A sobering gut check for the market

By Shawn Tully, senior editor-at-large August 19, 2013: 8:51 AM ET

 

What a rigorous metric called "EVA" says about the value of stocks. Hint: it ain’t pretty.

 

FORTUNE — Forget P/Es. Trailing, forward, westward, or eastward, the venerable price-earnings ratio tells you little more about the value of a company than its marketing budget. Or (ugh!) its "consensus analyst rating."

The best measure of how companies perform for shareholders is a wonkish tool called Economic Value Added, or EVA. The advantage of EVA is that it corrects the gap, so to speak, in regular GAAP accounting by gauging what’s really important: whether shareholders are getting returns superior to what they’d garner putting their money in another, equally risky stock or index fund.

 

According to EVA, a company only truly enriches investors when it exceeds the return that the market already expects from similar stocks. When it beats that bogey, it’s truly making money for you. When it falls short, it’s a loser — even if its official earnings numbers look good.

 

EVA’s big innovation is imposing a charge for all the capital that companies deploy to generate profits. Under GAAP, an auto or soft drink manufacturer can keep raising earnings per share by piling cash into expensive acquisitions or modestly profitable new plants. Sure, the interest on the debt used for those investments gets lopped off earnings. What’s deceiving is that companies pay no charge for their biggest source of capital: the equity raised from shareholders and invested on their behalf in retained earnings. That’s money you could put somewhere else and earn interest on it. So shareholders should make sure they’re being properly compensated for that investment.

EVA presents the real picture of that shareholder compensation by placing a stiff fee — equal to the prevailing cost-of-capital — on every dollar of equity sitting on the company’s balance sheet. In the EVA mindset, the only true profit is "economic profit," the cash generated after paying the full capital charge. Generating EVA is like shooting under par, or at least beating your handicap, in golf. It’s a mark of superior performance. And producing big, consistent gains in EVA is the driver and hallmark of great stocks, from Wal-Mart (WMT) to Amazon (AMZN).

 

The consulting firm Stern Stewart pioneered EVA in the 1990s, winning such devotees as legendary Coca-Cola (KO) chief Roberto Goizueta. Firm co-founder Bennett Stewart now champions EVA as CEO of EVA Dimensions, which sells software and data that companies use to do this rigorous valuation analysis, and produces original equity research for big institutional money managers.

 

So what does EVA say about the stock market now? Well, it ain’t pretty.

 

Read the full article at http://finance.fortune.cnn.com/2013/08/19/stocks-valuation-eva/