A New Way to Value the Market

I came across this article by Geoff Colvin, senior editor from Fortune magazine, and I thought it is an interesting article to share with my readers. The article discussed about the valuation of company using the economic value added (EVA). I have reposted the article in my blog here for your reading.

Are stocks cheap yet? That slippery, eternal question is worth a look right now because a remarkable new set of data has just become available, allowing us to analyze the market in ways we never could before. I wish I could tell you that this new trove of numbers reveals that stocks are a screaming buy. It doesn't. But it does suggest that, amid all the recent tumult, just maybe the market is being rational.

The new data are derived from the most fundamental, capital-based way of analyzing a company's finances and value. How much capital is a company using? What is its return on capital? How much does the capital cost? Those questions hold the key to corporate performance, but finding the answers in most financial statements isn't easy, and many executives don't know the answers themselves. The Stern Stewart consulting firm began popularizing these concepts more than 15 years ago with the term EVA (economic value added), and the new data come from EVA Dimensions, a firm that is now the source of Stern Stewart's EVA data.

EVA-based analysis has proven extremely valuable in analyzing individual companies. I almost never make calls on specific stocks, but in late 1999 the EVA analysis of AOL was so compelling that I wrote a column declaring flatly that the stock price could not possibly be justified. That column was published on Jan. 10, 2000, right near the overall market peak (and the very day that AOL announced it was using its insanely overvalued stock to buy my employer, Time Warner (TWX, Fortune 500) - but that's another story). I also used EVA analysis to write last summer that Google (GOOGLE) was overpriced at $540; that call looked wrong for a while, though as I write this the stock is at $501.

One thing you couldn't do with EVA analysis was use it to value the whole market. Compiling the data for a significant number of companies used to take months. But now, through the miracles of our networked world, EVA Dimensions can compile it every day for 2,669 companies in the Russell 3000 (those for which at least two years of data are available). This is essentially the U.S. stock market. So: Is it worth what it costs?

Look first at how well the companies are doing at their most basic task, which is earning a return on their capital that's greater than the total cost of that capital. Turns out they've been doing very well. The dollar difference between their return on capital and cost of capital (their EVA) was $375 billion over the past four quarters. It was only half that much in 2005, and in 2004 it was negative, which isn't surprising. Over time, for the broader market, EVA should be more or less zero since competition is always forcing high returns down toward the cost of capital, while companies that can't meet their capital cost will eventually go under. So America's publicly traded companies did great last year; in fact, with economic growth strong through the third quarter, it's safe to say that they were at or near the top of the business cycle.

Next question: How are they being valued? On a recent day when the Dow closed at 12,265, the 2,669 Russell 3000 companies had a total enterprise value of $29.8 trillion (equity plus debt). To judge whether that's a lot or a little, consider that over the past four quarters these companies produced after-tax operating profits of about $1.8 trillion. Even if we assume that earnings will only match, not exceed, that level in future years, then the companies' aggregate market value today would still be $22.5 trillion (note to finance wonks: that's their profits capitalized at their capital cost of about 8.1%), which is about 75% of their actual market value.

So now we reach the central question. About 25% of the current market value of these companies is based on expectations of future profits above and beyond the profits they earned last year, at the top of the business cycle. Does that seem reasonable? Actually, it just might. The math gets a bit tedious, but you can assume no profit growth for the next several years and very modest growth thereafter, and the valuation still looks okay. Buying at today's prices may not make you rich. But - for the first time in a long time, in my view - it isn't crazy.

Company and Stock?

Have you thought of these questions of what are the differences between a growth company and a growth stock? How about a defensive company and a defensive stock? Do they equate one another? What are their differences? Below is a summary of what do they actually meant.

Growth companies are ones that consistently earn higher returns than required by their risk. A growth stock is one that earns higher returns than other stocks of equivalent risk. Typically growth stocks have P/E ratios higher than that of the market average P/E as well.

A defensive company is a company that has earnings that are relatively insensitive to downturns in the economy. A utility company is a good example. These types of firms typically have low business risk and moderate financial risk. A defensive stock is a stock that will not decline as much as the market when the overall market declines. The returns of defensive stocks have a low correlation with the returns of the market. Defensive stocks are characterized by having low beta values.

A cyclical company is a company with earnings that tend to follow the business cycle. An automobile company is a good example. Cyclical companies often have high levels of fixed costs (business risk) and/or leverage (financial risk). A cyclical stock is a stock with rates of return that will change more than changes in the return on the overall market. These are stocks with betas greater than one, indicating more than a one-to-one reaction to changes in the return on the market.

A speculative company is a company that has assets that are very risky, but have the potential to generate very large earnings. An oil exploration company is a good example. A speculative stock is a stock that is highly likely to have very low or negative returns, because they are almost always overpriced. These stocks have a low probability of a return near that of the market, but a slight probability of an enormous return.

How is STI index being computed?

For those who observe closely on the indexes such as the S&P500, the DJIA, the STI etc., have you ever wonder how these indexes are constructed? There are 3 basic ways to compute these indexes. They are

1. Price-weighted
2. Market value-weighted
3. Unweighted

The returns on a price-weighted index could be matched by purchasing an equal number of shares of each stock represented in the index. Since the index is price-weighted, a
percentage change in a high-priced stock will have a relatively greater effect on the index than the same percentage change in a low priced stock.

A value-weighted index assumes you make a proportionate market value investment in each company in the index. The major problem with a value-weighted index is that firms with greater market capitalization have a greater impact on the index than do firms with lower market capitalization.

An unweighted index places an equal weight on the returns of all index stocks, regardless of their prices or market values. The procedure used to compute an unweighted index value assumes that the index portfolio makes and maintains an equal dollar investment in each stock in the index.

So how is the STI index computed? The STI index like most of the major US index are computed using the value-weighted approach and covers all sectors. As it is value-weighted, the influence of the large capitalisation constituent stocks on the index is moderated by weighting them by their free float percentages.

You can find more information on the STI index by clicking here and other information about other indexes such as the Nikkei 225 Index, MSCI Taiwan Index etc., by clicking here.