ECONOMIC VALUE ADDITION (EVA)

HOW WOULD YOU ANALYSE THE FINANCIAL(OPERATIONAL) PERFORMANCE OF A COMPANY.

AND THE INVESTOR PERCEPTION

NET PROFIT?

GROSS MARGINS?

RETURN ON ASSETS?

CASH FLOWS?

EARNINGS PER SHARE?

PE MUTIPLE (PRICE EARNINGS RATIO)

COMPANIES USE THESE MEASURES FOR:

MAKING STRATEGIC DECISIONS. EVALUATING INDIVIDUAL PRODUCT OR LINES OF BUSINESS. BONUSES FOR LINE MANAGERS AND BUSINESS UNIT HEADS. AND INVESTORS FOR VALUATIONS

HOWEVER THE PROBLEM WITH THESE MEASURES IS:

NO ONE MEASURE IS CONCLUSIVE.

NO ONE MEASURE CAPTURES ALL ACTIVITIES OF

THE COMPANY.

NO ONE MEASURE IS CONSISTENT WITH THE

DIFFERENT GOALS OF THE COMPANY AND INVESTORS.

WHAT IF WE HAD JUST ONE FINANCIAL MEASURE THAT LINKS ALL DECISION MAKING WITH A COMMON FOCUS?

ECOMONIC VALUE ADDED (EVA)

Stern Stewart developed EVA and has

helped

more

than

200

companies
its EVA

worldwide

implement

framework for Financial management

and incentive compensation.

EVA = PAT ( Notional / Imputed Cost of Equity Capital )

EVA (Rs.) = NOPAT ( WACC * CE )

NOPAT = NET OPERATING PROFIT AFTER TAX.
NOPAT = PAT + INTEREST + [NET DIFF BET NONOPERATIONAL INCOME AND EXPENSES]

WACC = WEIGHTED AVERAGE COST OF CAPITAL

WACC includes Cost of Equity + Cost of Debt

CE

= CAPITAL EMPLOYED

 WACC Includes
Cost Of EQUITY + Cost Of DEBT

The Cost of EQUITY consists of two factors : i). Risk Free Returns ii). Risk Premium

Cost of Equity

= Risk Free Returns + Risk Premium

Risk Free Returns

Refers to the returns that you can get without taking any risk. Generally the rate of return givne by RBI Bonds are taken as the base. ie. Currently 8%.

Risk Premium
It refers to the amount of risk an individual takes by investing in this company. This %age may vary from person to person. It depends upon his perception about the returns that he expects from the company.

 The next process is to take the weighted average cost of Capital Employed ie. (Equity + Debt).

Suppose the ratio of equity and debt is 2:1 ,

the weightage is assigned accordingly.

EVA Drivers: Strategies for Improving EVA

Parameters Used for the Ranking of Wealth Creators

EVA
MVA

EVA is the net operating cash profit (NOPAT)

earned by the company less the cost of capital

where the non cash expenses like depreciation are

added back to NOPAT and non operating items

are reduced from the cost of capital.
EVA = (NOPAT Non-recurring items + Depn.) Cost of cap.

MVA (Market Value Added) is the value that the current share-holders can get over and above the equity ownership represented by the financial

accounts. It represents the markets perception of the companys ability

to add value to the current book value from future earnings. MVA is a measure of the value added by the companys management

over and above the capital invested in the company by its investors.

MVA =

Market

value

of

the

firm

Economic

capital.

MVA

= Market Capitalization Book Value of net worth

Why MVA and EVA???

Both these measures focus on Capital Efficiency, instead of just absolute measures. MVA tells us how much wealth has been created or destroyed by a company relative to original investment. The company with the highest market Capitalization may not be the biggest wealth creator. MVA - a better measure in the long run however is affected from the

vagaries of the stock market.

That is why, for sustainable wealth creation, companies should focus on improving their business fundamental economic performance i.e. EVA.

WHAT IS ECONOMIC VALUE ADDED?

A VALUE BASED FINANCIAL MEASURE. EVA IS THE FIRST REAL ATTEMPT TO ALIGN GOALS OF ALL MAJOR STAKEHOLDERS. AN EFFECTIVE PROTECTION AGAINST SHARE HOLDER

VALUE DETERIORATION.
A GOOD BASE FOR MANAGEMENT COMPENSATION SYSTEMS TO MOTIVATE MANAGERS TO CREATE

SHAREHOLDER VALUE A CONCEPT PRACTICALLY THE SAME AS RESIDUAL

25

INCOME

 MANAGERS INVESTORS.

ARE

OBLIGED

TO

CREATE

VALUE

FOR

THERE IS A MINIMUM LEVEL OF PROFITABILITY EXPECTED

FROM INVESTORS IS CALLED CAPITAL CHARGE. CREATING LESS RETURN THAN THE CAPITAL CHARGE IS ECONOMICALLY NOT ACCEPTABLE. INVESTORS CAN ALSO TAKE THEIR MONEY AWAY FROM THE FIRM SINCE THEY HAVE OTHER INVESTMENT ALTERNATIVES.
26

WHAT IS NEEDED TO CALCULATE COMPANYS EVA

COMPANYS INCOME STATEMENT COMPANYS BALANCE SHEET

27

EVA CALCULATION STEPS

CALCULATE NET OPERATING PROFIT AFTER TAX (NOPAT) IDENTIFY COMPANYS CAPITAL(C ) DETERMINE REASONABLE COST OF

CAPITAL RATE (WACC) CALCULATE COMPANYS EVA

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ILLUSTRATION FOR CALCULATION OF EVA

29

INCOME STATEMENT
NET SALES 2600

COST OF GOODS SOLD SELLING AND ADMN EXPNESES DEPRECIATION OTHER OPERATING EXPENSES OPERATING INCOME INTEREST EXPNESES INCOME BEFORE TAX TAX (40%)
NET PROFIT AFTER TAX

1400 400 150 100 550 200 350 140

210
30

BALANCE SHEET
LIABILITIES EQUITY R&S NET WORTH 300 640 940 FIXED ASSETS PLANT EQUIPMENT ASSETS 1550 650 410

LONG TERM LIABILITIES

1060 MISC. FIXED ASSETS

350 CURRENT ASSETS

490 800

CURRENT LIABILITIES ACC. PAYBLE ACCURED EXP. TOTAL LIABILITIES

5/2/2012

100 RECEIVABLES 250 INVENTORY 2350 TOTAL ASSETS

31

400 400 2350

CALCULATE NOPAT
NET SALES COST OF GOODS SOLD SELLING AND ADMN. EXPENSES DEPRECIATION OPERATING INCOME INTEREST INCOME BEFORE TAX TAX (40%) NET PROFIT AFETE TAX ADD: INTEREST BACK NOPAT 2600 1400 400 150 550 200 350 140 210 200 410

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IDENTIFY COMPANYS CAPITAL

COMPANYS CAPITAL (C) ARE TOTAL LIABILITIES LESS NON INTEREST BEARING LIABILITIES
TOTAL LIABILITIES LESS
ACCOUNTS ACCURED

2350

PAYABLE

100 250 2000

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EXPENSES

CAPITAL ( C)

DETERMINE WACC
WACC= (S/B+S)Ke + (B/B+S) Kd IN OUR CASE COST OF DEBT IS 10% AND

COST OF EQUITY IS 15% ASSUMED)

WACC= 0.47*15% + 0.53*6% = 10.23%
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5/2/2012

EVA CALCULATION
NOPAT LESS CAPITAL CHARGE (WACC* C) ECONOMIC VALUE ADDED 410 2000*10.23 =204.6 205.4

5/2/2012

35

MARKET VALUE ADDED-MVA

MVA= Market value of firm Book value of firm MVA = Present value of all future EVA

5/2/2012

36

OWNERS VALUE ADDED-OVA

OVA = ( PAT before interest + Inflationary Asset-Appreciation + Appreciation in the value of brands and human resources) (Actual cost of equity capital + Actual cost of borrowing + Appropriate opportunity cost of reserves)
5/2/2012 37

CFROI AND CVA BY BCG

CFROI=( CASH FLOW ECONOMIC DEPRICIATION)/CASH INVESTED CVA= CASH FLOW ECONOMIC DEPRICIATION-CAPTIAL CHARGE ON GROSS INVESTMENT

5/2/2012

38