When Profits Are Losses: Analyst's Toolkit

Economic Value Added is a measure that can help investors determine which companies are generating enough earnings.
Author:
Publish date:

BOSTON (

TheStreet

) -- Earnings can be misleading.

A company that has ample profits but carries expensive financing may be in worse shape than one with softer earnings and cheaper financing. A metric for performance evaluation developed by Stern Stewart & Co. known as Economic Value Added, or EVA, can help draw a distinction between firms that are flying high and those treading water.

Investment managers such as

T. Rowe Price

(TROW) - Get Report

,

Charles Schwab

(SCHW) - Get Report

,

Legg Mason

(LM) - Get Report

,

BlackRock

(BLK) - Get Report

and

Franklin Resources

(BEN) - Get Report

suffered earnings declines as the stock market took a nosedive starting late last year. But they have recently performed beyond expectations as investment gains have stanched net outflows from mutual funds and boosted management fees. Applying EVA to those companies will show which are enriching shareholders beyond the minimum required return.

The theory behind EVA is that investors, whether equity or debt holders, demand a base charge for the use of their money to fund firm activities. The weighted average of those charges is called the weighted average cost of capital, and represents the minimum return that a firm must generate to satisfy the most basic expectations of its investors. Multiplying the weighted average cost of capital by the total invested capital, the sum of the debt, additional paid-in capital, common shares and all other forms of invested capital, results in the amount that it costs the company to maintain its financing structure. Economic Value Added takes that charge and subtracts it from the net operating profit after tax (NOPAT), which results in the profitability of the firm after the effect of its financing choices.

The formula appears to be fairly light. However, there are many adjustments that can be made to NOPAT to make room for various items on a company's income statement, but the general form is the following:

EVA = NOPAT - (Invested Capital X WACC).

That metric can turn previously strong performance into something less desirable, as is the case with BlackRock. With diluted earnings per share for the trailing 12 months of $5.06, the mutual-fund firm looked to be one of the strongest performers in the asset-management industry. However, after adjusting for the cost of capital, BlackRock's performance deteriorates to show a loss of over $1 billion. That indicates that the company hasn't generated sufficient earnings to cover the cost of its financing. Since equity holders are paid back last, that deficit falls squarely on their shoulders.

The same is true for T. Rowe Price and Franklin Resources. Both posted positive earnings, but the application of the EVA model shows that the companies didn't perform well enough to meet the demands of equity investors. T. Rowe Price's operations resulted in an EVA loss of $156 million, while Franklin Resources had a loss of over $200 million.

Legg Mason never appeared to be very strong in terms of earnings for the trailing 12 months due to massive write-downs. But its EVA performance isn't much worse than that of BlackRock. Legg Mason is far smaller, so the figures aren't as comparable. An EVA loss of almost $1.2 billion isn't appealing, though fewer write-downs will help the company raise its numbers.

Charles Schwab is the only one of the group to actually have a positive EVA figure for the trailing 12 months. With Economic Value Added of almost $58 million, it appears that Chuck is doing right by his investors.

Schwab is also the only firm, besides T. Rowe Price, to have a "buy" rating from TheStreet.com Ratings. Schwab's share price has trailed the company's competitors this year, but with a price-to-earnings ratio of 23, below the industry average of 27, and a strong Economic Value Added figure, it appears to be one of the best bets in the world of asset managers. Still, its shares have fared worse than its rivals. The company's stock has risen 6.6% this year, compared with BlackRock's 65% and Franklin Resources' 67%. BlackRock and Franklin Resources may not be able to sustain such gains, as the companies are fraught with more risk.

Economic Value Added is a good measure to use to compare a company against itself. A negative EVA indicates a company isn't generating enough cash to satisfy its financing scheme, which was crucial during the credit crunch that sank the financial world and the stock market last year.

-- Reported by David MacDougall in Boston.

Prior to joining TheStreet.com Ratings, David MacDougall was an analyst at Cambridge Associates, an investment consulting firm, where he worked with private equity and venture capital funds. He graduated cum laude from Northeastern University with a bachelor's degree in finance and is a Level III CFA candidate.