The Fortune 500 testifies to many qualities among companies, chief among them years and years of success (you won’t find rookie enterprises on the list) and most of all, massive scale. It’s all very laudable, but what should an investor make of this elite assemblage? All of them are star companies — but which are the star stocks? To answer that question, we turned to the savvy team at EVA Dimensions, which employs one of the most insightful measures of company performance: economic value added. In simple terms, EVA adjusts profits to account for a company’s cost of capital — a much more telling gauge of value creation than earnings alone. EVA is arguably the purest metric for determining a company’s effectiveness in turning one dollar of input (capital) into a dollar of output (profits).
The metric provides a useful snapshot of recent history, and EVA Dimensions crunched the data to reveal the largest value creators — and destroyers — in the Fortune 500 over the past five years. Technology firms dominated the top rankings. Apple led the way with eye-popping average annual EVA growth of 22.1% (relative to 2007 sales), compared with a median 0.3% for Fortune 500 companies. Travel site Priceline.com ranked second, with Google and IT outsourcer Cognizant Technology Solutions also placing in the top 10. The bottom of the list was dominated by capital-intensive oil and gas companies dogged by low prices (such as Devon Energy and Chesapeake Energy) and financial institutions battered by the financial crisis (including Bank of America and Bank of New York Mellon).
How does an EVA acolyte view the stock market today? Craig Sterling, EVA Dimensions’ global head of equity research, is cautious. Like profit margins, EVA margins are the highest they’ve been in at least 25 years. Indeed, they’re even loftier than they were in 2007 before stocks collapsed. Meanwhile, interest rates are so negligible that financing costs are at historic lows. If you believe margins will remain high and interest rates depressed for the next five years, Sterling says, then the stock market looks 14% undervalued. But when he did the same research in late 2011, it was 20% undervalued. “You’re being paid less for your risk today,” Sterling says. “If interest rates go up or profitability doesn’t hold, that could be trouble.”
Despite that, he sees some promising values among Fortune 500 stocks. EVA Dimensions, which advises money managers and large corporations, developed a stock-picking formula based on 24 factors, including EVA performance, riskiness of cash flows, and valuation measures similar to book value. Its research suggests that the approach would have outperformed the Russell 1,000 index by nine percentage points a year over the past 15 years.
Among the top choices is Starwood Hotels, the operator of the Westin, W, and other luxury lodgings. The company is the most profitable it has ever been, Sterling says, “and they’re getting better at what they do.” Starwood transformed itself over the past decade from a hotel owner to a hotel manager working with franchisees. The strategy is boosting returns on assets and driving margins higher, Sterling says, and therefore the stock deserves a higher premium to other hotel operators than its current modest one.
Deere’s EVA profitability is also hitting all-time highs. But investors seem blasé about the iconic maker of tractors and other agricultural equipment. Deere’s EVA momentum, which reflects how quickly the company is adding value, is more than 50% higher than the rest of the Fortune 500 over the past year. Yet shares moved in line with the broader market. “Valuation hasn’t kept up with profit potential,” says Sterling, who asserts that the profit cycle for machinery manufacturers is still strong.
Rounding out EVA Dimensions’ top 10 picks are industrial conglomerate 3M; chocolate maker Hershey; bank titan J.P. Morgan Chase, which recently reported blowout quarterly earnings; biotechnology firms Amgen and Biogen; oil giant Chevron; IT equipment maker EMC; and department store chain Nordstrom.
According to EVA Dimensions’ formula, one stock in the bottom ranking of five-year EVA performance, Bank of New York Mellon, is a good value. Among the top five-year performers, a handful — most notably Apple — still register as “buys.” Despite the numbers, Sterling has trepidations about Apple. EVA Dimensions changed its rating to a “buy” in March after the shares’ steep fall from $700. (The firm had previously advised underweighting Apple, beginning in March 2012, when shares traded for $589.) Still, Sterling points out that increased competition has dimmed Apple’s prospects. Its EVA margin is two percentage points below its peak last year, the first decline in two years, and capital spending has risen. “It’s still a kick-ass company,” Sterling says, “and among the most profitable companies out there.” He argues that the bad news has already been priced into Apple shares. But now that Apple’s epic ascent has been broken, he notes, the stock could stay depressed for a while to come.
This story is from the May 20, 2013 issue of Fortune.
