YouMaketheCall 149look, industry, relative maturation (rookie, vintage, or classic), and
accounting policies use din calculating net income. Don’t count on
P/E ratios being comparable across companies.
The P/E ratios of our group of companies fluctuated wildly dur-
ing the 1990s an dearly 2000s, along with the volatile overall market.
But suppose the market price of a share of common stock sits be-
tween 25 an d50 an dsuppose its average earnings per share are
aroun d$1.00. The P/E ratio thus has range dfrom 25 to 50. The
implied cap ratehovers between 2% an d4%. Does that mean you
shoul duse such rates? Why woul dit? But suppose a stock ha da P/E
ratio of 5. Now that sounds like a deal with a thick margin of safety.
Economic Value Added
Consider an all-industry metric created (and trademarked!) by a
business consulting firm that apparently has realize dthat the mar-
ketplace is thirsting for new tools to justify all kinds of crazy ideas.^15
The tool has been cleverly named “economic value added” (EVA). It
says that a company’s performance can be evaluate din terms of
whether returns on capital are higher than costs of capital. If they
are, value is being added.
Though the components of the EVA calculation are simple to
state—the company’s return on capital minus its weighte daverage
cost of capital—we already know that pinning down the latter is a
lot harder than it sounds.
For EVA, the weighte daverage cost of capital coul dbe define d
simply as the appropriate discount rate at which to value the com-
pany, but that doesn’t escape the circularity trap. Or it could be the
cost of the company’s indebtedness—the average interest rate paid
on its debt during the measured period. But if that is all it is, then
EVA is just another name for leverage.
If it includes a mixed measure of the cost of debt and the ex-
pecte dreturn on equity, the measure not only still has the problem
of circularity but also gets nonparsimonious. All it really tells you is
by how much a company beat expectations. If return on equity last
year was 10% an dthe market this year expects the same 10% but the
company actually has delivered 12%, EVA says it increased value by
an additional 2%—but you don’t need a name like EVA to tell you
that.
Worse, part of the motivation to develop tools such as EVA was
to overcome earnings management techniques: managerial manip-