Archive for October, 2007

How to Increase Economic Value Added (EVA)

Economic Value Added, or EVA, is a proprietary residual income model developed by Stern Stewart & Company. In its basic formulation, EVA equals net operating profits after tax (NOPAT) less the dollar weighted average cost of capital ($WACC).

Given this formulation, the ways a management team could increase the firm’s EVA would be to:

  • increase revenue
  • minimize operating expenses needed to generate a given amount of revenue
  • produce the same goods and services using less capital
  • invest additional capital in opportunities that will earn more than the associated capital charge
  • reduce the cost of capital

Posted on 31st October 2007
Under: Valuation | No Comments »

Portfolio Monitoring and Rebalancing

After an investor develops a strategic asset allocation, things can change. The investor’s circumstances may change due to marriage, divorce, childbirth or job changes. More frequently, the economic and market conditions may cause various assets to drift from the strategic allocation weight.

To keep track of changes in investor circumstances and any necessary changes in the strategic allocation that may result, investment managers should have a process in place.

Provided that there are no changes to the strategic allocation, variations from target allocations that result from changing market conditions can be managed by rebalancing the portfolio periodically to restore the target weights.

Posted on 31st October 2007
Under: Active Management, Asset Allocation, FInancial Planning, Portfolio Management | No Comments »

Elements of an Investment Policy Statement

The Investment Policy Statement is the governing document that should rule all future investment management decisions. At a minimum, it should contain the following components:



  1. A brief description of the client and the client’s situation
  2. The purpose of establishing the policies and guidelines
  3. The duties and investment responsibilities of the client, the manager, the custodian and (if any) the investment committee. These include any fiduciary duties, communication requirements, accountability and costs.
  4. A statement of investment goals, objectives and constraints
  5. A schedule for reviewing performance and the policy statement itself
  6. A description of the performance measures and benchmarks to be used
  7. Any special circumstances or considerations
  8. The investment strategies and style to be used
  9. Guidelines for portfolio rebalancing

Posted on 30th October 2007
Under: FInancial Planning, Portfolio Management | No Comments »

The Residual Income Valuation Model

When used to value stocks, the residual income model separates value as the sum of two components:

  • The current book value of equity (BV)
  • The present value of expected future residual income [sum from time t=1 to infinity(RI/(1+r)^t)]

The model can be used to value the firm (based on total book value and residual income) or a share, using book value and residual income per share.

Unlike models that discount dividends or free cash flow, in which a significant portion of the estimated value is the terminal value, a residual income model tends to be front-end loaded by the reliance on book value. This can be an advantage since forecasting errors tend to magnify over time. Using only the residual income is likely to result in smaller errors and even if the error is not reduced, the future income is less significant to the overall value calculation.

Posted on 30th October 2007
Under: Financial Statement Analysis, Investing in Stocks, Investment Returns, Valuation | No Comments »

The Importance of the Portfolio Perspective in Investing

Even though different assets may appear to have different characteristics, there are many factors that contribute to the returns of multiple assets. For example, companies in the same industry will have similar exposure to the overall industry supply and demand factors, and these industry factors will affect the stocks of both companies. There are broader economic forces that affect nearly every asset.

When individual assets are considered in isolation, these interrelationships are effectively being ignored. As a result, the investor’s overall risk and return opportunities are likely to be misunderstood.

Posted on 29th October 2007
Under: International Investing, Investing in Stocks, Investing in bonds, Portfolio Management | No Comments »

Reclassifying Pension Related Cash Flows for Analysis Purposes

On the statement of cash flows, all contributions to a pension fund are treated as operating cash flows. Such contributions are typically constrained by minimum requirements set by law and maximum levels above which the contributions are no longer tax deductible. Contributions will not typically match the changes in the actual obligation.

If the company pays more into the plan than the change in benefit obligation, it will reduce the net liability of the fund. Conversely, contributing less than the change in benefit obligation will increase the net liability. For analysis purposes, changes in liability may be better treated on an equal basis with changes in other liabilities – namely as financing cash flows.

To do so, the investor would need to examine the pension disclosures and determine the difference between the change in the funded status and the actual contributions made to the plan. This difference would then be treated as a cash inflow or outflow from financing activities. This can be useful to gauge the sustainable level of cash from operating activity as well.

Posted on 21st October 2007
Under: Accounting, Adjusting Reported Financial Statements, Financial Statement Analysis | No Comments »

Using the Market Price to Calculate Implicit Return Using the H-Model Dividend Discount Model

The dividend discount model and other discounted cash flow approached define the value of a stock as a function of the current cash flow, growth and a required rate of return. Normally these models are used to derive a valuation, which is then compared to the current stock price to determine whether the stock is “overvalued” or “undervalued.” The determination will be affected by the assumptions made regarding required return and growth.

An alternative is to reverse the model and use the current stock price to determine the average assumptions being implicitly made by investors. For example, consider a stock with a $20.00 current share price and $1.00 in expected annual dividends. The consensus long-term growth estimate is 6%, and the investor believes this growth rate reflects the typical belief of market participants. I showed how to do this using the Gordon growth model here.

But what about more complicated models?  Back in August I used a two-stage H-model to estimate the value of Rockwell Automation, and came up with a potential value of $91.59, which was much higher than the $69.00 share price. The model was based on a required return of 10%. Alternatively, we can figure out what the return would be based on the $69 share price (assuming of course that the other inputs were correct.)

To estimate the required return from the H-Model, the formula can be rearranged as r = (D0/P0)[(1 + gl) + H(gs - gl)] + gl where D0/P0 is the current dividend yield, gl is the terminal growth rate, gs is the initial high growth rate and H is the half-life of the high growth. In our example:

D0 = $1.16

P0 = $69.00

gl = 7%

gs = 36%

H = 5

So r = ($1.16/$69)[1.07 + 5(0.36 - 0.07)] + .07 = 0.017(1.07 + 1.45) + 0.07 = 0.43 + 0.07 = 11.3%.

Posted on 21st October 2007
Under: Investing in Stocks, Valuation | No Comments »

Constant Growth Free Cash Flow to the Firm Valuation Model

Free cash flow to the firm models value an entire company rather than a share of the stock. The valuation formula is essentially the same as the dividend discount model, but there are some important differences.

Under a free cash flow to the firm model, Value = FCFF1/(WACC – g)

Compare this to the Gordon growth model, where the value of a stock is estimated as D1/(r-g).

Again, the formula is nearly identical. It is simply a present value function. What has changed is the type of cash flow being discounted and the rate used to discount it.

When valuing a stock, the dividends received are an appropriate cash flow. The discount rate should be the required return for equity investors.

When valuing a firm, the cash flow is the cash flows the company will generate. The appropriate discount rate is the firm’s weighted average cost of capital or WACC.

Posted on 20th October 2007
Under: Valuation | No Comments »

Operating Liabilities and Financial Liabilities

In the course of business, firms can accrue two types of liabilities: operating liabilities and financial liabilities.

Operating liabilities are the consequence of normal operating practices. Operating and trade liabilities occur when the company owes money to suppliers (accounts payable) or employees (wages payable) for goods and services that have already been provided but not yet paid for. In addition, in some business customers are required to pay a deposit before receiving the goods and services they are buying. In such cases, the amount of the deposit creates a liability that the firm must satisfy by delivering the promised goods or service or by refunding the deposit.

Financial liabilities represent borrowings from banks or other lenders that must be repaid with interest.

Posted on 19th October 2007
Under: Accounting, Financial Statement Analysis, Fundamental Analysis | No Comments »

Strengths and Weaknesses of Multi-Stage Dividend Discount Models

Multistage dividend discount models offer several advantages and disadvantages as valuation tools.


  • Allow significant flexibility when estimating future dividend streams
  • Provide useful value approximations even when the inputs are overly simplified
  • Can be reversed so the current stock price can be used to impute market assumptions for growth and expected return
  • Investors are able to suit their model to their expectations rather than force-fit assumptions into the model
  • Specifying the underlying assumptions allows for sensitivity testing and analyzing market reactions to changing circumstances


  • Subjective inputs can result in misspecified models and bad results
  • Over-reliance on a valuation that is at heart an estimate
  • High sensitivity to small changes in input assumptions
  • Flow-through of minor data entry or formula errors when using spreadsheets

Posted on 18th October 2007
Under: Investing in Stocks, Investment Returns, Valuation | No Comments »