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How to Find a Company's TRUE Profit - Economic Value Added Explained Simply - YouTube
Channel: Learn to Invest - Investors Grow
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hi i'm jimmy in this video we're looking
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at a great way
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to look at the genuine profitability of
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a company
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beyond the typical earnings per share
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this is called economic value added
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you might hear you might see the
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shortened to eva or you might even hear
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it called something like economic profit
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so we're gonna look quickly at the
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formula for economic value added
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and then we're gonna look at some
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examples some real life examples to see
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how we can apply
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this method okay let's jump right in so
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this is the formula for economic value
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added
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and it may look like a lot but we'll
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break it down step by step
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so economic value added so eva
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is simply the net operating profit
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after tax oftentimes you'll see that
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shortened to no pat
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we take that and we subtract the
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invested capital times the weighted
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average cost of capital
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this is abbreviated to whack wacc now
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just to clean this up a bit
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this is how the formula will typically
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look if you ever google it
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so let's start with notepad notepad is
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net operating profit after tax
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net operating profit you might hear this
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called ebit or
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earnings before interest and taxes so
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all we do is we take
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ebit and we adjust it for taxes so to
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adjust ebit by the tax rate all we have
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to do is look up the company's tax rate
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they'll list that in either their
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quarterly report or their annual report
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we take their tax rate and we multiply
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that we do one minus the tax rate
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multiply that by ebit
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so if their tax rate is 20 it would be
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one minus twenty percent so point eight
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times their ebit that would give us net
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operating profit after tax
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now the reason i ran us through this
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particular example
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is because the purpose of economic value
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added
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is to determine how much the company is
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returning
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after accounting for the cost of capital
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interest expense is the cost of capital
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so all
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notepad is doing for us is eliminating
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the interest expense
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basically we want to isolate the profit
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excluding any interest expense
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okay now we move on to invested capital
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so to calculate
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there's a few ways to calculate uh
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invested capital but i think the
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simplest way
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is to take the equity from the balance
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sheet which represents sort of the stock
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portion of the invested capital and then
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we add any interest-bearing debt
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so basically how much bond how many uh
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what are the amount of bonds that they
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the company has out there
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add that to equity and that is the
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invested capital within the company
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and then we have the weighted average
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cost of capital now the i actually did a
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video on how to calculate the weighted
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average cost of capital
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and basically it's the cost of debt and
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the cost of equity
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so the cost of the stock to the company
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and then let's say they have 80
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equity and 20 debt well you have to
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weight
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the overall cost of capital if you're
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curious how to do that calculation
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you should probably go see that video
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that takes a little bit longer to
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describe
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but basically this is how much the
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interest rate that a company
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pays essentially sort of pays for
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capital so again i'll leave a link to
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that video in the description below
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but here's a quick example of why this
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is important
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so let's imagine that there was a
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company that was starting a it's a brand
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new company they're just starting out
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and they borrow let's say a million
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dollars
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and the in borrowing a million dollars
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so now they have a million dollars maybe
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they get a loan from bank maybe they do
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it via bonds
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whatever it is but let's pretend that
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that million dollars is costing them
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five percent per year so they go out and
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they start building their widgets they
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sell their widgets
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and let's imagine that they return on
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their million dollars invested capital
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they return
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five percent what have they added
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profitability it's very possible that
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they're profitable
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so the company may look profitable and
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the
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untrained investor might look at that
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and be like oh good they're giving us a
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return
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but what economic value essentially
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tells us is because
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their cost of capital is the same as
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what they are earning
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well they're not really they're not
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bringing back any economic return
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they're not giving us
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anything on top of their cost of capital
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that's what economic value
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added is trying to give us it's trying
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to tell us how much
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in a dollars in from a dollar's
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perspective how much has that company
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returned
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on top of their cost of capital so the
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advantage of economic value added
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is that it gives us a much cleaner look
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at
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how the company is truly performing okay
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now
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let's look at some examples of how we
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can take economic value added and apply
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it to real-life investment research
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to see how companies that we own or that
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we want to own are
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truly performing for us so this is the
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chart
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of 3m's economic value added going all
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the way back to 2002.
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now i've done videos on 3m in the past
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so for curious to learn more about that
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company i'll leave a link
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to that video in the description below
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but the numbers on the left-hand side
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here these are
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in billions of dollars and we can see
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that this number has been consistently
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pro it can
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has been consistently part of positive
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which tells us
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that the 3m as a business as management
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of 3m well they've done a good job
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of consistently adding value to the
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business
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to the stockhold for the stockholder so
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whatever that overall capital is costing
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them both debt
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and equity whatever that capital is
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costing them is ultimately they are
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ultimately outperforming that so that's
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a good thing now another example is
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jonathan and johnson
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again johnson johnson going all the way
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back to 2002 and we could see that
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they have been again consistently
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profitable except for
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2017 where and i said profitable i meant
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consistently positive economic value
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added
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but they've except for 2017. now
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if we were just if we were curious about
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investing in johnson johnson
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this would be a good thing to look at
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what happened in 2017.
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now i actually went back and looked at
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this and it turns out that with the tax
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changes that were happening in the u.s
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back then well there was a big offset in
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taxes for that year
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so this that was one of the reasons this
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was a one-off a negative year
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it was enough for me to dismiss it
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because their no pat net operating
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profit after tax was still a fairly
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significant number
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but there were just their adjustments in
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there so hence the reason it came up
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with a negative number that year but
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it's not something that worried me but
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we only know that if we look at this
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and research it now when we do research
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it i think it's important for us to
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recognize
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how uh economic value-added could
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ultimately move
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so pulling up this formula down here
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well there's a few ways to adjust
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economic value added let's say they
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wanted to we wanted to see a company
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increase economic value added
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first thing they could do is increase
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the net operating profit after tax
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if that goes higher all else the same
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the
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uh eva will continue to move higher and
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this is sort of ideal this this implies
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that the company is sort of getting more
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and more
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profitable or creating a greater
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economic profit which is a good sign
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for investors another option is to lower
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the cost of capital the
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whack you could lower the whack or you
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could lower the invested capital
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now i should also point out that one way
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to lower the cost of capital
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generally equity has a higher cost of
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capital
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than debt does generally debt has a
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lower cost of capital
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so in theory if you wanted to lower
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whack you could take up more debt
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now that's counterintuitive you might
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you know so
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it depends how the company is doing it
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but i do i bring that out because i want
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us to be aware
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that if we see a company taking out debt
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we might look at a company that has
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plenty of cash and say why are they
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taking out debt well it's because debt
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can be cheaper than taking out more
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stock
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so sometimes it's a logical thing to do
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but we want to be aware if they're
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taking out too much debt
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that's sort of a bad sign even if it
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improves eva so let's clean this up a
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bit
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and now we're going to add another i
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think is a more interesting chart
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so this is general electric's economic
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value added again
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going back to 2002 and you can see that
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they have been consistently negative for
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every single year so this means that the
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company and ultimately the management
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team
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of that company has consistently reduced
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the
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economic value of the overall business
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they're continuing
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to drag down the value of the business
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every year
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now in general electric's defense there
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have been a few management changes
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during this time period
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and perhaps they're almost done with
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this perhaps this is going to go
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positive in the near
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future but that's a big prediction to
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make i have researched general electric
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and i was not aware i did not recognize
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how long they've been destroying the
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value of the company now i was curious
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about the cause
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what would cause general electric's
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numbers to be so bad for so long
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so i actually went and found their ebit
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numbers which is the first step ebit is
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short for
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earnings before interest and taxes and
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it's the first step
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to coming up with the net operating
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profit after tax so in theory you want
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this number to be high
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and hopefully positive that's really the
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only way to get a positive economic
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value at it and if you're ever looking
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for ebit but you can't find it maybe
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you're looking at a site like yahoo
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finance or even the company's financials
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and you can't find
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earnings before interest and tax but you
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might also hear it called
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operating income operating in income and
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ebit are generally the same thing
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so that's usually the line you can go
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with so for ge
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because this number has been broadly
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positive for many many years
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well this means that their invested
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capital and
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their weighted average cost of capital
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are way too high they have to lower
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those
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they should be paying off debt which
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would reduce their invested capital
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probably also increase their cost of
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capital so perhaps they also buy back
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some stock
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they should do whatever they can to
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lower those two numbers
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to try and they should also be trying to
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simultaneously
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increase their net operating profit
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after tax if they want to add any real
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value for
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investors so we can see with these three
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examples that economic value added does
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a good job
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of painting a picture of what the
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company is doing
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for investors now i actually did a video
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where i go through
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a more in-depth research process that i
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use to analyze a stock
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called eight steps to analyze a stock so
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if you're curious
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you can incorporate this into that
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process
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you can incorporate this into the early
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stages of that process
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to help narrow down which years are
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better to invest which years are better
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better to analyze to try to truly
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understand the company
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so if you're curious about the research
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process well i got a link right here to
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that video i got a link in the
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description below
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and thank you so much for sticking with
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me all the way to the end of the video
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i really do appreciate it thank you and
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i'll see in the next video
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