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Economic Value Added: The Invisible Hand at Work: By: Michael Durant, CPA, CCE
Economic Value Added: The Invisible Hand at Work: By: Michael Durant, CPA, CCE
There is nothing that points to EPS as anything more than a ratio that accounting has developed
for management reporting. Many executives believe that the stock market wants earnings and
that the future of the organizations stock depends on the current EPS, despite the fact that not
one shred of convincing evidence to substantiate this claim has ever been produced. To satisfy
Wall Streets desire for reported profits, executives feel compelled to create earnings through
creative accounting.
Accounting tactics that could be employed to save taxes and increase value are avoided in favor
of tactics that increase profit. Capital acquisitions are often not undertaken because they do not
meet a hypothetical profit return. R&D and market expanding investments get only lip service.
Often increased earnings growth is sustained by overzealous monetary support of businesses
that are long past their value peak.
We must ask then, what truly determines increased value in stock prices. Over and over again
the evidence points to the cash flow of the organization, adjusted for time and risk, that investors
can expect to get back over the life of the business.
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 firms ability to earn
more than the true cost of capital. EVA combines the concept of residual income with the idea
that all capital has a cost, which means that it is a measure of the profit that remains after
earning a required rate of return on capital. If a firms earnings exceed the true cost of capital it
is creating wealth for its shareholders.
XYZ Company
Sales
Cost of Goods Sold
Gross Profit
$2,436,000
1,700,000
736,000
400,000
336,000
Taxes
134,000
NOPAT
202,000
$500,000
$200,000
$700,000
$1,400,000
To calculate the weighted cost of common equity we consider the present market price of the
stock less issuing costs. For example we issue common stock for $100 a share less $15.00
issuing cost or proceeds of $85.00 per share. This is divided into the future earnings per share
estimate by investors or reliable analysts. If we use $12.00 per share, then the weighted cost
will look like this:
$12.00/$85.00 = 14.1% after tax cost of common stock
Using the 14.1% and the total common equity of $700,000 our cost of common equity is
$98,700.
Common Equity
Total Capital
$1,400,000
$158,500
The Weighted Average Cost of Capital is $158,500/$1,400,000 = 11.3%. Cost of capital is
calculated by multiplying total capital by the weighted average cost of capital.
Calculating EVA
After tax operating earnings less the cost of capital is equal to EVA. From the above example
we can calculate XYZ Companys EVA and determine if this business is creating wealth for its
owners.
XYZ Company
NOPAT
Charge for Capital
$202,000
Capital Employed
Cost of Capital
Capital Charge
ECONOMIC VALUE ADDED
$1,500,000
11.3%
$169,500
$32,500
Conclusion
EVA is both a measure of value and also a measure of performance. The value of a business
depends on investors 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.
EVA is changing the way managers run their businesses and the way Wall Street prices them.
When business decisions are aligned with the interest of the shareholders, it is only a matter of
time before these efforts are reflected in a higher stock price.
Levy, Haim and Marshall Sarnat, Capital Investment and Financial Decisions, Englewood Cliffs, New Jersey;
Prentice Hall International, 1982.
OByrne Stephen F., EVA and Market Value, Journal of Applied Corporate Finance, Spring 1996, 116 126.
Smith, Adam, The Wealth of Nations (New York: Modern Library, Inc., originally published in 1776), p.28.
Stern, Joel M., EVA and Strategic Performance Measurement, Global Finance 2000, The Conference Board, Inc.,
1996.
Tully, Shawn, Americas Greatest Wealth Creators, Fortune, November 9, 1998, 193 196.
Tully, Shawn, The Real Key to Creating Wealth, Fortune, September 20, 1993, 123 132.
Michael W. Durant, CCE, CPA is the Director of Credit, VF Jeanswear, Greensboro NC.
He is the former Director of Research for Credit Research Foundation.
Copyright 1999 by the Credit Research Foundation.
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