Economic Value Added: A Bird's Eyeview


By

Bhargav Pandya
Lecturer
Shree Leuva Patel Trust MBA Mahila College
Amreli (Gujarat)
E-mail:
bhpandya@rediffmail.com
 


Introduction:

The goal of Financial Management is to maximize the shareholder's value. The shareholder's wealth is measured by the returns they receive on their investment. Returns are in two parts, first is in the form of dividends and the second in the form of capital appreciation reflected in market value of shares of which market value is thee dominant part.

The market value of share is influenced by number of factors, many, of which, may not be fully influenced by the management of firm. However, one factor, which has a significant influence on the market value, is the expectation of the shareholders regarding the return on their investment.

There exist very measures like return on Capital Employed, Return on Equity, earnings per share, Net Profit margin, and Operating profit margin to evaluate the performance of the business. The problem with theses measures is that they lack a proper benchmark for comparison. The shareholders require at least a minimum rate of return on their vestment depending on the risk in the investment. To overcome these problems the concept of EVA vas developed.

Evolution of EVA:

It was Stern Stewart & Co. who devised an accounting method called Economic Value Added (EVA), which measures whether the company is generating adequate profits to reward, its shareholders. EVA is the registered trademark of Stern Stewart & Co. It is the financial performance measure that captures the true economic profit of an enterprise. It is also one of the measures most directly linked to the creation of shareholder wealth over time.

Concept of EVA:

The company creates shareholders value only if it generates returns in excess of its cost of capital. The excess of returns over cost of capital is simply termed as Economic Value Added. To put in a simple terms EVA is the profits generated by any economic entity over its cost of capital employed. The entity can be a company, country or the entire human civilization. If the difference between the above two parameters is positive than the entity is said to be creating wealth for its stakeholders. A negative EVA on the other hand indicates the company is a destroyer of value.

EVA is just a way of measuring an operation's real profitability. EVA holds a company accountable for the cost of capital it uses to expand and operate its business and attempts to show whether a company is creating a real value for its shareholders.

Calculation of EVA:

EVA is essentially the surplus left after making an appropriate charge for the capital employed in the business. It can be calculated in the following way.

EVA = NOPAT (TCE x WACC)
Where,
NOPAT = Net operating profit after tax
TCE = Total capital employed
WACC= Weighted average cost of capital

While calculation of NOPAT, the non-operating items like dividend/interest on securities invested outside the business, non-operating expenses etc. will not be considered. The total capital employed is the sum of shareholders funds as well as loan funds. But this does not include investments outside the business.

In determining the WACC, cost of debt is taken as after tax cost and cost of equity is measured on the basis of capital asset pricing method. Under Capital asset pricing model, cost of equity Ke is given by the following:

Ke = Rf + bi (Rm- Rf)
Where
Rf = Risk free return
Rm = Expected market rate of return
bi = Risk coefficient of particular investment

For example an investment of Rs 1,000 in a soaps and detergent shop produces 7% return, while the similar amount invested elsewhere earns returns of 15%. EVA can be defined as a spread between a company's return on capital employed and cost of capital (similar to the opportunity cost of investing elsewhere) multiplied by the invested capital. The EVA from this case would be

EVA = (7%-15%) * Rs 1,000 = (Rs 80)

An accountant measures the profit earned while an economist looks at what could have been earned. Although the accounting profit in this example is Rs 70 (7% * Rs 1,000), there was an opportunity to earn Rs 150 (15% * Rs 1,000). So in this case the company can be called as a destroyer of wealth.

Thus, the litmus test behind any decision to raise, invest, or retain a Rupee must be to create more value than the investor might have achieved with an otherwise alternative investment opportunity of similar risk.

EVA Example:

Now consider this example based on the formula explained above. You can put different balance sheet and profit figures to know your own EVA.

Particulars

(Rs m)

Equity Capital

500

Reserves

7,500

Net worth

8,000

12.5% debentures

2,000

Capital employed

10,000

Weight of equity

0.8

Weight of debt

0.2

NOPAT (as per definition)

1,500.0

Return on tax free government bonds *

11.0%

Beta *

1.1

Market premium *

15.0%

Corporate tax rate *

33.0%

Cost of borrowings *

12.5%

Cost of equity

15.4%

Cost of debt

8.4%

WACC

14.0%

NOPAT as a % of capital employed

15.0%

 

 

Cost of Capital

1,400

EVA

100


* Assumptions

As calculated in the above example the company has generated EVA of Rs 101 m. That means maintenance of shareholder value will require the company to earn NOPAT over Rs 1,400 m. In other words the % of NOPAT to capital employed should be greater or atleast equal to the % of WACC.

Where to use this concept?

In the present market scenario every second company is making an attempt to impress the investors, with their excellent financial performance showing the high growth rate. With the limited resources available the investor is confused as to who is better and why? Here comes the concept of EVA, which helps the investors in simplifying investment decision making. Apart from looking at only P/E or EPS of the company, EVA helps the investors to see whether the valuation of the company really justifies the high or low P/E.

EVA & P/E

EVA is the measure and reflection of a good management. A good management is one which can 'Create value, Give value and Get value'. To achieve this the management of the company has to deploy more and more capital to those activities wherein the amount of NOPAT generated by the activities is greater than the amount of WACC. Then only they will be able to generate real wealth for their stakeholders. So who are these stakeholders they are our mutual funds, pension plans, life insurance policies, and many small investors, which represent the vast majority of stock ownership. Our largest institutional investors represent the savings of everyday citizens. Investors invest their savings and bear risk, in the hopes of the best return possible.

EVA and Indian Companies:

There are very few companies in India, which are successful in generating EVA. As a reason these companies have been given premium valuation on the bourses. HLL, Infosys and Dr. Reddy's have been given the premium valuations by the market not only based on their EPS performance but also on the basis of their ability to consistently increase shareholders wealth.

The graph hereunder presents the growth pattern of EVA of Infosys and HLL, two companies that have been successful in generating wealth and this is also reflected in their market cap.


Conclusion:

The corporates, which were paying lowest preference to the shareholders interest, are now giving the highest preference to it to generate value for shareholders. The true example of this is the software viral, which affected investors in the past few months. Even though in short term these software companies might provide a good return to investors, in the long term only those companies will be able to survive which are actually generating the returns.

EVA is too sophisticated a tool for lay investors to use. They may not indulge in the exercise of computing it but must try to understand from the numbers reported by the company whether it is generating a positive or negative EVA. Investors should be cautious enough in selecting companies, which have high EPS but low EVA and consequently lower ROCE and RONW.

So only those companies can be called as Real Wealth Creators, which know the above principals. As it is rightly said by someone ' You only get richer if you invest money at a higher return than the cost of that money to you. Everyone knows that but many seem to forget it'

Bibliography:

  • Kishore Ravi, "Advanced Accounting", New Delhi Taxmann Allied Services Ltd. 2004.
  • Chandra Prasanna, Financial Management Theory and Practice, New Delhi Tata McGraw-Hill Publishing Ltd. 2002.
  • www.equitymaster.com
     


Bhargav Pandya
Lecturer
Shree Leuva Patel Trust MBA Mahila College
Amreli (Gujarat)
E-mail:
bhpandya@rediffmail.com
 

Source: E-mail October 2, 2005

  

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