ROI, EVA and MVA

The purpose of a business is to make profits, and the purpose of a shareholder is to

create shareholder wealth. There are various measures to determine the
profitability of a business, and the extent to which it is enhancing shareholder
value. The measures include Return on Investment, Economic Value Added and
Market Value Added. Each of them is significant in their own right, and is
interconnected with the other measures. Any business must be evaluated based on
all the three measures, as each shows a different aspect of the company.

Return on Investment

Profits are the acid test of the existence of a company, the all-important indicator of
the fortunes of a company from the investor’s point of view.

Profit is the residual amount that is retained by the business after subtracting all
expenses from the revenues earned during that accounting period.

Profits = (Income during the period) – (Expenses incurred to earn such

income)

Profit is a measure of how much of the revenue received from customers for goods
and services is available for reinvestment in the business or distribution to owners.
However, profit as a stand-alone measure does not take into account the level of
investment needed to generate that profit.

ROI = Profit / Investment

The ROI can also be evaluated as ROE, ROCE or ROTA, all of which indicate the
amount earned as against the amount invested to create such income.

What is important in calculating the ROI or the ROTA measures in the consistency
between the aim of the measure and the constituents of the denominator and the
numerator. For example, the finance manager must decide that if he/she were
measuring the ROTA, would the total assets include Net Book Value or Gross book
value or the replacement cost of the Fixed Assets. If the ROCE was being measured,

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then only the productive assets should be taken into account. Hence, the manager
must take two important decisions –
- what constituents the assets/ investment in the above measure
- what is the valuation to be used for fixed assets on which depreciation
is charged

The consistency of the numerator and the denominator becomes a major issue
when measuring the performance of a company, as otherwise it may present a
distorted picture. An example of this can be wrongly taking PBIT/Equity as a
measure of ROI. Here the PBIT accrues to both debt holders and shareholders, while
the denominator presents only the equity shareholders. Since PBIT is not the
income earned by the shareholders, it cannot be used to show the ROI on their
investment (share capital).

The main constraint of ROI as a measure of performance of a company is that it

does not indicate whether the company is adding any value or not. This means that
even though the business may be earning an positive ROI, it may be possible that
the cost of capital is more than that, indicating value erosion rather than value
creation.

Economic Value Added

The fact whether the company is creating value can be verified using the EVA as a
measure. It computes the value created or destroyed each year by deducting a
charge for capital from the NOPAT of the companies.

EVA = NOPAT - Capital Charge (Capital * CoC)

EVA implementation improves overall capital efficiency and ensures that the
company is moving forward in the right direction. It also integrates financial
measurement with business imperatives in a comprehensible form.

EVA makes adjustments for many items that are treated differently from the GAAP
practices. The off balance sheet items, Research & Development expenditure,
interest expenditure, deferred tax expenses, amortization of goodwill etc. This is the
greatest advantage of EVA, since it helps to generate a profit number that more

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closely represents economic cash flows and restates the balance sheet to reflect
the true value of resources used to generate income.

The EVA is based on the same concept of choosing those projects that have a
positive NPV, since they add to the value of the firm. Similarly, companies are
evaluated based on whether they add to shareholder value or not.

EVA also makes the managers accountable for those factors that are within his/her
control, like the return on capital or the cost of capital (provided these decisions are
actually vested with each investment centre). He is not taken to task for the factors
out of his control like the market sentiments regarding the stocks. Further, it tests
all aspects of the functioning of the manager, with the feasibility of his/her
investment, and financing decisions.

Market Value Added

MVA, or market value added, is the differential in the book value of a firm’s equity
and the market value of its equity. It is the difference between the market value of
a company (both equity and debt) and the capital contributed by investors. MVA is
the difference between what investors have contributed and what they could get by
selling at today's prices. If MVA is positive, it means that the company has
increased the value of the capital entrusted to it and thus created shareholder
wealth. If MVA is negative, the company has destroyed wealth.

MVA = Total Market Value - Total Invested Capital

Hence, the primary objective of the firm is to maximize the value added as
perceived in the market. MVA is essentially the premium over book value of equity.

MVA and EVA

EVA is a function of the relationship between a firm’s earnings and its cost of
capital, and MVA is a function of that firm’s expected future EVA. So market value
added is clearly a function of a firm’s earnings. The current year MVA is
approximately the discounted present values of future expected EVAs.

MVA = Firm Value - Total Capital

MVA = [Debt plus Equity Value] - Total Capital

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 MVA = PV of Expected Future EVA

EVA and ROI

EVA is a function of a firm’s net income less its cost of equity capital (K E*BVE). This
would suggest that EVA is maximized by maximizing the differential between
earnings and the cost of equity capital.

MVA, EVA and ROI

MVA is the surplus of the market’s valuation of a firm’s equity over the book value
of that equity. In other words, MVA is the value premium over the shareholders’
historical investment in a firm. If a firm is adding economic value by maximizing its
return on equity (and its EVA), the market may reward it with a large MVA.

Thus we can see that the MVA in percentage terms is as follows:

%MVA = ((Price/Earnings) x ROE) – 1

Since %MVA is a function of both the price/earnings multiple and ROE, it is clear
that a firm’s value is related to things that management can influence, and things
that management cannot influence. Management can influence the aspects of a
business that ultimately are reflected in a firm’s ROE. However, management
cannot influence overall market or industry trends and the impact that those trends
may have on prevailing price/earnings multiples or the pricing of individual
securities.

It is seen that MVA, EVA and ROI are interconnected in a very intricate pattern, one
reflecting in the other. The measures must be used in conjunction with each other,
as analysing the performance of a company would be incomplete without assessing
its performance on all 3 fronts. Hence, for purposes such as performance evaluation
of the employees and such, the measure must be fixed as preferably EVA. But for
valuing the company, it is essential to test performance on the market perceptions,
the actual shareholder value created and the earnings made as compared to the
investment required to create that income.

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