America's Wealth Creators Big companies like Microsoft, GE, and Intel are making investors richer than ever before. But as FORTUNE's annual MVA rankings show, these giants will have to keep growing like small startups to meet the market's expectations.
By Shawn Tully

(FORTUNE Magazine) – Imagine that you're standing at the pinnacle of glory. You're the CEO of a megaplayer called General Giant, the top dog in its industry and still growing fast. You didn't reach these heights by chance. You excel at hatching technologically advanced products that sell for premium prices. As soon as rivals catch up, you outflank them with a wave of fresh offerings that do the job faster or make it simpler. But your greatest achievement is refusing to let your size slow your reflexes. To crown your achievement, Wall Street loves your story and believes that you, the big guy, can outrun nimble startups. Your reward: an Olympian stock price.

The view from this lofty perch looks pretty good, right? Well, sort of. That huge valuation is a blessing, but as FORTUNE's annual MVA list (for market value added) shows, it could put a hex on the future. General Giant is really a proxy for the top 20 wealth creators in this year's rankings, a group that encompasses tech pioneers Microsoft and Lucent, legendary marketers Coca-Cola and Johnson & Johnson, and cost-crunchers General Electric and Wal-Mart. Our 1999 list--which is based on data from 1998--shows that investors, as never before, are putting their big bets on a handful of companies with superb track records. This new flight to quality could mean that investors are making sensible choices; so far it's been impossible to go wrong picking most of these stocks. But today's prices should also sound alarms. By swelling the market values of what we'll call the Towering Twenty, investors are raising expectations of their future performance from merely daunting to stratospheric.

So what do the MVA numbers show? To keep it simple, let's say that General Giant represents the average company in the Towering Twenty. At the beginning of 1999, General's MVA--total market value minus invested capital--was $136 billion. That's fine, but look at what that value is based on. Last year General handed shareholders only $1.7 billion in EVA--operating profit minus the cost of capital. (We'll get back to MVA and EVA in a minute.) Hence the market sets General's MVA at 79 times its EVA earnings. Two years earlier its MVA would have been 47 times EVA. According to Stern Stewart, the firm that coined the MVA/EVA names and popularized the concepts, General must multiply its EVA more than sixfold, to more than $10.6 billion, by 2004 to support its current MVA. If it fails, its stock price, and MVA, could collapse.

In pondering the task ahead for General Giant, consider the fate of the Nifty Fifty. In the early '70s investors created a similar aura around a group of big-cap growth stocks that included Xerox, Polaroid, Avon, and International Flavors & Fragrances. "This does remind me of the Nifty Fifty phenomenon," says Al Jackson, head of global equity research at Credit Suisse First Boston. "Most of those stocks went kaboom. You really have to wonder if these valuations are valid."

The MVA list confirms what lofty P/Es already suggest: that a few big companies are getting pricey, while investors are only lukewarm about most other large caps. But the MVA and EVA numbers tell the story better because they remove accounting distortions that can make profits look rosier than they really are. To compile this year's list, Stern Stewart took America's 1,000 largest corporations (measured by market cap) and ranked them by MVA, the total wealth created for investors by the end of 1998. We publish the MVA standings of the 200 largest corporations--as well as an update of what's happened to the MVA of the top ten through Oct. 22 of this year. Stern Stewart senior financial analyst Charles Protell crunched the numbers.

MVA and EVA answer the most critical question in business: Is management creating or destroying wealth for its shareholders? Let's look first at MVA. It's the total value the market places on all the company's stocks and bonds--in other words, what investors would pocket if they sold all their securities--minus the capital they invested, including equity and debt offerings, retained earnings, and bank loans. The difference between what investors could take out and what they put in is MVA.

If MVA is positive, management has achieved Job One by making shareholders richer. If not, it's just burning capital. Look how Cisco (No. 8) has turned a few dollops of investor money into mounds of MVA. Over its entire life, Cisco has collected just $9.5 billion from shareholders and lenders for all of its labs, inventories, and research. Yet it parlayed that slender investment into networking products so lucrative that at the start of 1999, the investors who put up that capital could have sold their stocks and bonds for $145 billion, reaping $136 billion in newly minted wealth, or MVA.

Like market cap, MVA rises and falls with the stock market. But the MVA for highly cyclical stocks can also drop in a generally good market, even when the companies are excellent performers. A case in point is oil services giant Schlumberger, which posted the biggest MVA decline on the list, shedding $16.5 billion in value during 1998. The decline happened because of a steep drop in oil prices, which prompted the Exxons and Shells to curtail their capital spending on exploration and development. Schlumberger's profits, and stock price, tumbled. Still, it weathered the downturn better than most of its rivals. This year oil prices are rebounding, and as the market foresees bigger profits, so is Schlumberger's MVA.

Although good companies can get buffeted in the short run, over the long term the key to the big MVA numbers posted by the Intels and GEs is a strong and growing EVA--the wealth management adds each year. EVA is similar to accounting earnings, but with a crucial twist. In their financial statements companies take a charge for debt in the form of interest. But the most important capital, the funds provided by shareholders, carries no accounting cost at all. Consequently, many managers treat equity as if it's free--or at least very cheap. (Just look at disastrous takeovers at inflated prices that buyers blithely finance with stock but would never dream of doing with cash.)

In fact, equity is very expensive. When investors buy stocks they expect returns at least as big as those they might get from an equally risky investment. If a company doesn't provide competitive returns, shareholders will sell, driving down the price and denying management the money it needs to keep growing. To derive each company's cost of equity capital, Stern Stewart determines what return investors expect from a basket of stocks in the same industry. And if the company isn't at least matching that competitive return, it isn't making money for its shareholders. For General Giant, our proxy, the current cost of capital including debt is around 11%. If the EVA is still positive after the capital charge, the company is producing real earnings for its shareholders. If not, it's destroying value by coaxing puny profits from loads of expensive plants and inventories, a la General Motors or RJR Nabisco, which show up at the bottom of the list.

The challenge for the Towering Twenty is that MVA is soaring, while EVA--the source of future MVA--is tiny by comparison. Last year the hot stock market boosted MVA for the top 20 companies by almost $1.1 trillion--a remarkable 64%. But EVA rose by a measly $8 billion, or 30%. That puts even more pressure on companies to generate huge increases in earnings without adding loads of capital.

To gauge how tough that will be, consider Microsoft. To sustain its $328 billion in MVA, investors expect it to expand earnings at a rate of more than 40% per year through 2004. Now, that's below Microsoft's annual average growth rate of more than 50% for the past five years. But the high valuation means that Microsoft will have to continue to grow like a startup despite its much bigger base. Just look at what investors expect Microsoft to earn in 2004: well over $40 billion, more than what GE, Intel, Wal-Mart, Coke, and Merck earned--combined--in 1998! Now we begin to see why even President Steve Ballmer says the market may be expecting too much from Microsoft.

Of course, Towering Twenty cheerleaders believe that these companies could still make or even beat expectations, if two factors continue to help them. The first is economic. The optimists say the climate will remain stable and balmy, with little inflation in sight. The second is competitive advantage. The top companies on this list all stay way ahead of their competitors: Microsoft and Cisco by creating the most popular technology; Merck and Pfizer by generating a steady stream of blockbuster drugs protected by patents; Coke and Procter & Gamble by nurturing their brands. That edge allows them to charge premium prices and book extra-large earnings.

But there is a danger. If management slips even a little, competitors could carve away at those big margins. Then a big slice of the profits that used to flow into the corporate coffers will go instead to consumers in the form of lower prices. The lesson from former highfliers like Lotus and Eastman Kodak is that fat margins are a magnet for new competitors. The troubling news for the Towering Twenty is that their huge valuations leave no margin for error. Any sign that management is faltering could send their shares into a tailspin.

The Towering Twenty scenario--the yawning gap between market value and real earnings--is even wider among tech companies. During 1998 the combined MVA of the 23 techies on the list, ranging from Compaq to Yahoo, jumped 118%, while their EVA went down by 9%. (MVA for everyone else on the list grew just 45%.)

In some ways the Internet firms embody an EVA/MVA paradox. The market expects Internet companies to generate huge earnings from tiny amounts of capital, precisely the conditions that generate big MVAs. Just look at the how the Web is rewriting the list. In one year America Online jumped from No. 113 to No. 23, with $71 billion in MVA. Yahoo (No. 65) and Amazon (No. 88) came out of nowhere. But for all three companies EVA is minuscule--virtually nonexistent. To keep their stock strong, the Internet companies have to grow earnings at spectacular rates on their existing businesses. They also must deliver on their promise to generate big returns on capital.

The danger is that with their high share prices, Web companies will start making reckless, multibillion-dollar acquisitions, using their stock as easy currency. Investors are already forecasting fabulous performances from the Internet target companies; those great expectations are built into the steep share price. If Internet acquirers pay a big premium over and above those already high valuations, it will be virtually impossible for them to generate a good return on their capital. A flurry of big bad deals could severely damage Wall Street's romance with the Web.

So how are the Towering Twenty doing in 1999? Stern Stewart has updated the MVA numbers for those companies, and they show that while many big-cap stocks are languishing, investors are still flocking to the Microsofts and GEs. Fifteen of the companies have actually added to their MVA this year, including Cisco, Lucent, and Home Depot. The bar just keeps rising. And as Internet stocks join the Towering Twenty, it could rise even higher. To check up on whether General Giant keeps rolling, or imitates the Nifty Fifty, click on next year's list.