EVA and Buffett/Munger

[FatOtt]

This was brought up in another thread, but I thought it deserved its own discussion.

I want to talk about the Buffett/Munger viewpoint on EVA, but first I’ll talk about economic value in general. The creation of economic value (as opposed to accounting profits) occurs when the return on a firm’s capital is greater than the cost of that capital. This is a pretty fundamental concept and there really shouldn’t be that much argument about it. It’s simplest to think about for a bank from a purely debt-financed perspective:

- If a bank can borrow money (by encouraging people to deposit money in checking accounts, savings accounts, and CDs) at 3%, but lend that money (in the form of mortgages, car loans, and personal loans) at 7%, they will make an economic profit.

It gets a little more complicated when the firm is financed by other means, namely equity. Unlike debt financing, which generates an explicit Interest Expense on the Income Statement, equity financing does not generate any cost on the Income Statement. The effect of this is that the cost of equity is not incorporated into the firm’s reported results on their Income Statement. But the use of capital has a cost, even if that cost isn’t recognized on the Income Statement. Investors do not give the firm money (i.e., buy shares of stock) with the expectation of no return. Rather, they buy that stock with the expectation of making some return, even though they don’t have the contractual right to that return (as debtholders do).

Because of this, it’s important to differentiate accounting profit (as shown on the Income Statement) from economic profit. Accounting profit recognizes a cost for debt financing, but not for equity financing. Economic profit is the more appropriate measure, but how is it calculated? Well, what you need to do is look at the firm’s total capital: all of the firm’s assets, regardless of whether they were financed with debt or equity. (Remember that Assets = Liabilities + Equity, so you can think of Assets as definitely being financed by either debt or equity.)

You then need to recognize that there is a cost associated with that capital: debtholders require an explicit return, while equity holders require some positive return in expectation, even though that required return is not observable.

So at the end of the day, the economic profit for the firm is equal to the Net Operating Profit After Taxes (NOPAT) – (Capital * cost of capital). If the firm was financed 100% via debt, this would be the number on the Income Statement. However, if the firm is financed by equity (which all publicly traded firms are), the cost of equity needs to be accounted for.

I’ll stop here and say that Buffett and Munger will agree with everything to this point. In fact, I believe they would say this is obvious – a firm must earn more than its cost of capital (however financed) in order to earn an economic profit. This is evident in their speeches, in their actions (see the imposition of a hurdle rate on reinvestment for their subsidiaries), and their comments in Annual Meetings. I’ll also point out that Berkshire and Coke (as mentioned by Evan) are not nearly the only firms who think in this manner. For example, I was reading the Constellation Brands annual report yesterday, where the CEO spent a lot of time talking about this very topic. I think it’s obvious that many (if not most) firm managers understand intuitively the need to earn more on assets than those assets cost.

The problem comes down to specifics. There are two components in EVA calculations that can cause controversy:

NOPAT: Net Operating Profits After Taxes is not an accounting measure (meaning that GAAP does not specify this calculation). Stern Stewart takes the GAAP Income Statement and makes a lot of adjustments to the Net Income number:

1. Back out Interest Expense. This isn’t at all controversial, just a recognition that if you’re looking at the return on assets, you can’t deduct interest expense. That interest expense is a return on assets that is being paid back to debtholders (not necessarily paid back in cash, just economically). The tax effect of this is removed as well.

2. Other items that Stern Stewart views as being incorrectly treated by GAAP. Now, I don’t work for Stern Stewart, so some of these may be factually off. But here’s the type of thing they adjust for: GAAP requires advertising expenditures to be expensed on the Income Statement, reducing Net Income. SS would say, “Wait a minute, those advertising expenditures are creating value – that’s how really valuable brand names like Coke and Starbucks are created. We’re going to treat those items as an asset rather than expense them. Same thing for Research & Development costs.” So there are some very specific adjustments made to the Income Statement. Some of these adjustments are probably very acceptable to Buffett and Munger, others might be considered twaddle.

Cost of Capital: Here’s the big issue. Buffett and Munger would both agree that there is some cost of equity. That is, they would never say that issuing equity has no cost or that there is no such concept as cost of equity. What they go ballistic about is attempts to actually calculate a firm’s cost of equity. This is where measures like beta come in to play. Bear in mind, a cost of equity calculation does not require beta, it’s just something that’s historically been used a lot. So a calculation of EVA might include the fact that the firm’s cost of equity is 11%. That’s more or less the hurdle rate on equity. If the firm had no interest-bearing debt, you’d say that EVA is equal to the firm’s earnings minus 11% times book value. That 11% times book value is the required rate of return on the firm’s capital base. If the firm isn’t earning at least 11% on its equity, they are actually destroying value. The cost of equity equal to 11% is similar to saying that investors’ opportunity cost is 11% - if they don’t invest in this particular firm, they could invest their money elsewhere and earn 11%. So the failure to earn at least 11% would be a destruction of value.

Overall, this is a major quibble that I have with Buffett and Munger. They take a concept like EVA that is at least 80% correct and argue with the remaining portion that they disagree with. I’m sure that they would say, “Well, the part that is correct is obvious, so we won’t talk about it. We’ll just talk about the part that’s incorrect.”

The problem is with people (and I’ve met a few) who don’t have the Buffett/Munger depth of understanding and who actually form opinions based on the Buffett/Munger soundbites. They hear the criticisms of EVA and infer that EVA as an entire concept must be fatally flawed and simply twaddle. They don’t realize that the bulk of what’s included in EVA (economic profit vs. accounting profit) is a very valuable way of thinking.

Sorry for the long post.