26.segmental reporting and eva-2010-bw

8/7/2019 26.Segmental Reporting and EVA-2010-Bw

1/27

Session 26 -Segmental Reporting and

Economic Value Added (EVA)

Segmental Reporting

Economic Value Added (EVA )

In Valuation

As a Performance Measure

Calculations

Pepsi

Interpretation


2/27

Segmental Disclosures

Advantages to disclosing information about segments?

Costs?


3/27

Segmental Disclosures

Advantages to disclosing information about segments?

Different operating segments of a company may be

very different in terms of level of profitability, growthand risk

Costs?

Release of proprietary information to competitors (orunions)

Accounting classification/allocation problems


4/27

SFAS 131 --What is a segment? A distinct revenue-producing component of an enterprise

Use the management approach to define segments

Use the same definition that management uses internally to make

operating decision and assess performance (but even if you dontdo this internally, you still have to define segments for external

reports)

Segments can be defined based on

type of product or service,

geographic area,

by legal entity, or

by type of customer


5/27

Ten Percent Tests - A segment must be

reported separately if it meets one ofthese 3 tests

10 % of combined revenues (include intersegmental sales)

10 % of combined profits (of segments reporting profits)

or 10% of combined losses (of segments reporting losses)

10% of combined assets

try to preserve comparability and consistency in the

definition of segments over time


6/27

Assuming the 10% test is met

Add up the total unaffiliated revenue of the reportable

segments

If this is not at least 75% of total unaffiliated revenues,go back and define more segments

Room for Discretion


7/27

Mandated Disclosure about Segments

General Descriptive Information

Information about profit or loss

Information about identifiable assets why not also liabilities?

Reconcile segment information with the enterprise

numbers

Restate previously reported segmental data if the definitionof segments has changed

Information about Major Customers


8/27

Information about Profits

Companies do NOT have to disclose segmental earnings in

accordance with GAAP

They can pick any profit-like performance measure theywant

In principle, they are suppose to disclose the performance

measure they most pay attention to internally

Obviously, consistency over time and across firms is a bigproblem here


9/27

Dividend Discount models can also be expressed in

term of Accounting numbers

Firms Equity value is equal to itsBook Value plus

Present Value of the expected future Abnormal Earnings

Another term for the abnormal earnings is Economic Value Added

The Market Value Added (MVA) by the Firm (the excess of what the net

assets are worth compared to the amounts invested plus profits re-

invested) is the Present Value of the Future EVAs

t t 10 0 t

t 1 e

(E rB )P B

(1 r )

g

!

!

t t 10 0 t

t 1 e

(E rB )

Market Value Added P B (1 r )

g

!

! !


10/27

Another way to express equity value

Equity value depends on your ability to

Grow your capital base (net assets or shareholders equity)

Earn an Excess ROE on that capital base

t t 1 t t 1

0 0 0t tt 1 t 1e e

(ROE r) (ROE r)G{1 }

(1 r ) (1 r )

g g

! !

! !


11/27

Abnormal EarningsEt - r Bt-1 = Net Incomet - re Book Value of Share Equityt-1

Interpretations

Earnings minus normal earnings Earnings minus charge for equity capital (note that the charge for

debt capital is already included in the earnings number)

Other names for it

Residual Income Economic Value Added (EVA)


12/27

EVA as a Performance Measure

"EVA is easily today's leading idea in corporate finance

and one of the most talked about in business. Simply

stated, EVA is just a way of measuring an operations' real

profitability. It allows you to look at almost any business

operation and see immediately whether it was becomingmore valuable or less. What makes it so revealing is that it

takes into account a factor no conventional measure

includes: the total cost of the operations' capital. Managers

who run their business according to the precepts of EVA

have hugely increased the value of their companies (CSX,

Briggs and Stratton, Coca-Cola, etc.)" S. Tully, "The Real

Key to Creating Wealth," Fortune, September 20, 1993


13/27

What is EVA? EVA is net operating profit minus an appropriate charge

for the opportunity cost of all capital invested in an

enterprise.

As such, EVA is an estimate of true "economic" profit, or

the amount by which earnings exceed or fall short of the

required minimum rate of return that shareholders and

lenders could get by investing in other securities of

comparable risk.

Stern, Stewart


14/27

Why a Charge for Capital?

The capital charge is the most distinctive and important

aspect of EVA. Under conventional accounting, most

companies appear profitable but many in fact are not.

"Until a business returns a profit that is greater than its costof capital, it operates at a loss. Never mind that it pays

taxes as if it had a genuine profit. The enterprise still

returns less to the economy than it devours in resources

Until then it does not create wealth; it destroys it."Peter Drucker, Harvard Business Review article

Equity capital (new investments or retained earnings) is

not free


15/27

There are Many Equivalent Ways of

Calculating EVA

All start with some measure of profitability and then

subtract a charge for capital

It is important that the profitability measure, the measure

of capital, and the charge for capital be consistent with

each other

The profit number is usually some variant of accountingnet income (I.e., accounting income with adjustments

number.


16/27

T

hree equivalent versions of EVA

Net Income - r e Shareholders Equityt-1

NOPAT - WACC Assetst-1

NOPAT - WACC* (Assets - Non Int Bearing Debt)t-1

In the last version, the capital basis can be viewed as

Working Capital + Long Term Assets


17/27

EVA - Pepsi

Calculation

What profitability measure is available?

Is this number before or after tax?

Has a charge for any type of capital already beendeducted?

Weighted Average Cost of Capital

Pre-tax rate on debt

Tax rate

Equity cost of capital

Interpretation


18/27

Does a Negative EVA in a period

mean that shareholder wealth was

destroyed (reduced)?

Refer back to Investment Example from last time


19/27

Pepsi - Subsequent Events1996

New CEO - stated they had been trying too hard

sometimes, overreached, got in front of their headlights

in their quest for growth Began to sell back restaurants to franchisees

1997

Left the restaurant business entirely

Spun off KFC, Pizza Hut, Taco Bell into a separatecompany called Tricon Global restaurants and gave to

shareholders

Sold the smaller businesses to outside investors


20/27

Pepsis Current Segments (2002 AR)

By Product type

Beverages - Pepsi Cola (NA and Intl); Gatorade

Snacks -- Frito-Lay (NA and Intl)

Foods Quaker Oats

By Geographic Area

North America (US and Canada)

International

Merger with Quaker Oats this was added as a segment


21/27

Desirable Features of EVA

The present value of EVA is equal to the present value of

cash flows

This holds for any accounting method!!!! (as long as it satisfiesclean surplus this means that The Change in Book Value of the

Firm = Net Investment + Net Income

The market value of an asset (or the firm) is equal to the

book value plus the present value of the remaining EVA -

this also holds for any accounting method!!!

What makes a good accounting method then?


22/27

The Accounting Methods Used to Calculate

the Profit and Capital Measures Matter if...

In a valuation context, you can only forecast over a finite

horizon

In a Performance Measurement Perspective Always

In these situations, the TIME PATTERN of when the EVA

occurs matters (the same would be true for whatever

performance measure you were looking at)


23/27

Limitations to Simple EVA

It is not the same as economic income (which is the change

in the present value of all future cash flows)

EVA is no more forward looking that the operating income

number that it started with

Negative Incentive Effects of Evaluating Managers on the

Basis of EVA

If the Profitability measure is conservative - I.e., if it

treats investments that generate economic assets as an

expense, then EVA will make managers even more

short sighted than conventional accounting measures

Refer back to Example from last time


24/27

Accounting Adjustments Made to

Profitability and Capital Measures

The nature of these adjustments are often things you would

want to do as a part of any good financial analysis

These adjustments are intended to undo "biases" in GAAP

accounting numbers.

These adjustments are sometimes intended to undo some

of management's discretionary accrual decisions bysubstituting your own (or the EVA consultant's)

is this always a good idea?


25/27

Common "Accounting Adjustments"

Made in Calculating EVA

Non-recurring events

Research and Development - Capitalized and amortizedwith any expected benefits

Intangible Assets - Brands, etc

Property, Plant, and Equipment - adjusted for inflation and

other factors LIFO Reserves - added to invested capital


26/27

More Adjustments

Non-Cancelable Operating Leases - treated as "debt

equivalents"

Pooling of Interest - where possible, convert to "purchaseaccounting"

Deferred Taxes - Treated as Equity, Not Debt

Note - if adjustments are made to the balance sheet, thecorresponding adjustments should also be made to the

income statement.


27/27

Limitations to these Adjustments

They often do capitalize some economic assets

but they generally do not look forward and measure the

PV of their inflows they merely capitalizes the historical cost outflow

If the accounting adjustments undo accrual decisions made

by managers, are the new ones really better?

26.segmental reporting and eva-2010-bw

Documents