"EVA - Demystified"

- by Manish Daga *

Introduction

The aim of any organization is to maximize the wealth of the shareholder, who own the organization and expect good long-term yield on their investment. This goal has often been ignored or at least misinterpreted. Earnings per share and Return on investment are used as the most important performance measures, although they do not theoretically correlate with the shareholder value creation very well. Stern Stewart & Co. pioneered the development of Economic Value Added (EVA) framework, which offers a consistent approach to setting goals and measuring performance, communicating with investors, evaluating strategies and allocating capital. EVA as a value based performance metric seeks to measure the periodic performance in terms of change in value. Maximizing EVA means the same as maximizing long-term yield on shareholders' investment. It is the measure that captures the true economic profit of the organization.

Economic Value Added Defined

Economic Value Added (EVA) may be defined as the net operating profits after tax minus an appropriate charge for the opportunity cost of all capital invested in an enterprise. Thus,

EVA = Net Operating Profit after tax - Weighted Average Cost of Capital

Weighted average cost of capital is defined as the cost of equity share capital plus the post tax cost of debt multiplied by the debt equity ratio. Cost of equity capital is the opportunity return from an investment with same risk as the company has. Cost of equity is usually defined with Capital asset pricing model (CAPM). The estimation of cost of debt is naturally more straightforward, since its cost is explicit. Cost of debt includes also the tax shield due to tax allowance on interest expenses. EVA can be rewritten as:

EVA = (ROI - WACC) x CAPITAL EMPLOYED

EVA captures the fact that equity should earn at least the return that is commensurate to the risk that the investor takes. In other words equity capital has to earn at least same return as similarly risky investments at equity markets. If that is not the case, then there is no real profit made and actually the company operates at a loss from the viewpoint of shareholders. On the other hand if EVA is zero, this should be treated as a sufficient achievement because the shareholders have earned a return that compensates the risk.

Market Value Added Defined

A return greater than the cost of capital adds to the value of the organization. Market Value Added for listed companies have been defined as the difference between the company's market and book value. In other words if the total market value of a company is more than the amount of capital invested in it, the company has managed to create shareholder value. If the case is opposite, the market value is less than capital invested the company has destroyed shareholder value.

Market Value Added = Company's total Market Value - Capital invested

And with simplifying assumption that market and book value of debt are equal, this is the same as:

Market Value Added = Market Value of Equity - Book Value of Equity

Book value of equity refers to all equity equivalent items like reserves, retained earnings and provisions. In other words, in this context, all the items that are not debt (interest bearing or non-interest bearing) are classified as equity. Thus market value added tells us how much has been added or reduced from the shareholder's investment. If a company's rate of return exceeds its cost of capital, the company will have a positive MVA and will sell on the stock markets with premium compared to the original capital. On the other hand, companies that have rate of return smaller than their cost of capital sell with discount compared to the original capital invested in company. Thus whether a company has positive or negative MVA depends on the level of rate of return compared to the cost of capital. All this applies also to EVA. Thus positive EVA means also positive MVA and vice versa.

Market Value Added = Present value of all future EVA

This relationship between EVA and MVA has its implications on valuation. By replacing the market value added with the present value of future EVA we can obtain the value of the company as:

Market Value of Equity = Book Value of Equity + Present value of all future EVA

Diagrammatically it can be shown as:

Advantages of Economic Value Added

• Measuring Profits the way shareholders count them: Peter Drucker has put the matter in a Harvard Business Review article as, "Until a business returns a profit that is greater than its cost of capital, it operates at a loss. Never mind that it pays taxes as if it had a genuine profit. The enterprise still returns less to the economy than it devours in resources... Until then it does not create wealth; it destroys it." EVA corrects this error by explicitly recognizing that when managers employ capital they must pay for it, just as if it were a wage.

• Management System: EVA can give companies a better focus on how they are performing, its true value comes in using it as the foundation for a comprehensive financial management system that encompasses all the policies, procedures, methods and measures that guide operations and strategy. The EVA system covers the full range of managerial decisions, including strategic planning, allocating capital, pricing acquisitions or divestitures, setting annual goals-even day-to-day operating decisions. In all cases, the goal of increasing EVA is paramount and thus removes a lot of confusion.

• Financial measure line managers understand: EVA has the advantage of being conceptually simple and easy to explain to non-financial managers, since it starts with familiar operating profits and simply deducts a charge for the capital invested in the company as a whole, in a business unit, or even in a single plant, office or assembly line.

• Ending the confusion of multiple goals: Most companies use a numbing array of measures to express financial goals and objectives. Strategic plans often are based on growth in revenues or market share. Companies may evaluate individual products or lines of business on the basis of gross margins or cash flow. Business units may be evaluated in terms of return on assets or against a budgeted profit level. Finance departments usually analyze capital investments in terms of net present value, but weigh prospective acquisitions against the likely contribution to earnings growth. EVA is the only financial management system that provides a common language for employees across all operating and staff functions and allows all management decisions to be modeled, monitored, communicated and compensated in a single and consistent way - always in terms of the value added to shareholder investment.

Pitfalls of EVA

EVA is a value based measure, and it gives in valuations exactly same the answer as discounted cash flow, the periodic EVA values still have some accounting distortions because EVA is after all an accounting-based concept, suffering from the same problems of accounting rate of returns (ROI etc.). In other words the historical asset values that distort ROI do distort EVA values also. EVA is the excess of ROI over WACC multiplied by the capital employed and thus as the ROI suffers from serious limitations of wrong periodizing and distortions caused by inflation the same gets incorporated in EVA also.

• Wrong Periodizing: In case on a single project the normal depreciation schedules cause the ROI and consequently EVA to be small at the beginning of a project and big at the end of the project. ROI is low at the beginning of the project as the capital base is high while at the latter stages the ROI shoots up because of the low capital base.

• Distortions caused by Inflation and Capital Structure: EVA is affected by the accounting policies. Thus in long run a higher EVA will be reported if for example R&D costs are charged to the income statements and are not capitalized. Similarly inflation brings about distortion in the value of assets and affects EVA.

• Paradox of EVA: We know that

  Market Value of Equity = Book Value of Equity + PV of all future EVA

  Thus the EVA valuation has two components book value and future EVA and by increasing the book value of equity we actually reduce the future EVA because of the capital costs and vice versa.

Implications

EVA is based on the common accounting based items like interest bearing debt, equity capital and net operating profit and it is usually always good when EVA increases and always bad when EVA decreases. Industries like telecom, forestry products, pharmaceuticals, semiconductors etc are the ones with very cyclical investments (not smooth over the years) and/or industries with very long investment horizon suffer most from the pitfalls of EVA. But even in such industries the EVA financial management system can be successfully implemented with changes in the accounting procedure like changes in depreciation schedule. In other industries with a lot of current (instead of fixed) assets and with short investment period EVA can be easily used to the benefit of the shareholders.

* Contributed by -
Manish Daga,
II Year, Xavier Institute of Management,
Bhubaneswar.