Would you invest in an asset if it were possible to get a better return elsewhere? Of course not.
Investing in shares is no different.
The fundamental question investors need to ask of a company is whether it's creating value.
Sasol . . . . enjoying a purple patch it may not sustain
In other words, does it deliver a return on the capital invested that is appropriate for the risk associated with that investment? If not, that same investment could have been made elsewhere and earned a better return.
Business consultant SternStewart has developed two measures to help investors judge whether companies will create value.
The first is economic value added (EVA). This is the excess of a company's economic return on capital over its cost of capital. Both the income statement and the balance sheet are adjusted to reflect true economic profit. For instance, research and development costs are capitalised and amortised over a three-year period, the principle being that it's an investment in future earnings and cannot be passed through the income statement in year one.
EVA recognises a cost for equity as well as debt. The cost of equity is a factor of the risk-free rate (government's R153 bond), market risk premium and a sector beta which captures the riskiness of a company. A weighted average of equity and debt is taken to determine the overall cost of capital. This year the average cost of capital for SA's 200 largest companies excluding banks and other financial institutions was 15,75%, down from 17,7% last year.
On an aggregate basis, SA's companies destroyed R6,1bn in EVA in 2001, a sharp turnaround from the R11,5bn value created the year before. The column to monitor in the ranking is the one labelled "Spread". A positive spread means economic return on capital exceeds the cost of capital.
The second measure developed by SternStewart is MVA or market value added - the basis for this year's ranking. It's the difference between the market value of debt and equity and the capital invested. Total MVA created on the basis of this year's ranking was R466bn, marginally down from last year.
The theoretical relationship between MVA and EVA is that MVA is the net present value of all future EVAs.
MVA is interesting because it puts a rand amount to the value a company has created over and above the capital employed to generate earnings. Its downfall is that it is at the whim of the market because it is investors who determine the level at which a company's shares trade.
SternStewart has developed two further measures: current operations value (COV) and future growth value (FGV). The former is the portion of MVA that assumes no improvement in current performance. It's the net present value of all future EVAs, assuming no improvement to EVA. Strip this portion out of the market value and what's left is the FGV. The higher the FGV, the greater the increase in future EVAs the market expects.
Synthetic fuel and chemicals heavyweight Sasol is a case in point. Its COV is 108% of its MVA, implying that the market believes Sasol is enjoying a purple patch that it's unlikely to sustain. Rising oil prices and rand depreciation have combined to give Sasol an edge that has resulted in a stellar performance. But these were coincidental factors that may not be repeated. So the market is saying Sasol cannot sustain its current level of EVA. (Remember, MVA is the net present value of all future EVAs in perpetuity. If Sasol were to sustain its current EVA, COV would be 100%.)
What stands out is the number of companies that the market does not think can sustain current levels of EVA. They include Nampak, Altech, Massmart and Netcare.
Mobile telecoms company M-Cell is a good example of the reverse. Its FGV constitutes 63% of MVA. The market expects improving EVA over the next few years - a seemingly logical prediction for the future of a company that is investing heavily now to be a big player in the burgeoning mobile telephony market.
In past rankings M-Cell had a vastly higher FGV, a result of irrational exuberance over telecoms stocks. At the time it seemed the earnings of these companies would grow through the roof.
Markets are not always rational. There is no such thing as a single, perfect valuation tool. That said, there is no getting past the fact that over five years , companies that are EVA-positive outperform their peers.