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The concept of Economic Value Added (EVATM) has been propounded as an economic measure of the extent to which a company adds value to shareholders' wealth. In most companies today the search for value is being challenged by a seriously out of date financial management system. Often, the wrong financial focus, cash strategies, operating goals, and valuation processes are emphasized. Managers are often rewarded for the wrong achievements and in many cases they are not rewarded for the efforts that lead to real value.
Adam Smith, one of the fathers of classical economic thought, observed that firms and resource suppliers, seeking to further their own self-interest and operating within the framework of a highly competitive market system, will promote the interest of the public, as though guided by a â€•invisible hand. â€• (Smith, 1776)
Accounting tactics that could be employed to save taxes and increase value is avoided in favor of tactics that increase profit. Economic Value Added (EVA) is a measurement tool that provides a clear picture of whether a business is creating or destroying shareholder wealth. EVA measures the firm's ability to earn more than the true cost of capital.
Value creation, today, for a competitive advantage and to have edge over other - is a widely accepted business objective over profit maximization and wealth maximization. Value is created when all the stake holders perceive a significant difference in quality or benefits, with the result that the offer is capable of commanding a premium relative to competitors offer. Traditionally the methods of measurement of corporate performance are many. Common bases used are: - Net Profit Margin (NPM), Operating Profit Margin (OPM), Return on Investment (ROI), Return on Net Worth (RONW) etc. Profit after Tax (PAT) is an indicator of profit available to the shareholder and Profit before Interest after Tax (PBIAT) is an indicator of the surplus generated using total funds. ROI is still recognized as the most popular yardstick of profitability measurement. Although these financial data have the advantage of being precise and objective, the limitations are far greater, making them less applicable in today's competitive market. For evaluation of the efficiency of any decision, value creation or value addition aspect is of utmost importance in the present backdrop of corporate governance. In order to maximize shareholder value, decisions must be made as to how best to allocate capital, how to evaluate investment opportunities and how to measure performance.
EVAÂ® (Economic Value Added) was developed by a New York Consulting firm, Stern Steward & Co in 1982 to promote value-maximizing behavior in corporate managers. This term has been used in the book named â€•The Quest for Valueâ€- which was published in 1991. Stern Steward & Co claims EVA to be their registered trade mark, while Peter Drucker claimed that he discussed EVA in 1964 in his book, â€•Managing for Resultsâ€-. It cannot be denied; however, without going into argument as to who invented EVA first that the concept became popular only after Stern Stewart & Co. marketed it. EVA, therefore enables the management to, invest in projects that are critical to shareholder's wealth. This will lead to an increase in the market value of the company. However, activities that do not increase shareholders value might be critical to customer's satisfaction or social responsibility. For example, acquiring expensive technology to ensure that the environment is not polluted might not be of high value from a shareholder's perspective.
EVA: AN OVERVIEW
Economic Value Added (EVA) is a comprehensive measure of operating performance. It measures the change in financial worth of an enterprise from one year to the next. It is a more comprehensive financial measurement tool than net income (revenues minus expenses) alone, because it includes the cost of the capital used to generate that income.
"A company can best maximize wealth by leveraging its most distinctive and proprietary assets - the talent, ingenuity, and energy of its people. That's what EVA does, and that's what makes it so powerful..."
- Joel M. Stern, CEO, Stern Stewart & Co., 1995
In corporate finance â€•Economic Value Added or EVA is an estimate of economic profit, which under US accounting can be determined, among other ways, by after making corrective adjustments to GAAP accounting, including deducting the opportunity cost of equity capital
In simple words EVA is â€•"The monetary value of an entity at the end of a time period minus the monetary value of that same entity at the beginning of that time period."
What separates EVA from other performance metrics such as EPS, EBITDA, and ROIC is that it
Measures all of the costs of running a business-operating and financing.
The chart helps the management following way: Deploy more and more funds to those activities where the amount of NOPAT generated by the activities is greater than the cost of capital. Withdraw fund from those activities wherein the amount of NOPAT is less than the amount of cost of capital unless there is strategic decision to lose in one activity in order to gain in another. Improve the operating efficiency of the organization to retain the same amount of NOPAT by possible continuous reduction of existing capital or / and continuous increase of the existing NOPAT with existing amount of capital.
4 Ms of EVA
Stern Stewart describes four main applications of EVA with four words beginning with the letter M.
EVA is the most accurate measure of corporate performance over any given period. Management System
A firm's true value comes in using EVA 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.
To instill both the sense of urgency and the long-term perspective of an owner, Stern Stewart designs cash bonus plans that cause managers to think like and act like owners because they are paid like owners.
When implemented EVA financial management and incentive compensation system transforms a corporate culture. By putting all financial and operating functions on the same basis, the EVA system effectively provides a common language for employees across all corporate functions...
The Three Pillars of Profit
Costs - what businesses pay for the inputs they require to produce saleable output
Value - the creation of well-being in the eyes of your customers
Price - what your customers pay for the output
Review of literature
Baatz (1994), commented that it is but one of many tools being developed to account for thecapital invested in an organization by the true owners of that organization - the shareholders.
Dodd and Chen (1996,) observed that EVA is the difference between companies adjusted net operating profit (after taxes) in a particular year and it total cost of capital.
According to George Athanassakos (2007), the Value-based management (VBM) is a management philosophy that uses analytical tools and processes to focus an organization on the single objective of creating shareholder value
Components of EVA
Net Operating Profit after Taxes
Calculating Net Operating Profit after Taxes (NOPAT)
NOPAT is easy to calculate. From the income statement we take the operating income and subtract taxes. Operating income is sales less cost of sales and less selling, general and administrative expenses.
Net Operating Income
Net Operating Income or NOI is a means of expressing pure operating results. In other words, financial results of NOI do not have the impact of financing (borrowing), investing, or accounting adjustments, which can distort a purely operational analysis. NOI is the amount of money generated exclusively from operations
Calculating Cost of Capital
Many businesses don't know their true cost of capital, which means that they probably don't know if their company is increasing in value each year. There are two types of capital, borrowed and equity. The cost of borrowed capital is the interest rate charged by the bondholders and the banks. Equity capital is provided by the shareholders. An investor's expected rate of return on an investment is equal to the risk free rate plus the market price for the risk that is assumed with the investment. The risk of a company can be decomposed into two parts. An investor can eliminate the first component of risk by combining the investment with a diversified portfolio. The diversifiable component of risk is referred to as non-systematic risk. The second component of risk is non-diversifiable and is called the systematic risk. It stems from general market fluctuations which reflect the relationship of the company to other companies in the market. The non-diversifiable risk creates the risk premium required by the investor. In the security markets the non-diversifiable risk is measured by a firm's beta. The higher a company's non-diversifiable risk, the larger their beta. As the beta increases the investor's expected rate of return also increases. (Levy, 1982)
Measuring Capital Employed
Accounting profits differ from economic profits. Under generally accepted accounting principles, most companies appear to be profitable. However, many actually destroy shareholder wealth because they earn less than the full cost of capital. EVA overcomes this problem by explicitly recognizing that when capital is employed it must be paid for. In financial statements, created using generally accepted accounting principles, companies pay nothing for equity capital. As discussed earlier, equity capital is very expensive. Economic profits are defined as total revenues less total costs, where costs include the full opportunity cost of the factors of production. The opportunity cost of capital invested in a business is not included when calculating accounting profits.
Long Term Debt
Long Term Debt includes bonds, mortgages and long term secured financing
Calculation of EVA
EVA is sales less operating costs (including taxes) less all financing costs. Put another way, EVA is net operating profit after tax (NOPAT) less the cost of all capital, equity as well as debt
EVA = NOPAT - (Cost of Capital x Total Capital)
EVA = (ROTC - Cost of Capital) x Total Capital
Example: For example, consider a company that earns NOPAT of $100 and ties up $800 in capital from debt and equity sources to support its business assets. Assume further that the firm's overall cost of capital is 10%, a rate that blends the after-tax cost of debt and equity at the proportions management would intend to use as a target. In this case, the firm must set aside $80 ($800 x 10%) to "rent" its capital from the market, and its EVA is $20, the profit residual.
EVA = NOPAT - (Cost of Capital x Total Capital)
$20 = $100 - (10% x $800)
EVA = (ROTC - Cost of Capital) x Total Capital
$20 = (12.5% - 10%) x $800
For each of these firms, the payoff from a successful strategy can be very large. For instance, Motorola which has a value per share of $32.39 with a high growth period of 5 years would be able to increase its value if it were able to grow longer
EVA can be a powerful tool. When properly applied, it allows a firm to ascertain where it's creating value and where it's not. More specifically it allows a firm to identify where the return on its capital is outstripping the cost of that capital.
Analysis of NPV and other techniques
Unlike simple traditional budgeting, EVA focuses on ends and not means as it does not state how manager can increase company's value as long as the shareholders wealth are maximized. This allowed managers to have discretion and free range creativity, avoiding any potential dysfunctional Short-term behavior
APPLICATION OF EVA AS BETTER CONCEPT
Ways to raise EVA of the firm
A Stern Stewart team works closely with a steering committee of representatives from line and staff functions to adapt EVA to the client's unique culture and management practices. The EVA implementation process generally involves the following steps:
Obtaining senior management commitment
Evaluating corporate and financial strategy, position, and alternatives
Understanding where, how and why value is created in your markets and company
Defining an action based value improvement plan
Re-engineering financial management to focus on value creation
Strengthening and aligning incentive compensation with value
Educating line managers
Communicating with investors
Value-focused Decision Making
To maximize shareholder wealth, decision makers at all levels must be value-focused. The market value of any firm is a function of its expected future performance, which in turn is a function of the effectiveness of management. Stern Stewart helps clients improve performance by better understanding the value inherent in their strategy and operations.
Whether we are assessing the value of an acquisition target, analyzing the economics of a product portfolio, formulating the structure of a compensation plan, or introducing a new financial management framework, we approach all projects from one vantage point - what strategy best maximizes the value creation of the business over time?
Managers Who Think and Act like Owners
We believe the most effective way to motivate managers to make value-based decisions is to link their incentives to goals that relate directly to value creation itself. Under this type of incentive structure, managers stand to gain substantially when, for example, EVA increases; when EVA falls, their incentive compensation should be at risk. This approach effectively makes a manager think like an owner, and provides strong motivation to make decisions that focus on the continuous improvement in EVA - decisions that the market will reward.
A Commitment to Continuous Improvement
A final condition for maximizing wealth is to focus on continuous improvement rather than short-term goals. Investors don't reward companies because managers have met their annual budget; they reward companies when managers regularly seek out and undertake initiatives that improve long-term performance. Stern Stewart encourages clients to stay focused on continuous improvement.
Value Based Strategy and Management
Stern Stewart's mission is to help clients establish clear, accountable links between management action and the creation of shareholder wealth. In our view, the most effective way to align management initiatives with shareholder interests is to implement a framework for decision-making that is based on our proprietary EVA measure. EVA has gained broad acceptance in the business community for its ability to help managers increase the value of their companies. More than 400 major corporations, globally, have adopted our EVA framework and been rewarded with significant improvements in corporate performance and share price.
Rationale for using EVA
EVA is the gain or loss that remains after assessing a charge for the cost of all types of capital employed. What an accountant calls profits in an income statement includes a charge for the debt capital employed which is commonly referred to as interest expense. However, an income statement does not include a charge for the equity capital that was employed during the accounting period. Therefore, EVA goes beyond conventional accounting standards by including a provision for the cost of equity capital. The cost of equity needs to be factored into business investment decisions in order to enhance shareholder value.
Although EVA is couched in financial analysis, its primary purpose is to shape management behavior. EVA can be used as a performance measure to evaluate an overall company, a division within a company, a location within a division, or an individual manager. By setting goals, EVA can become a motivational tool at various levels of management. EVA can also be used in downsizing decisions.
Perhaps the real key to appreciating EVA lies in its simplicity. Often time's non-financial managers are hard pressed to understand financial tools; EVA can help to facilitate communication thereby enhancing coordination within a company. Managers need to train to recognize the opportunity to strive for an increase in economic value added. Once properly trained, managers can then pinpoint key financial focal concerns germane to decisions.
EVA is both a measure of value and also a measure of performance. The value of a business depends on investor's expectations about the future profits of the enterprise. Stock prices track EVA far more closely than they track earnings per share or return on equity. A sustained increase in EVA will bring an increase in the market value of the company. As a performance measure, Economic Value Added forces the organization to make the creation of shareholder value the number one priority. Under the EVA approach stiff charges are incurred for the use of capital. EVA focused companies concentrate on improving the net cash return on invested capital
The value of a firm has three components. The first is its capacity to generate cash flows from existing assets, with higher cash flows translating into higher value. The second is its willingness to reinvest to create future growth, and the quality of these reinvestments. Other things remaining equal, firms that reinvest well and earn significant excess returns on these investments will have higher value. The final component of value is the cost of capital, with higher costs of capital resulting in lower firm values. EVA emphasize economic value added and reward managers for increasing the same often assume that increases in economic value added are not being accomplished at the expense of future growth or by increasing risk.
The EVA based performance measurement system is the basis on which the company should take appropriate decisions related to the choice of strategy, capital allocation, merger & acquisitions, divesting business and goal setting. While deciding resource allocation it becomes necessary to appreciate the EVA Impact of such decision. Management Accountants have the full knowledge about the company that would create value. They are in a position to guide a company in its restructuring mission for value creation.