Misapplication of Economic Value Added in Bangladesh

Form a company with equity of BDT 100 mn. Put that amount in a bank deposit account that yields 10% per year. This company will continue to see a 10% growth in earnings along with a 10% return on investment (pre-tax). Is this a very good company from a shareholder perspective?

The concept of Economic Value Added (EVA) was introduced to answer this question (along with certain other things like accounting inconsistencies between companies but that is outside the scope of this article). The logic of EVA is simple. When we invest in a company with equity and/or debt there is a minimum required return we should get. This is known as the Weighted Average Cost of Capital (WACC). For the company to make economic sense the return on investment has to be at least equal to or preferably greater than the WACC. Otherwise the company is destroying value. It would be better to not have that company at all.

Let me give an example. Assume a company in Bangladesh is only financed by equity. This company would have a WACC of at least *15-16% (WACC=Cost of equity in this case). If this company does not generate a Return on Invested Capital (ROIC) then it is surely destroying shareholder’s value.

Now that the theory part is over let me go into the real problem in the case of Bangladesh. Most companies have a segment showing the Economic Value Added. The problem starts with their version of WACC. Most of them are using the government bond yield as the WACC. This is funny and infuriating because its like saying that this is a risk-free business. By the result of using very low cost of capital these companies are showing that they are generating economic profit when in reality they are not. In fact, I have a big doubt whether even 50 of the 250+ companies listed on the Dhaka Stock Exchange are generating ROIC>WACC in the truest sense.

Secondly, the calculation of invested capital is also a tricky subject. I have a lot of reservations on whether companies are calculating Invested Capital properly. By showing lower invested capital it is possible to jack up ROIC (ROIC=NOPAT/Invested Capital).

It is very important that shareholders understand whether a company is creating or destroying value. Also from the company management perspective as well EVA is a very important metric. Unfortunately it seems that neither the sponsors, the management or the minority shareholders understand the correct application of EVA.

*The 15-16% comes from Risk Free Rate plus a Risk Premium.

 

Asif Khan, CFA

Asif Khan is presently a Research Analyst (Financial Sector) for Exotix which is a frontier market focused investment bank. He has more than 6 years of work experience as equity analyst in both buy and sell side roles across Asian frontier markets. Asif is a CFA Charterholder and has a dual major in Finance & Economics from North South University.

6 thoughts on “Misapplication of Economic Value Added in Bangladesh

  1. Great article especially the first paragraph (even 100 million sitting in a bank account yields 10%, but that doesn’t necessarily mean it’s a good investment!).

    Please correct me if I’m wrong. You get a WACC of 15-16% with a risk free rate of around 9% and ERP of 6-7%, right? I tried using 17% as WACC for a while and I found only a handful of decent undervalued stocks in DSE. Do you face the same problem or maybe I’m doing something wrong.

    1. I agree with you in the sense that only a handful of companies will look undervalued using 17% COE. However, note that if the company is levered then 17% will be overestimating WACC. For companies with debt financing the WACC will become lower.

      There is also another critical issue. For DCF valuation WACC is not the only determinant. The other and more important factor would be your estimates of future cash flows. If you get that wrong stocks might look overvalued even if they are not.

  2. Thanks Asif bhai, you mentioned very important points. It’s very easy to overlook these key issues and focus only on certain metrics; then you’re bound to get the valuation over or understated. Having said that, I think the best part about valuation (and also possibly the worst) is that it’s very unlikely that two analysts will get the same valuation for a security. It’s highly subjective and this leaves a lot of room for human judgment (or misjudgment) and biases.

  3. awesome writeup, nice to see someone is actually putting emphasis on the idea of economic value added. I have a separate schedule on EVA in my DCF model. Gives me a better idea of how much of the intrinsic value is actual profit retained.
    As for the invested capital, I normally take total assets and subtract all non interest bearing liabilities. Sometimes companies may have off balance sheet financing which could be added back in, but that may be subjective.
    I am not really familiar with the scenario in Bangladesh regarding the wacc calculation. At least they could have added a risk premium along with the Risk free yield to justify the cost of equity a lil bit more loll.

    1. I agree. EVA is a useful tool to understand what is driving (or destroying) value. Most of the companies in Bangladesh do not understand the concept intuitively which is why their calculations are often grossly incorrect.

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