0:14

But very simple example just to round up the idea of the, you know,

Â whether a company's creating or destroying value.

Â Let's consider a company that is generating a NOPAT of $9 million.

Â So from an accounting point of view, this company is making money.

Â It's investing $100 million of capital.

Â That capital was raised from capital providers, and

Â these capital providers actually require the return of ten percent.

Â So the cost of capital of the company is ten percent.

Â So we're dealing with a company that makes, in any given period,

Â $9 million with $100 million of capital invested and

Â the capital providers require a return of 10%.

Â Did this company create value or not?

Â Well I'm sure you can guess now what the answer is going to be.

Â We can calculate EVA with the first definition.

Â A NOPAT of 9 million minus $100 million of

Â capital multiplied by the 10% cost of capital, that gives me minus $1 million.

Â Why minus $1 million?

Â Well remember what the product of capital multiplied by the cost of capital is.

Â Its basically what we call the capital charge.

Â So, the managers of this company need to be delivering at least $10 million to

Â properly compensate the capital providers, but they have delivered only $9 million.

Â So they have been $1 million short, and

Â that is the negative EVA that you have here.

Â So, they generated $9 million.

Â There was a minimum expectation of generating $10 million,

Â the minus one million is the shortage of that provision of profits,

Â provision of cash to the capital providers.

Â We can use the second formula.

Â Second formula will be remember,

Â capital multiplied by the return on capital minus the cost of capital.

Â And the return on capital was the NOPAT,

Â in our case nine million divided by the capital, in our case 100 million.

Â So that gives you 9%.

Â Now, 9% is the return on capital, 10% is the cost of capital, so

Â we have a negative spread.

Â And that negative spread, you know, if we put any amount of

Â capital at any negative spread, then we're going to be destroying value.

Â And in this case, because we're putting $100 million

Â in an activity that generates a return on capital is 1% that's

Â point lower than the cost of capital will destroying 1 million of value.

Â So as we said before, you can use formula number one or formula number two.

Â You're going to get numerically exactly the same number, and

Â in this very simple company, in both cases we're destroying $1 million of value.

Â Another way of saying that is that this company actually

Â generated an accounting profit of $9 million, but

Â generating an economic loss, a negative economic profit of $1 million.

Â It fell short of compensated capital providers, and therefore,

Â this company had a positive accounting profit but a negative economic profit.

Â 3:27

And before we actually look into these numbers,

Â let me say that I made a few assumptions just to simplify the example a little bit.

Â But the numbers are fairly accurate, and they actually,

Â you'll see that they go where they want to go and we're going to try to get

Â a company that is clearly creating value and one that may be destroying value and

Â so that's basically what we going to try to put together with this example.

Â So let's start with Apple.

Â Apple in May 2014, at that point in time,

Â the company was generating a NOPAT of almost $40 billion.

Â Now Apple, as you know, in terms of market value is the largest company in the world.

Â In terms of revenue, it generated $176 billion back in the year 2013.

Â And out of that, 40 billion of that, almost 40 billion were profit.

Â So we're going to start from a note about a 39.8, almost 40 billion dollars.

Â Now, they did so with a lot of capital.

Â They have a lot of capital invested over $120 billion, so

Â almost $121 billion of capital invested, and if you calculate the cost of capital,

Â we're not going to go into the nitty gritty now, its about 7%.

Â A little bit lower than 7%, 6.8%.

Â Now, knowing the NOPAT, the capital, and

Â the WACC, we know that we can actually calculate everything else.

Â But before we do it, because we're going to calculate the EVA with both

Â expressions, lets calculate the return on capital.

Â And as you remember, that is simply,

Â in this framework, the NOPAT divided by the capital, so the $39.8 billion

Â divided by the $120.8 billion, and that gives you a round number of 33%.

Â Now, we could stop the calculations here.

Â We're dealing with a company that has a return on capital of 33% and

Â a cost of capital of 7%.

Â They're creating huge value.

Â And now we can still run the EVA numbers, but we could

Â stop here whether we're asking the question of they're creating value or not.

Â Of course, they are.

Â They are beating the cost of capital by a huge margin.

Â They're creating a big gap of over, well over 20 percentage points.

Â Now, if we still want to calculate the numbers, expression number one.

Â NOPAT $39.8 billion minus the $120.8 billion

Â of capital invested multiplied by the 6.8 cost of capital.

Â That gives me, remember, that second part, the capital of 100 and

Â almost $121 billion multiplied by the cost of

Â capital of almost seven percent gives me the capital charge.

Â And so, the minimum amount of money that the capital providers actually would

Â expect would be $8.2 billion.

Â But, guess what?

Â Apple is generating $39.8 billion.

Â So, it's got to compensate the capital providers and then some.

Â And the excess of how much more money they

Â have is the $31.65 billion that you're seeing there.

Â In other words, they need to deliver at least $8.2 billion in terms of cash.

Â They deliver almost $40 billion of cash, therefore, they produce $31, almost $32,

Â billion dollars more than they should from the point of view of value creation.

Â The second expression highlights what we were saying before.

Â And what we were saying before is that when you look at the spread between

Â the return on capital of 33% and the cost of capital of almost 7%,

Â well you have a 26 percentage points, a gap between one and the other.

Â And if you actually apply $121 billion of capital to that spread,

Â you go back to the same number we calculated before,

Â Apple is generating $31.65 billion of economic profit.

Â That is profit beyond what capital providers were requiring for

Â providing that capital in the first place.

Â So in this framework, if you believe this whole idea of residual income,

Â economic profit, EVA, we can clearly say that last year Apple create,

Â clearly Apple created value.

Â Now, let's compare that to Yahoo.

Â Situation of Yahoo is a little bit different.

Â Yahoo, first, is a much smaller company.

Â They have actually $4.7 billion of revenue, out of which they actually

Â created about $180 million in profits, about 179 million dollars in profits.

Â Now, in order to create $179 million in profits, they used capital, and

Â they used $12.8 billion in capital.

Â Far less than Apple, about one-tenth the amount of capital that

Â Apple actually used, but the problem is that they have a higher require return,

Â which is actually pushing at 9%.

Â And before we actually keep on with the calculations,

Â remember that we can calculate one more thing, and

Â that is what we call the Return Capital, the NOPAT divided by the capital.

Â So if we divide the 879 million by the $12.8 billion in capital,

Â we get a return on capital of 6.8%.

Â And we're going to keep going, but we could stop right there.

Â And the reason that we could stop right there is that if you have a company that

Â has a return on capital of less than 7% but it has a cost of capital of almost 9%,

Â well, you know, you're investing resources but

Â you're not creating enough return to satisfy the capital providers.

Â Be that as it may, we can calculate the EVA with expression one,

Â and creating that the EVA with expression one would be the NOPAT,

Â $879 million minus the capital invested which is $12.8 billion,

Â multiplied by the cost of capital of 8.9%.

Â And if we multiply that $12.8 billion by 8.9%,

Â we get a $1.1 billion capital charge.

Â Now where's the problem?

Â That capital providers are requiring at least $1.1 billion, but

Â Yahoo provided them with less than $880 million.

Â So there was a shortage of $260 million, and that is what,

Â in this framework, we would create value destruction.

Â The capital providers were expecting $1.1 billion, Yahoo provided

Â them with 180 billion, so there was a shortage there of $260 million.

Â Or we can look at this with a second expression.

Â And the second expression, as we clarified before, says that we look at the spread,

Â which is 6.8 and with respect to 8.9.

Â That basically means that there's a negative spread of over two

Â percentage points.

Â And if we apply capital to any activities in which we have a negative spread,

Â we're going to destroy value, and that value destruction is going to be,

Â obviously, the same number as before, and that is going to be $260 million.

Â In other words, in this framework, we would say that Yahoo destroyed value.

Â So we looked at two companies, Apple and

Â Yahoo, at the same point in time based on figures for 2013.

Â And we're saying, well at this particular point in time,

Â Apple was creating value because it had a positive and huge EVA, and

Â Yahoo was destroying value because it did have a negative EVA.

Â 10:52

All right. So, as you

Â see that the idea of EVA is very simple.

Â It basically tells you that you need to compare the return on

Â capital with the cost of capital.

Â And as long as the former is higher than the later, then you're creating value,

Â otherwise you're not.

Â So whether you're focusing on EVA, or residual income, or

Â economic profit, and all the maybe little differences between them,

Â they all take you to a very basic and elementary and important idea which is

Â managers are using capital, someone has to provide that capital.

Â Those capital providers require return.

Â That return is related to the risk that you perceive in the corporation, and

Â when you bring everything together, if you actually delivered a return that is

Â higher than the return required by the capital providers,

Â then you're going to be delivering, that value that shareholders actually expect.

Â Or you can think of this from the point in dollars and

Â cents rather than in percent, that would be the first.

Â A formulation of EVA where you say that one can calculate,

Â given the capital that I'm using and

Â the cost of capital, what is the minimum amount of cash that I need to produce?

Â If I produce more than that, I will be creating value.

Â If I produce less than that, I will be destroying value.

Â One way or the other all these ideas of EVA residual income or economic profit.

Â Again, they point in the same direction and that is a very important direction.

Â Managers need to use capital.

Â That capital is not free.

Â That capital is going to be requiring a return related to the risk of putting this

Â capital in this company, and when I bring everything together, I need to compare

Â the return that I provide with the cost of raising that capital in the first place.

Â Now, that is the very simple idea of EVA.

Â And as we said before,

Â it is not the only way to think about the process of value creation.

Â Some other consulting companies might actually tell you, I have a better

Â variable to measure whether you are creating or destroying value.

Â And now we go back to an example that at this point is very familiar to you,

Â which is the CAPM.

Â Again, the CAPM is not the only way to calculate the cost of capital, but

Â it's very intuitive, it's very widely used, and there are many alternatives, but

Â it's kind of the beacon, you know,

Â it's kind of the benchmark against all the other models are measured against.

Â Well, EVA is a little bit of that, in this whole business of value creation.

Â It's very intuitive, it's easy to understand, it's very widely used.

Â That doesn't mean that it's the only one or that it's the best one.

Â There are other competing measures of value creation, and

Â we're discussing one that is actually popular, again intuitive and

Â also it has an economic rationale.

Â As we've been saying before, it compares the two basic variables of return and

Â cost of capital and what you need to do in order to create value for

Â the shareholders.

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