ECONOMIC VALUE ADDED
Introduction
Investors are currently demanding Shareholder value more strongly than ever. In the1980s, shareholder activism reached unforeseen levels with the companies in the United States. Thereafter also investors in Europe have increased the pressure on companies to maximize shareholder value and the concept is catching on in India.
The financial theory has since long suggested that every company’s ultimate aim is to maximize the wealth of its shareholders. That should be natural since shareholders own the company and as rational investors expect good long-term yield on their investment. In the past, this ultimate aim has however been often partly ignored or at least misunderstood. Against this background it is no wonder that so-called Value based measures have received a lot of attention in the recent years. These new performance metrics seek to measure the periodic performance in terms of change in value. Maximizing value means the same as maximizing long-term yield on shareholders’ investment.
Currently the most popular Value based measure is Economic Value Added. There has been a vivid debate for and against EVA in academic and management literature. Unfortunately most EVA advocates and adapters have not acknowledged or discussed the faults of EVA, while they have praised the concept as a management tool. On the other hand most criticism against EVA has kept to fairly insignificant topics from the viewpoint of corporate control.
What is EVA?
The idea behind EVA is that shareholders must earn a return that compensates the risk taken. In other words equity capital has to earn at least the same return as similarly risky investments in 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. This approach - using average risk-adjusted market return as a minimum requirement - is justified since that average return is easily obtained from diversified long-term investments on stock markets. Average long-term stock market return reflects the average return that the public companies generate from their operations.
EVA is based on the common accounting items like interest bearing debt, equity capital and net operating profit. It differs from the traditional measures mainly by including the cost of equity. Mathematically EVA gives exactly the same results in valuations as Discounted cash flow (DCF) or Net present value (NPV), which are long since widely acknowledged as theoretically best analysis tools from the Shareholders perspective. These both measures include the opportunity cost of equity, they take into account the time value of money and they do not suffer from any kind of accounting distortions. However, NPV and DCF do not suit in performance evaluation because they are based exclusively on cash flows. EVA in turn suits particularly well in performance measuring.
Simply stated, EVA is just a way of measuring an operation’s real profitability. The traditional financial statements normally show only one component of the total cost of capital to arrive at net profits, only the explicit
cost of borrowed capital is considered. EVA recognises that to arrive at true profits, cost of borrowed capital as well as equity capital should be deducted from net operating profits. Thus what makes EVA so revealing is that it takes into account a factor no conventional measure includes - the total cost of capital.
Some other aspects of EVA:
Profits the way shareholders count them
The capital charge is the most distinctive and important aspect of EVA. Under conventional accounting, most companies appear profitable. However, many actually are destroying shareholders wealth because the “profits” they earn are less than their full cost of capital. EVA corrects this error by explicitly recognising that when managers employ capital they must pay for it, just as if it were a wage. By taking all capital costs into account, including the cost of equity, EVA shows the amount of wealth a business has created or destroyed in each reporting period. In other words, EVA is profit the way shareholders define it. If the shareholders expect, say, a 10% return on their investment, they “make money” only to the extent that their share of after-tax operating profits exceed 10% of equity capital. Everything before that is just building up to the minimum acceptable compensation for investing in a risky enterprise.
Aligning decisions with shareholder wealth
Stern Stewart & Co. developed EVA to help managers incorporate two basic principles of finance into their decision making. The first is that the primary financial objective of any company should be to maximise the wealth of its shareholders. The second is that the value of a company depends on the extent to which investors expect future profits to exceed or fall short of the cost of capital. By definition, a sustained increase in EVA will bring an increase in the market value of a company. This approach has been effective in virtually all types of organisations, from emerging growth companies to turnarounds. This is because the level of EVA isn’t what really matters. Current performance already is reflected in share prices. It is the continuous improvement in EVA that brings continuous increase in shareholder wealth.
A financial measure line managers understand.
EVA has the advantage of being conceptually simple & easy to explain to non-financial managers, since it starts with familiar operating profit and simply deducts a charge for the capital invested in the company as a whole, a business unit or even a single plant, office or assembly line. By assessing a charge for using capital, EVA makes managers care about managing assets as well as income, and helps them properly assess the trade-offs between the two. This broader, more complete view of the economics of a business can make dramatic difference.
Ending the confusion of multiple goals
Most companies use a numbering array of measures to express financial goals and objectives. Strategic plans often are based on growth in earnings of market share. Companies may evaluate individual products or lines of business on the basis of gross margins or cash flows. Business units may be evaluated in terms of return on assets or against a budgeted profit level. Finance departments usually analyse capital investments in terms of net present value, but weigh prospective acquisitions against the likely contribution to earnings growth. And bonuses for line managers and business-unit heads typically are negotiated annually and are based on a profit plan.
EVA eliminates this confusion by using a single financial measure that links all decision-making with a common focus: How do we improve EVA? 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 modelled, monitored, communicated and compensated in a single and consistent way - always in terms of the value added to shareholder investment.
Economic Value Added (EVA) is a business management tool and a financial measure. But more importantly, EVA is a thought process. EVA measures the value created for shareholders, employees and customers. It focuses on growing business and increasing long-term profit by making smart decisions about investments and allocation of resources. EVA allows a company to accurately measure the value it is creating for its shareholders.
Here is an everyday example that will help understand EVA better:
You are starting a small business from home. Your uncle decides to take a chance and invest in your company. He gives you Rs. 500. You also take a Rs.1000 loan from the bank. This Rs. 1500 is your capital.
The interest rate of the loan is 10%. That means you will be paying the bank Rs. 100 per year to loan you the money. Although he is family, your uncle still expects some return on his money. You agree on a 15% return. So your uncle expects Rs. 75 per year for his investment in your company.
That Rs. 175 that the bank and your uncle expect is your capital charge, which equates to an 11.7% cost of capital (Rs. 175/Rs. 1500).
At the end of the year your business has earned Rs. 300 after paying taxes. This figure is your NOPAT. You owe the bank Rs. 100 for the loan and your uncle expected to earn Rs. 75 on his investment. So you take the Rs. 300 (NOPAT), subtract Rs. 175 (capital charge) and you have Rs. 125 left (your EVA).
This example illustrates how EVA is used as a financial measure. A business only creates value when its profit is greater than the charge for the capital it uses. As you can see, the EVA financial equation is simple. The basic idea of EVA can be expressed as a simple formula:
Net Operating Profit After Taxes (NOPAT) - Capital Charge = EVA
In order to understand the formula, you need to understand these terms:
Net Operating Profit After Taxes (NOPAT): the earnings left over after deducting from sales revenue all the operating expenses, including taxes but excluding interest.
Capital: all the money a company has tied up in assets needed to run the business, including cash, inventories and receivables, less accounts payables and other liabilities. It also refers to equipment, real estate, computers and other fixed assets.
Cost of Capital: the percent of return that lenders and shareholders can reasonably expect to receive each year. The cost of capital is the return required to attract investors and keep them from investing in other companies or opportunities.
Capital Charge: a rupee amount determined by multiplying the cost of capital times the capital. It represents the amount required in rupee terms to meet the expectations of investors (lenders and shareholders) and can be thought of as an asset rental charge for the capital that is used during the period.
Illustration: Common Income Statement
Net Sales 2,600.00
Cost of Goods Sold -1,400.00
SG&A Expenses -400.00
Depreciation -150.00
Other Operating Expenses -100.00
Operating income 550.00
Interest Expenses -200.00
Income Before Tax 350.00
Income Tax (40%) -140.00
Net Profit after Taxes 210.00
BALANCE SHEET
LIABILITIES / Rs. /ASSETS
/ Rs.Capital Stock / 300.00 / Property, Land / 650.00
Retained Earnings
Profit/Loss Account
Long-Term Debt
Short-Term Debt / 430.00
210.00
760.00
300.00 / Equipment
Other Long-Term Assets
Inventory
Cash / 410.00
490.00
235.00
50.00
Accrued Expenses (A\E)
Accounts Payable (A\P) / 250.00
100.00 / Receivable (A\R)
Other Current Assets / 370.00
145.00
TOTAL / 2350.00 / TOTAL / 2350.00
EVA Calculation Steps
1. Calculate Net Operating Profit After Tax (NOPAT)
2. Identify company’s Capital (C)
3. Determine a reasonable Capital Cost Rate (CCR)
4. Calculate company’s Economic Value Added (EVA)
Step 1: Calculate Net Operating Profit After Taxes(NOPAT)
Net Sales 2,600.00
Cost of Goods Sold -1,400.00
SG&A Expenses -400.00
Depreciation -150.00
Other Operating Expenses -100.00
Operating income 550.00
Tax (40%) -140.00
NOPAT 410.00
Note: This NOPAT calculation does not include the tax savings of debt. Companies paying high taxes and having high debts may have to consider tax savings effects, but this is perhaps easiest to do by adding the tax savings component later in the capital cost rate (CCR)
Step 2: Identify Company’s Capital (C)
Company’s Capital (C) are Total Liabilities less Non-Interest Bearing Liabilities:
Total Liabilities 2,350.00
less
Accounts Payable (A\P) -100.00
Accrued Expenses (A\E) -250.00
Capital (C) 2,000.00
Step 3: Determine Capital Cost Rate (CCR)
In this example: CCR * = 10%
Because owners expect 13 % return* for using their money because less is not attractive to them; this is about the return that investors can get by investing long-term with equal risk (stocks, mutual funds, or other companies). Company has 940/2350 =40% (or 0.4) of equity with a cost of 13%. Company has also 60% debt and assume that it has to pay 8% interest for it. So the average capital costs would be:
CCR ** = Average Equity proportion * Equity cost + Average Debt proportion * Debt cost = 40% * 13% + 60% * 8% = 0.4 * 13% + 0.6 * 8% = 10%
* Note: CCR depends on current interest level (interest higher, CCR higher) and company’s business (company’s business more risky, CCR higher).
** Note: if tax savings from interests are included (as they should if we do not want to simplify), then CCR would be:
CCR = 40% * 13% + 60% * 8% *(1- tax rate) = 0.4 * 13% + 0.6 * 8% * (1 - 0.4) = 8.08 % (Using 40 % tax rate)
Step 4: Calculate Company’s EVA
EVA = NOPAT - C * CCR
= 410.00 - 2,000.00 * 0.10
= 210.00
This company created an EVA of 210.
Note: this is the EVA calculation for one year. If a company calculates EVA e.g. for a quarterly report (3 months) then it should also calculate capital costs accordingly:
Capital costs for 3 months: 3/12 * 10% * 2,000 = 50
Capital costs for 4 months: 4/12 * 10% * 2,000 = 67
Capital costs for 6 months: 6/12 * 10% * 2,000 = 100
Capital costs for 9 months: 9/12 * 10% * 2,000 = 150
Thus EVA is also a valuable tool for management. However, the core of EVA is its effect on the decision-making process. It is a change of mindset for the whole company!
Why EVA?
Considering the many changes that must be made to incorporate EVA into the business, one may ask, "Why are we doing this?" Here are a few reasons:
EVA has the strongest correlation to a company's stock price than any other financial measure.
EVA is a better financial measure than traditional accounting measures.
EVA provides a single focus that helps unite the company.
EVA drives continuous improvement at every level.
EVA is easy to understand and apply to daily work routine.
EVA provides continuity for decision-making, performance measurement
and communication.
EVA aligns the interests and goals of investors and employees.
The background of EVA
EVA is not a new discovery. An accounting performance measure called residual income is defined to be operating profit subtracted with capital charge. EVA is thus one variation of residual income with adjustments to how one calculates income and capital. One of the earliest, to mention the residual income concept was Alfred Marshall in 1890. Marshall defined economic profit as total net gains less the interest on invested capital at the current rate. The idea of residual income appeared first in accounting theory literature early in 1924 and appeared in management accounting literature in the 1960s. Knowing this background many academicians have been wondering about the big publicity and praise that has surrounded EVA in the recent years. The EVA-concept is often called Economic Profit (EP) in order to avoid problems caused by the trademarking. On the other hand the name "EVA" is so popular and well known that often all residual income concepts are often called EVA although they do not include even the main elements defined by Stern Stewart & Co
At this point it is necessary to introduce the concept of MVA as MVA has often been confused with EVA, but they are not the same.
Market Value Added
EVA is aimed to be a measure that tells what has happened to the wealth of shareholders. According to this theory, earning a return greater than the cost of capital increases value (of a company), and earning less decreases value. For listed companies Stewart defined another measure that assesses if the company has created shareholder value. 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. Stewart calls that difference between the company’s market and book value as Market Value Added.
- Market Value Added = Company’s total Market Value - Capital invested OR
- 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.
Market value added is identical by meaning with the market-to-book -ratio. The difference is only that MVA is an absolute measure and market-to-book -ratio is a relative measure. If MVA is positive that means that market-to-book -ratio is more than one. Negative MVA means market-to-book -ratio less than one.
According to Stewart, Market value added tells us how much value company has added to, or subtracted from, its shareholders’ investment. Successful companies add their MVA and thus increase the value of capital invested in the company. Unsuccessful companies decrease the value of the capital originally invested in the company. Whether a company succeeds in creating MVA (increasing shareholder value) or not, depends on its rate of return. If a company’s rate of return exceeds its cost of capital, the company will sell on the stock markets with premium compared to the original capital (has positive MVA). 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. 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. Stewart defined in his book the connection between EVA and MVA as