know that if we look at this
and research it now when we do research
it i think it's important for us to
recognize
how uh economic value-added could
ultimately move
so pulling up this formula down here
well there's a few ways to adjust
economic value added let's say they
wanted to we wanted to see a company
increase economic value added
first thing they could do is increase
the net operating profit after tax
if that goes higher all else the same
the
uh eva will continue to move higher and
this is sort of ideal this this implies
that the company is sort of getting more
and more
profitable or creating a greater
economic profit which is a good sign
for investors another option is to lower
the cost of capital the
whack you could lower the whack or you
could lower the invested capital
now i should also point out that one way
to lower the cost of capital
generally equity has a higher cost of
capital
than debt does generally debt has a
lower cost of capital
so in theory if you wanted to lower
whack you could take up more debt
now that's counterintuitive you might
you know so
it depends how the company is doing it
but i do i bring that out because i want
us to be aware
that if we see a company taking out debt
we might look at a company that has
plenty of cash and say why are they
taking out debt well it's because debt
can be cheaper than taking out more
stock
so sometimes it's a logical thing to do
but we want to be aware if they're
taking out too much debt
that's sort of a bad sign even if it
improves eva so let's clean this up a
bit
and now we're going to add another i
think is a more interesting chart
so this is general electric's economic
value added again
going back to 2002 and you can see that
they have been consistently negative for
every single year so this means that the
company and ultimately the management
team
of that company has consistently reduced
the
economic value of the overall business
they're continuing
to drag down the value of the business
every year
now in general electric's defense there
have been a few management changes
during this time period
and perhaps they're almost done with
this perhaps this is going to go
positive in the near
future but that's a big prediction to
make i have researched general electric
and i was not aware i did not recognize
how long they've been destroying the
value of the company now i was curious
about the cause
what would cause general electric's
numbers to be so bad for so long
so i actually went and found their ebit
numbers which is the first step ebit is
short for
earnings before interest and taxes and
it's the first step
to coming up with the net operating
profit after tax so in theory you want
this number to be high
and hopefully positive that's really the
only way to get a positive economic
value at it and if you're ever looking
for ebit but you can't find it maybe
you're looking at a site like yahoo
finance or even the company's financials
and you can't find
earnings before interest and tax but you
might also hear it called
operating income operating in income and
ebit are generally the same thing
so that's usually the line you can go
with so for ge
because this number has been broadly
positive for many many years
well this means that their invested
capital and
their weighted average cost of capital
are way too high they have to lower
those
they should be paying off debt which
would reduce their invested capital
probably also increase their cost of
capital so perhaps they also buy back
some stock
they should do whatever they can to
lower those two numbers
to try and they should also be trying to
simultaneously
increase their net operating profit
after tax if they want to add any real
value for
investors so we can see with these three
examples that economic value added does
a good job
of painting a picture of what the
company is doing
for investors now i actually did a video
where i go through
a more in-depth research process that i
use to analyze a stock
called eight steps to analyze a stock so
if you're curious
you can incorporate this into that
process
you can incorporate this into the early
stages of that process
to help narrow down which years are
better to invest which years are better
better to analyze to try to truly
understand the company
so if you're curious about the research
process well i got a link right here to
that video i got a link in the
description below
and thank you so much for sticking with
me all the way to the end of the video
i really do appreciate it thank you and
i'll see in the next video