0:13

We just learned how to estimate cost of capital and how to use cost of capital to

Â figure out whether a company is generating economic value or not, right.

Â That is very useful, and it seems, actually, quite easy, but

Â here comes a problem.

Â 0:31

Most real world companies are going to have different division, right?

Â You're not investing only in one type of product,

Â you might be investing in many different products.

Â That's true even for PepsiCo, right.

Â Most of PepsiCo's investments are related to soda, right, soft drinks.

Â But PepsiCo also has other food business.

Â The general point is that if a company has different divisions, the company

Â wide cost of capital is generally not the right discount rate for all of them.

Â Okay?

Â Remember the initial idea.

Â Discount rates have to reflect the specific risk of each project.

Â Right? In this case,

Â the discount rate has to reflect the specific risk of each division.

Â 1:26

So now what I want to talk about is how would we do it, right?

Â If we have this problem,

Â if the division is different from the company, how can we do this calculation?

Â Okay.

Â The example I'm going to use is Altria,

Â which is a conglomerate that produces mostly tobacco.

Â Okay.

Â Most of their business is to sell cigarettes,

Â smokeless tobacco and cigars, mostly cigarettes.

Â That's the big business.

Â Both in the US and abroad, okay.

Â But they also have some other smaller divisions.

Â In particular they have a wine division that we're going to talk about here.

Â And also some financial services.

Â This is the wine division of Altria.

Â It makes wines in Washington state,

Â the division is called Ste.Michelle Wine Estates which you might have seen before,

Â especially if you live in the US, these are broadly, these wines are sold

Â very generally in supermarkets and all that, so you might have seen them.

Â So these wines are made in Washington state, okay?

Â And now they are made by this company called Ste.Michelle Wine Estates.

Â They also owned by some other wineries around the world but

Â this is the big business, okay?

Â 2:40

What we want to do then, suppose if we are Altria, right?

Â The CFO of Altria has to figure out whether the wine division

Â Ste.Michelle Wine Estates is generating economic profit or not.

Â Okay?

Â So how do we do that?

Â How do we compute EVA for the wine division?

Â Right?

Â The first thing we need is data on profits and assets, separated by division.

Â Right?

Â And this data might be difficult to come by.

Â Companies are not necessarily required to report this data.

Â So some of them do, others don't, okay.

Â If you are inside the company you are definitely going to have that information.

Â Even at a more granular level, even for specific projects and all that.

Â In the case of Altria, they were nice, and

Â they actually report data separately for the wine, for different divisions.

Â In particular we are using here the wine and the tobacco division.

Â We have operating profit and assets separately by division.

Â What we don't have is cash separated by a division here, okay?

Â It turns out that Altria does not hold that much cash, so we're just going

Â to assume for this calculation that cash is equals to zero, okay?

Â Remember that in general, you want to deduct cash from all from your assets to

Â figure out operating assets, okay.

Â We do have OPAT, so all we have to do is to tax the operating profit.

Â These taxes are 30% then your OPAT would be $57.8 million, okay?

Â So in 2014, the wine division of Altria generated $57.8 million in profit, right?

Â And the question that the CFOis trying to figure out is this or not?

Â Right?

Â Is this a sufficient profit for the wine division or should be looking for more?

Â Does the division have to perform better, right?

Â 4:49

You'll find out that Altria also does not have a very high beta.

Â Similar to PepsiCo, Altria's beta is 0.5, okay.

Â We can use the range and

Â all that, the bottom line is that Altria will have a lower beta.

Â Maybe between 0.4 and 0.7, like PepsiCo.

Â 5:06

Is this the right beta to use?

Â If you're trying to answer the question we just posed,

Â which is to figure out the performance of the wine division, is that the right beta?

Â Which risk is this beta reflecting?

Â 5:42

If you look at the table that we just worked with,

Â most of the assets are invested in tobacco.

Â Most of the profits come from tobacco.

Â Most of the equity value is going to reflect tobacco.

Â There is no guarantee that if we use 0.5,

Â we are actually going to be measuring a wine beta, okay.

Â So now what we need to think about is, then how do we do it, right?

Â 6:07

It's really very important because EVA, it is useful to figure out EVA for

Â the company as a whole but EVA is even more useful

Â when you think about individual projects, when you think about divisions, right?

Â You can use EVA for executive compensation for example, right.

Â If the wine division is doing great, then the chief manager

Â of the wine division might get paid more, might get more stock for example.

Â But to determine that, you have to figure out the cost of capital for the division.

Â And we cannot directly measure it.

Â 6:42

Why?

Â Because the wine division does not trade separately in the stock market.

Â You cannot find the stock price for the wine division.

Â There's no way you can estimate the beta even if you had the most sophisticated

Â statistical tools in the world,

Â you're not gonna be able to estimate beta because you don't have the data.

Â So there two approaches that we use here in corporate finance.

Â One is to take a range of similar companies,

Â and use an industry beta, right?

Â So that's the beta that is going to be averaged out across many

Â firms in a related industry.

Â The second one is what we call a pure play approach,

Â which is to try to find a singular company that is publicly traded.

Â 7:25

So let me give you example here for Ste.Michelle for Altria's wine division.

Â We can start from a beverage beta, right?

Â A beverage beta is definitely going to be better than a tobacco beta, right?

Â Using this table here, you'll see that the beverage beta,

Â 7:43

using 35 company's in this case, is 0.95, right?

Â So it's a beta that is a lot closer to one, than the tobacco beta, okay?

Â We can also try a pure-play approach.

Â 7:59

Which is to, in this case, we're looking for the wine beta.

Â So what we need to search for is a company that mostly makes wine.

Â A company whose main business is wine, and

Â that is publicly traded in the stock market.

Â In this case we are lucky.

Â We can use a company called Constellation Brands, okay?

Â Which produces wine all over the world,

Â including the US, Australia and many other parts.

Â And we can get data for Constellation Brands.

Â We can go to Capital IQ or Yahoo Finance for example and

Â you will find that the beta is around one.

Â The beta is 1.02 in this case.

Â So think about this we had the option of using the tobacco beta, right.

Â 8:46

We had the option to use the tobacco beta.

Â But it actually turns out the beta, a wine beta,

Â wine WACC, would actually turn out to be higher, right?

Â Because, remember, the higher the beta the higher the WACC, right?

Â So if we use a beta of 1 here,

Â we are going to end up with a required return on equity of 8% right?

Â Instead of six and a half percent which we would have obtained if we

Â were using the tobacco beta.

Â Okay?

Â So just a couple more data points here to compute the WACC to go from

Â required return on equity to the WACC.

Â We have to add the debt to value and the cost of debt, right?

Â We take those from Altria.

Â Those are company wide values.

Â Again there could be a difference in the cost of debt from the wine division to

Â the tobacco division but it's less likely to be the case.

Â Going back to the idea we discussed before, a debt securities are safer.

Â The equity gets the residual cash flows.

Â So the cost of that, the required return on that for the tobacco division should be

Â closer to the required return on that for the wine division and here we don't

Â have a good data to get a better estimate so let's just use that, okay?

Â As it turns out, Altria does not have a lot of leverage anyway so

Â that's not even if we are getting this numbers slightly wrong,

Â It's not gonna throw off our estimate that much.

Â Okay?

Â So if we apply the WACC formula, we're going to find a cost of capital of 7.4%.

Â Okay?

Â So the cost of equity, the required return of equity is eight.

Â The cost of capital is 7.4%.

Â Okay?

Â And now, we can go back and estimate EVA.

Â Right?

Â 10:33

Using, for example, 7.4 we would deduct.

Â We have the OPAT, we have the operating assets.

Â We deduct the WACC times operating assets from the OPAT.

Â We get an EVA of minus 6.3 medium.

Â Okay?

Â What does this mean?

Â Right?

Â It means that looking at that year in isolation, 2014,

Â the wine division did not generate sufficient economic profits, okay?

Â 11:21

And go back to what we've been discussing.

Â Which mistake would you have made if we had used the tobacco beta?

Â Suppose we had used the 0.5 instead of one for the beta?

Â You would have ended up with a higher EVA.

Â Right?

Â Essentially, you would be underestimating risk, because beta measures risk.

Â So 0.5 is very different from one.

Â 11:53

For the company it matters a lot, if you're using EVA for

Â performance evaluation, for compensation, you have to try to get it right.

Â So even if this calculation isn't perfect,

Â it's definitely better than if we had used 0.5, okay?

Â 12:09

How would we use EVA?

Â So suppose that we have checked this calculation and

Â really made sure they're not of that all the numbers are solid and

Â that we find out that the wine division is, in fact, generating negative EVA.

Â What does that mean?

Â Should we go ahead and restructure this division?

Â Should we sell it off?

Â What should Altria do?

Â Here you have to be a bit careful.

Â 12:41

EVA by the definition, tells you if a company generated economic profits in

Â a given year or if a division generated economic profit in a given year.

Â So what might be happening is that perhaps the wine division is expected to grow

Â a lot, and to generate higher profits in the future.

Â So, having negative EVA today doesn't mean you have to sell off the wine division.

Â What it does mean is that you have to make sure the wine division,

Â the performance of the wine division, is going to pick up.

Â If that never happens, if EVA never turns positive,

Â then at some point the restructuring is necessary.

Â Essentially this means that, that division is not creating economic value.

Â Something has to be done.

Â So it's very useful information for a CFO, for a CEO, for

Â the company as a whole to use EVA and be able to figure out whether the division or

Â a project is contributing in economic value or not.

Â