Smith Barney Inc. is applying a controversial new analytical tool to evaluate financial companies, and it may not be long before many more Wall Street bank analysts follow.
The new tool, Economic Value Added analysis, also known as EVA, is gaining popularity as bank analysts try to discern why bank stocks have risen as high as they have. By traditional measures, such as price-to- earnings ratio, many bank stocks have moved into uncharted territory.
Although some analysts have dismissed EVA as financial gimmickry, others have quietly incorporated it into their analysis of financial companies' value.
"Traditional valuation parameters are deficient," said thrift analyst Thomas O'Donnell of Smith Barney, who recently announced that he is incorporating the tool into his analysis of the government-sponsored enterprises-Freddie Mac, Fannie Mae, and Sallie Mae.
"EVA explains the impact of such factors as low inflation and aggressive stock repurchases, whereas the p/e ratio measures it but doesn't explain it," said Mr. O'Donnell. "EVA is just another weapon in the arsenal."
Some critics, however, say the new method is just an attempt to justify banks' high share prices, and others warned that EVA could be misleading when applied to financial stocks.
"I don't believe in it," said bank analyst Richard X. Bove of Raymond James & Associates. "I think equity is more important than debt, and in the end the Stern Stewart model drives you toward buying debt for equity. It works beautifully in low interest rate environments, but in a high interest rate environment, it would create a problem."
EVA is a packaging of basic financial concepts outlined by Bennett Stewart 3d in his 1990 book "Quest for Value" and later marketed by his company Stern Stewart & Co.
The technique, initially used to analyze industrial companies, began to filter down to bank analysts and financial companies in the last year and a half.
Simply put, EVA analysis is an attempt to determine whether a company is creating wealth for its shareholders or destroying it. The system incorporates revenue, capital management, and riskiness of operations into the equation, said Charles Kantor, a vice president at Stern Stewart.
A key component is the cost of capital, Mr. Kantor said.
Banks have been very profitable and generated plenty of excess capital, Mr. Kantor said. The EVA framework forces bank managers-and analysts-to weigh how the additional capital is deployed, through share repurchases, acquisitions, or reinvesting in line businesses.
Senior analyst Henry C. Dickson was the first at Smith Barney to apply EVA to banking analysis. He began applying it to money-centers and regionals three months ago. Jacqueline Reeves, who covers smaller banks, soon followed.
Mr. O'Donnell said that EVA analysis has supported his suspicion that the government-sponsored enterprises are undervalued, prompting him to upgrade all three. He expects to apply the analysis to savings and loans in coming weeks.
Smith Barney is not alone in using this analysis tool on financial institutions. Regional bank analyst Bradley G. Ball of Credit Suisse First Boston has been plying the tool for the past six months. Diane Merdian of Montgomery Securities Inc. is another advocate of its use.
Bank analyst Anthony R. Davis of Dean Witter Reynolds Inc., who has used the analysis tool for two months, said it is just a matter of time before it sweeps Wall Street.
"It is so consistent with what banks are already doing," said Mr. Davis. "Many banks have EVA or similar-type applications such as risk-adjusted rate of return. If it is being practiced consistently by banks, then analysts on the sell side have to understand what they are doing."
Three banking companies, Centura Banks Inc., Rocky Mount, N.C.; Silicon Valley Bancshares, Santa Clara, Calif.; and Banc One Corp., Columbus, Ohio, have vigorously applied the concept, said Mr. Kantor of Stern Stewart.
Money manager Matthew Lindenbaum of Basswood Partners, Paramus, N.J., said many more banks are trying to apply EVA. "The market will eventually reward companies that use it and punish those who don't," he said.
"Any company that comes to me saying that they are using EVA is telling me that they are concerned with economic reality," said Mr. Lindenbaum. "I would almost start a fund of companies that use EVA."
Mr. Davis of Dean Witter acknowledged the potential for analysts to "get carried away with EVA"-and to overlook some profits of the business.
Bank analyst Nancy A. Bush of Brown Brothers, Harriman & Co. said that EVA has its merits but falls short because there is no standard way to measure capital costs.
"The logic of it is great, but is it the new Holy Grail of investing? I don't think so," said Ms. Bush.
The bottom line, said Ms. Bush, is this:
"The present market environment is unprecedented, and people are looking for some guiding light for what to invest in and what to divest in. Some banks may look great on an EVA basis but may go out and do a hugely dilutive deal; we are looking for simplicity-black and white-when in fact we may have to settle for gray for a while."
