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EVA and the “New Economy”

2024; Wiley; Linguagem: Inglês

10.1111/jacf.12636

1078-1196

Gregory V. Milano,

Research, Science, and Academia

The business world is changing at a pace we have not seen for many years. The expansion of the Internet and the advance of telecommunication technologies are offering new channels for media distribution and communication. Many view this as a completely new paradigm for business in which the rules of the game are changing. Certainly, new market entrants are breaking into established markets at a pace most of us could not have anticipated. The dynamic of these "new economy" businesses is new in that there are more clicks and fewer bricks. Talented human capital is flowing into the businesses, making it difficult for traditional businesses to attract and retain the people they need. The new era is being heralded as the knowledge revolution, following behind the industrial revolution and the information revolution. It is all quite exciting and challenging. Some have observed that this means the end of the EVA performance measurement and incentive compensation system. They claim that although the EVA system is useful for old-line companies with heavy investments in fixed assets, the efficient management of investor capital is no longer an imperative for new-age firms that, after all, operate largely without buildings and machinery—and, in some cases, have negative working capital! EVA skeptics also note that, for companies with little or no current profits, a dearth of hard assets, and an overhang of management share options, the financial statements on which EVA partly relies provide almost no basis for valuation. In the pages that follow, I argue that EVA is not only suitable for the emerging companies that lead the new economy, but it is even more important for such companies than it was for their "rust belt" predecessors. So, while there may be a new economy in terms of trade in new products and services, there is no new economics—the principles of economic valuation remain the same. As they have in the past, companies will create value in the future only insofar as they promise to produce returns on investor capital that exceed the cost of capital. EVA is uniquely suited to instill that message in the management and employees of new- and old-economy companies alike. The valuations of new economy companies have hit lofty peaks indeed. As of the end of the last millennium, Yahoo was worth $110 billion, or about twice that of Abbott Labs, Phillip Morris, or McDonald's. At that time, Yahoo was worth over 20% more than Motorola, nearly 40% more than Morgan Stanley Dean Witter, and nearly 1000% more than Textron! Unless we believe investors have totally lost their minds, there must be a plausible explanation. Some say that these companies will generate enormous cash flow in the future. The basic premise of modern corporate finance is that value is the sum of the present values of all future free cash flows a business is expected to generate. An investor needs to just forecast his or her expectations for the future revenue, costs, and capital; convert each year to a free cash flow figure; and calculate the present value. Simple, right? What's the Yahoo cash flow forecast for 2014? What is the terminal value—that is, the assumed value at the end of the explicit forecast? With the cash flow approach applied to a business with such high future growth value, we find the really important numbers are almost impossible to forecast. Discounted cash flow, or DCF, is theoretically correct but practically useless for the new economy. We find it is much more straightforward to use the EVA approach. The benefit of EVA for "new economy" valuation is that it shows a greater percentage of the value occurring in the earlier years, where forecasting is more practical. Our studies show that, in a typical 10-year DCF analysis of a new economy company, 80%–99% of the value is in the terminal value. When EVA is applied with the same forecast, only 20%–50% of the value is in the terminal value. This helps give valuation experts more comfort with their answers. But the benefit of EVA goes beyond this by correctly treating as capital those cash outlays that represent investments as opposed to current expenses. It allows us to see the pattern of value creation, not just the present value. In our forecast, what is the year-by-year contribution to value? Cash flow just doesn't tell us. Many new economy companies are investing heavily to grow, and the resulting negative cash flow doesn't tell us much about performance each year. EVA, on the other hand, tells us how much contribution to value is being made each year. Does the profit this year justify the cumulative investment, including soft investments such as product development and brand advertising, that we have made thus far? Security analysts and investors have an easier time checking that their forecasts make sense. How does this help us to understand the value of new economy stocks? Most of these companies do not even have accounting profits, let alone enough to cover a capital charge! Of what use is EVA? Here we see a shortfall of accounting, not EVA. The key investments in a new economy company are in research, development, marketing, and advertising. The accountants view these outlays as expenses against current profits. The accountants apparently expect all the value from R&D investments to show up in the year the R&D money is spent. A more realistic approach is to capitalize these investments, as in an EVA system, and amortize them over their expected useful life. In fact, the entire accounting framework is pretty useless for these companies. Take the case of RealNetworks, Inc., which is a successful developer of software for displaying audio and video media on PCs and over the Internet. As shown in Table 1, which presents accounting statements for RealNetworks from 1995 through 1998, RealNetworks incurred costs over this 4-year period that were 35% higher than the revenue they received. The fact that the company's stock price rose dramatically during this same period leads critics of GAAP accounting to point out how useless accounting statements are for valuing new economy companies. On closer examination, this case provides striking evidence of the bias of accounting against activities like R&D and brand-building, indeed against almost all corporate investments in intangibles with longer-run payoffs. For RealNetworks, expenditures on R&D and sales, marketing, and advertising amounted to 72% of total accounting expenses over this 4-year period. How are investors supposed to use this information to understand performance? Imagine what would have happened if the company had been foolish enough to pay bonuses to generate accounting profit; in that case, managers would have had incentives to cut the very R&D and sales and marketing investments that were driving the success of the company. Treating these expenditures as period expenses is like charging the cost of a chemical plant against operating profit in the year the plant is built. It makes no sense at all. Despite the trend in its accounting earnings, RealNetworks, as shown in Figure 1, has had stellar share price performance since flotation. EVA does a much better job of tracking the value of this business. When we adjust the accounting statements to treat research, development, selling, and marketing as investments with a 5-year life, we get the results shown in Table 2—namely, a series of dramatic year-to-year increases in net operating profit and EVA. We have long known that accounting standards do not provide very useful information to investors. With companies from the new economy, this is truer than ever. It has made exciting and paradoxical journalism to talk of companies with high valuations and no earnings, but this is in large part the result of an accounting framework that is systematically flawed. Investors and managers tracking the performance of these companies should use EVA and should treat expenditures in R&D and sales and marketing as investments, not period expenses. As shown in Table 2, EVA for RealNetworks is in fact remarkably high, averaging 40% of revenue for the 4-year period and rising to 44% in 1999. There are very few (if any) old economy companies that can deliver EVA margins of this size. Value is driven both by performance today and by developing the core competencies and competitive position necessary to deliver value in the future. We can see this if we divide our EVA valuation equation into two components (see Figure 2). The first is simply the present value of EVA, assuming that the current level of EVA is simply maintained year after year. This is calculated as the current EVA divided by the cost of capital. When this is added to the capital base, we can see what the company would be worth if the market thought current performance would be repeated forever. We call this the Current Operations Value, or COV. The second is the present value of expected improvements in EVA from this point forward. We call this the future growth value, or FGV. For companies where FGV is a substantial percentage of the total enterprise value, it is useful to look more closely at the components of FGV. Despite their strong trends in EVA, virtually all new economy companies have the majority of their current value in FGV. There are three primary sources of FGV. First is the expected growth in performance from currently marketed products. Second is the expected contribution of products in development that are just being released. Third and last is the contribution to the value of products that the company has not even identified yet. This is the value investors are willing to assign to a company to recognize that there is some probability that a successful team will still come up with new ideas far out into the future. This three-part division of future growth value can readily be seen in the case of pharmaceutical companies with their currently marketed drugs, their "pipeline" of promising compounds, and their know-how in developing new products for the future. EVA margin: Successful new economy companies have very high EVA margins (EVA/sales), and those that do not often exhibit the potential to generate very high EVA margins in the future. A much higher percentage of each dollar of revenue drops to the bottom line as EVA after all taxes and capital charges. In the case of RealNetworks discussed above, this figure is about 40%. In 1998, it was 24% for AOL, 30% for Cisco, 44% for Microsoft, 17% for Oracle, and an amazing 59% for Yahoo! These figures are truly remarkable by old economy standards. The new economy EVA margins reflect a dramatic reduction in variable costs, which often run less than 15% of sales. Tasks that were once completed by people are now completed by software. As well-known Stanford economist Paul Romer has described the new economy, we are creating new recipes for activities that allow global scalability without people in the loop. We are converting human "wetware," or the knowledge in people's heads, into "software" that can be replicated with near-zero costs. On top of this, there is very little traditional capital required in terms of bricks and mortar. Taxes, too, are kept very low since all the investments in R&D and marketing and advertising are written off in the year incurred. As new economy consultant Peter Keen noted at Stern Stewart's annual EVA Institute Management Conference, "the key factor to monitor is the marketing cost to acquire customers, and then the growth in repeat business, and the repeat business per transaction. Once you have the repeat business, then you can move to digital margins. And digital margins average about 80%." Such high EVA margins make every dollar of current volume and future sales growth several times more valuable than a dollar of revenue produced by old economy companies. High growth rate: Most of these companies are quite small, but are growing very rapidly. Although growth-for-growth's sake does not add value, when growth is coupled with very high EVA margins, the value implications are enormous. By 1998, RealNetworks had a 3-year compound annual growth rate of 230% per year. For AOL, the figure was 99%; for Cisco, 62%; for Microsoft, 35%; for Oracle, 34%; and for Yahoo, an amazing 430%. These growth rates are clearly not sustainable and will decline as the company grows, but the point is that a fast-growing, high-margin business can be worth much more than its relatively stagnant old economy counterparts. It is no wonder Yahoo has the valuation that it does. Low current market share: Although current growth rates are important, it is the potential for future growth that influences the forecasts of investors. Growth can come from an expansion of the market category or from stealing market share from others. The new economy, by its very nature, has served to expand certain markets for products and services. There are new channels for purchase. Moreover, it's important to recognize that the sale of a book by Amazon.com does not necessarily mean a missed sale for a bookstore. Many of these sales simply would not have occurred without the new channel. However, a large percentage of long-term growth comes from pilfering market share from others. Thus, an important indicator of how long the growth can last is the present market share represented by the company. As long as this is a small percentage, there is plenty of room for growth by encouraging customers to switch. Ability to differentiate: In the new economy, barriers to entry are often quite weak. Just as the current Internet stars invaded the turf of entrenched players, new upstarts can invade their turf. Further, customers can readily comparison-shop, leading to intense price pressure. As Lord Kenneth Baker said at our EVA Institute, "distribution margins will be under immense pressure. This is what the Internet does more than anything else. If goods can be sold as easily as this, they will incur fewer costs. The balance has shifted to the consumer." This is true, unless the new economy firm has the ability to differentiate its products from those of its competitors. Products or services that are differentiated are much less vulnerable to price competition. The value of a business is much higher if it can sustain margins and growth rates for the long-term, and this is essential to high value figures. Essentially, it is the first two drivers of FGV, EVA margin and sales growth, that make a company valuable. The third driver, low current market share, allows the sales growth to be extended into the future and the final driver, differentiation, fortifies EVA margins against attacks by competitors. To see the strong impact that EVA margins and sales growth have on value, consider two hypothetical companies. The first is a reasonably well performing Old World Company (OWC) and the other is a rising upstart New World Company (NWC). OWC has $2 billion in annual sales with $1 billion in invested capital and the current EVA is $20 million, a 1% EVA margin. The company is growing at 5% per year and is expected to continue this in the future while maintaining its EVA margins. With a 25-year time horizon and a flat EVA in perpetuity thereafter, the company has a present value of $1.33 billion. This company is considered a solid, if not exciting, performer. The second company, NWC, is very small but growing fast. Sales are now only $10 million on $5 million in capital, including capitalized R&D and marketing. EVA is now $3 million, a 30% EVA margin. NWC generated growth of 100% this past year, but the surplus growth (defined as growth in excess of 5%) is expected to decline by 10% per year. In other words, growth this year is expected to be 90.5%, next year 82.0%, the following year, and so forth. The EVA margin is also expected to decline in a similar manner. Even though NWC is only 5% of the size of OWC, the current total market value is exactly the same: $1.33 billion. This yields a valuation for NWC that is 133 times the present level of sales. As the company grows, this multiple will undoubtedly come down, but it is still a staggering number to consider. When we look back at Yahoo in 1998, with an EVA margin of 59% (twice the level of NWC's) and a 3-year trailing compound annual growth rate of 430% (over four times NWC's), a valuation over $100 billion at the end of 1999 is perhaps not too far out of reach. This valuation was about 500 times its year-earlier (1998) sales. Hence, the potential power of growth and EVA margins to explain current values. In this example, it will take 17 years for NWC to grow larger in sales than OWC. But the value in present terms is still the same. Bear in mind that the COV of OWC comprises nearly 90% of its total market value, while the COV for NWC is a mere 2.2% of current value. With so much of the value of NWC based on the future, we would expect its share price to be much more volatile as the market constantly readjusts the expectations for the future. In essence, this is why we see much larger rises and falls in the NASDAQ, with all heavy representation of new economy companies, than in the Dow. Much more of the value of the Nasdaq depends on the future and is therefore subject to frequent revision. When a considerable amount of a company's value is in FGV and that future value is quite variable, a better understanding of intrinsic value may be gained by applying "real options" techniques. Although real options have become almost a cliché in financial circles, our experience suggests that a minority of those who talk about option techniques truly understand their relevance or practical use in valuation. The analysis can be somewhat more complex than applications to oil and gas, where enormous databases on price and cost trends are available, but the technique is helpful nonetheless. On January 30, 2000, Barry Riley wrote in the Financial Times, "The S&P 500 returned 21% last year, but the median stock returned zero, which is another way of saying that 250 stocks lost you money. You had to be in technology." Although this sounds startling, it is not an uncommon outcome. We usually see a small percentage of shares that do so well that they pull up the average to a point well above the median. An option on a share gives the right, but not the obligation, to purchase and allows us to participate in this potential upside while avoiding the downside. It is the elimination of all these potentially negative outcomes that makes an option's value always greater than its in-the money value. Although several factors drive the value of options, the single most important is the volatility of the asset value. It is, in fact, the high degree of uncertainty about the future and the many options available now and in the future to new economy companies that cause their value to rise so dramatically. These companies have so much of their expected performance ahead of them that their shares are in essence options on participation in the future. To consider the impact of volatility on the value of options, consider exchange-traded call options on the shares of two well-known companies, General Electric and Amazon.com. GE's stock price has a volatility of about 30%, and Amazon.com's is about 100%. Using the standard Black-Scholes-Merton model for option valuation, we considered similar options on these two shares. With low volatility, the option value for GE drops off rapidly as the exercise price increases. But with high volatility, the option value of Amazon.com remains high even at very high exercise prices. Indeed, with a standardized share price of $10, a volatility of 100%, and an exercise price of $30 (or three times the current price), the option in Amazon.com is still worth $6.23, or 62.3% of the share price. And this is with a time frame of 5 years, which is long for a financial option, though short for the real options faced by new economy companies. By contrast, a similar option with an exercise price of $30 on General Electric would be worth only $0.572. So, an option to buy Amazon.com at three times the current share price over the next 5 years would be worth nearly 11 times (6.232/.572) that of a similar option to buy General Electric. This, again, is due to the importance of the tremendous upside on highly volatile shares. The key point is that a financial option gives the holder the right, but not the obligation to purchase a share for a specified price over a specified time. It can be worth substantially more than we might think. The greater the volatility and uncertainty, the more valuable the option becomes. But the benefit of this valuation approach extends far beyond mere financial options. Many strategic investment and operating decisions provide companies with options that can be quite valuable, particularly in times of great uncertainty. To understand new economy valuation, we must understand the value of real options. Companies of all types are faced with real options every day. In start-up companies where much of the compensation of key employees takes the form of stock options, the cost of the human capital has a large element of "optionality" in the following sense: If the company does well, the providers of the human capital reap large rewards; but if it doesn't do well, they get nothing, and the company minimizes its fixed costs. The fact that the providers of human capital absorb some of the downside potential in this way provides a source of option value to the shareholders. The future of the new economy provides more options than ever before. If a company is positioned with substantial content and a large subscriber base, it stands to make significant gains when bandwidth to the household increases. Advanced telecommunications, video telephones, movies-on-demand, work-from-home capabilities, and a whole host of other potential future developments become possible. When this happens, there will be investments in infrastructure to handle the throughput, but these investments will only be made when the technology makes them valuable. Companies such as AOL and Yahoo are positioning themselves to take advantage of the increased future potential by establishing the right, not the obligation, to invest in these areas. The result is significant option value. Of course, every company in every industry has such strategic options and this adds value to their shares. But, as we saw above with financial options, the value of out-of-the-money options is much more valuable when volatility and uncertainty are high. If we think of the entire extended sector as one valuation problem, we can picture a portfolio of options that are available. The collective value of these options, when combined with the value of current activities, should be the sum of the total value of all companies in the extended sector. The judgment managers need to make is which options are most valuable. To do this, we have to look at the drivers of value. Let's consider a simple example of a single real option. In the banking and brokerage business, there has been a strong move toward online transactions, but the reality is that only a few percent of the populace have signed up for this service. And even these people still mix online banking with telephone and face-to-face banking. The investments the banks are making in this field may or may not be earning an adequate return right now, but the banks have purchased an option to participate in this new customer interface. Will the vast majority of all banking, both commercial and private, ever take place over the network? Will Peter Keen ever be right when he says, "the world needs banking but it probably does not need banks?" We do not know. There are technological and cultural barriers to rapid acceptance. Most people do not have computers at home, and they are being discouraged from "surfing" the Internet for personal use at work. But the reduction in marginal costs and fixed assets, improved consistency of service, and overall convenience may end up drawing people in quite rapidly. If the transition does occur, it could be worth hundreds of billions of dollars in value—some of which will be transferred to consumers, though the banks will retain the rest. If online banking achieves little acceptance, then the strategic option turns out to be worthless, but at least the banks will have avoided the larger investments in infrastructure by making smaller initial investments to explore market potential. Thus, they have purchased the right, but not the obligation, to grow an Internet banking service. If we return to thinking about the extended new economy sector, and consider who will win and who will lose, we will have an easier time grasping the issues. Who would have guessed in 1980 that Microsoft would replace IBM as the powerhouse of computers? But we all could have predicted that the use of computers would rise and that someone would make a lot of money. Too many commentators waste too much effort discussing whether AOL will win, or Amazon or eBay. Before we even consider the relative slice of the pie, and the high variability in possible outcomes, we should consider the size of the total pie, which itself has a very wide range of possible outcomes. The new economy, when viewed correctly, is really made up of several sectors in the traditional sense. We start with the dot-com companies. But, since these would be of little interest without content, we also must consider companies that own content. These are media companies such as Time Warner and Disney, but the group also includes any company that owns content of potential interest to people or businesses, such as maps, census data, and encyclopedias. Next, we consider companies that provide "appliances," which is the new word for any piece of electronic equipment such as computers, televisions, and phones, as well as a wide range of focused application appliances now beginning to come to market. This sector includes equipment providers such as Dell and Sony, but also important suppliers to them such as Intel. Because people need platforms such as search engines and operating systems to be able to use their appliances, companies such as Microsoft and Yahoo make up yet another category. Finally, we need a means of communication, so the telecommunications companies, including telephone, wireless, and cable providers, are included. There are two main reasons for considering the extended sector. First, innovations in one sub-sector can transform all the other sectors immediately. If the telecommunications folks figure out how to get 10 times the volume down the copper wires connected to most houses, this will allow more elaborate Web sites with lots of video and user-friendly features. Content such as high-quality video, which is now nearly unavailable on the Web, will suddenly be readily accessible. The state-of-the-art for dot-coms increases to the benefit of content providers, which in turn creates a demand for new appliances and platforms. The pace of innovation in this group of sub-sectors is remarkably rapid. When we consider the extended sector as a whole, we see some companies with different mixes of value contribution over time. We break these into two groups. There are companies that are creating a lot of value now. Others are creating very little value now but have very large future growth values. It is the valuations of, especially, this second group that have attracted a lot of skepticism. But, as I suggested earlier, the collective group of new economy companies can be thought of much as we view a pharmaceutical company's pipeline of compounds. A pharmaceutical company has a group of drugs it now markets that typically produce very high current value and may have some opportunity for growth. It also has a pipeline of compounds that drain resources now but are expected to create substantial value in the future. Investors accept the idea that the pipeline of a pharmaceutical company contributes significantly to the current valuation of the company even though these compounds are running losses and draining resources every year, and do not promise the chance of profit contribution for many years. Yet many of these same people are unwilling to accept that a new economy stock with similar economic characteristics may have considerable value as well. The dynamics are the same, except the pharmaceutical compound is being managed inside a company that is also producing products that deliver profits now. The new economy stock is out on its own. There is another component of pharmaceutical valuation to be considered. It is generally estimated that 15% to 40% of the value of a pharmaceutical company comes from its long-term future—from compounds that are not yet in the development pipeline and may not even have been discovered by researchers. In other words, the market is willing to recognize that although we do not know what they will be working on in the future, the company is likely to deliver value. Thus, the value of the "unidentified future" plays an important role in the current valuation of pharmaceutical companies—and the same is true of the extended new economy sector. Due to patent lives, future value must come from new compounds in pharmaceutical companies, but new economy companies have no definitive life dictated by patents, so they can have future value beyond the lives of current products. Of course, some of the future value will come from companies that are now emerging or may not have even formed yet. If we take the extended new economy sector as a whole, then we see a valuation problem that is very similar to valuing a pharmaceutical company. The difference is that in pharmaceuticals we have many integrated companies that perform research, development, production, and marketing. They have currently marketed drugs, a pipeline of potential drugs, and the know-how to create new drugs in the future.