GS’s use of the economic value added (EVA) valuation method is the first time it has been used on a pan-European basis, and bridges the gap between NAV and the other measures used by general equities investors
When Goldman Sachs’ (GS) analysts initiated their coverage of 20 property companies in February, it also widened the use of economic value added (EVA) as a valuation tool for quoted property companies.
The method, which focuses on the return on capital employed by property companies, is used at ABN Amro in the Netherlands as well as Charterhouse Securities and Credit Suisse First Boston in the UK. However, GS’s implementation is the first time the method has been used on a pan-European basis. GS analysts Jeppe de Boer and Victor van Bommel, who were poached from ABN Amro last year to cover the property sector at GS, say the EVA method bridges the gap between using net asset value (NAV) and other measures that the general equities investors judge companies by.
“It is a big challenge to get general equities investors interested in the sector,” says de Boer. With EVA, however, the analysts say that they are able to employ methods which evaluate performance on the same basis as is used in the energy and pharmaceutical sectors. Coverage in these sectors doesn’t use the EVA method but the evaluation focuses on similar drivers such as the efficiency of capital employed. This means that general equities investors can feel more comfortable and familiar with the research produced on property companies, encouraging more interest and investment into the sector.
“It does stop people thinking the property sector is a pariah because it is valued completely differently to other sectors,” says Nan Rogers, property analyst at Charterhouse Securities, adding that it is an important method which reflects the changing nature of the property company. “As property companies change their business practices and look more at providing services, and do not just buy and manage, this captures different types of returns.”
EVA was developed by US firm Stern Stewart & Co. The method benchmarks return on capital employed (ROCE) against the cost of capital, in this case, GS’s market implied cost of capital (MICC), to produce a fair value for each European property company. A positive EVA, where companies generate returns in excess of their cost of capital, deserve, according to GS, to be valued at a premium to their NAV and are viewed as value creators. Those companies with a negative EVA are value destroys and should be discounted to their NAV. GS works out the company’s fair value from NAV by taking into account its value creation or destruction with its present value of EVA. (see “How it works”)
GS’s research throws up some interesting results. The analysts claim that its EVA research supports the current (mainly discounted) trading positions of the majority of the property companies. For example, according to GS, the Swedish company Drott is trading fairly at a discount of 21% to NAV. GS’s valuation method gives Drott a negative EVA which means it is destroying value and a discount to its NAV is correct.
However, with Haslemere the opposite is true. GS views the now demerged UK business of Rodamco as a value creator, although its fair value should be almost equal to its NAV. The company, however, is trading at a discount of 28%. GS says that Haslemere’s high standing using this valuation method does throw up the argument for tax efficient vehicles. Haslemere is a Dutch-based tax transparent vehicle. This, says GS, demonstrates that property is a hard industry in which to gain adequate returns without some tax advantages. “It supports EPRA’s (European Public Real Estate Association) argument for a tax efficient vehicle,” adds de Boer.
Chris Bartram, chairman of Haslemere, supports GS’s method as a “very valid way at looking at companies” by using return on equity employed. Although he does dispute GS’s views that Haslemere’s strategy focuses just on NAV performance. “We focus on total returns,” he says. Batram considers GS’s market implied cost of capital at 7.28% to be quite high and the Haslemere’s tax advantages helps it achieve under these conditions. It illustrates that those without tax advantages must use leverage or do “something special”. Bartram says that many feel that a single sector focus constitutes this special something but Haslemere pursues a multi-sector approach, believing that “sectors have cycles”.
Criticism of the method from some quarters stems from its use of a 10-year estimate, with the model assuming status quo after three years. One senior executive in a quoted property company said that this assumes a strategy of buying, developing and holding, which is not always the case for property companies. Also, looking back on past performance, he felt that “a lot of our performance in that time was not showing through in income.” Instead, it came through NAV such as through unplanned projects which the company had not envisaged in its strategy.
The executive added that the usefulness of NAV, therefore, cannot be ignored as valuers, by using discounted cashflow methods, are “estimating the value inherent in that property”. This, says the property company, is therefore linked to the value inherent in the business. “It would be mad to ignore NAV.”
There is however praise for methods such as GS’s that, in the spirit of EPRA, may encourage a wider base of investors for the sector. Nick van Ommen, EPRA chief executive, says that valuation methods will be one issue on the agenda at an EPRA members workshop in April that will also look at corporate governance and international accounting and valuation standards.
How it works
A company’s EVA is calculated using the two measures of ROCE (return on capital employed) and MICC (market implied cost of capital). First ROCE is calculated. This is defined as NOPAT (net operating profit after taxes) divided by capital employed. NOPAT is calculated by taking EBIT (earnings before interest and taxes) which mainly comprises net rents minus overhead expenses, and subtracting taxes. If depreciation has been subtracted (as happens in countries such as Germany and Sweden) this is added back. GS assumes that depreciation on real estate only occurs to depress effective tax rates. Capital employed comprises NAV plus the market value of interest bearing debt. After establishing a 10-year ROCE forecast by dividing future NOPAT through future capital employed, a market implied cost of capital (MICC) is subtracted from estimated future ROCE to give a positive or negative EVA spread. As all company specific issues are already included in ROCE, GS considers it fair to apply a uniform cost of capital with a few exceptions such as Metrovacesa which derives income from the very different business of housing development. The EVA spread multiplied by capital employed gives an estimated total EVA for each year forecasted. A present value of future EVA per share (ie future value creation or destruction) is then calculated which should equal a company’s discount or premium to NAV. GS says the model is based on a clear and proven relationship between ROCE and discounts or premiums to NAV
Goldman Sachs’ hits and misses
Canary Wharf – recommended list
Goldman Sachs sees Canary Wharf as a strong player because of its monopoly position in one of the prime business locations in Europe. It also directs its strategy towards maximising its potential from its Enterprise Zone Allowance position which sees it effectively paying no taxes until 2005. GS is also impressed with the management incentives: “Alignment between shareholders and management is close to ideal: a large proportion of senior management’s compensation is linked to total return on equity.” According to GS, its fair value suggests a 19% upside on the current share price.
Haslemere: Market Outperformer
In GS’s opinion, Haslemere is the most undervalued real estate stock in Europe and has a 40% upside from its share price. Its superiority in GS’s view comes from its tax efficient status (its Dutch FBI status means it is subject to a 0% corporate tax rate) which allows it to generate a ROCE which exceeds the UK peer group average by more than 30%. The tax status appears to outweigh the risks its sees Haslemere’s management taking with its strong focus on NAV growth rather than cash returns.
Hammerson: Market Performer
According to GS, Hammerson has excellent in-house management skills but ” ‘being very good at real estate’ no longer makes a company stand out”. The bank estimates that Hammerson is 19% overvalued. In France, it sees the company having strong competition from local players and tax efficient competitors so “generating sufficient (cash) returns on capital employed will be difficult for Hammerson in our view”.
