2. What is EVA?
‡ Economic value-added (EVA) is the after-tax cash flow
generated by a business minus the cost of the capital it has
deployed to generate that cash flow.
‡ Representing real profit versus paper profit, EVA underlies
shareholder value, increasingly the main target of leading
companies' strategies.
‡ Shareholders are the players who provide the firm with its
capital; they invest to gain a return on that capital.
3. EVA concept
‡ The concept of EVA is well established in
financial theory, but only recently has the
term moved into the mainstream of
corporate finance, as more and more firms
adopt it as the base for business planning
and performance monitoring.
‡ There is growing evidence that EVA, not
earnings, determines the value of a firm.
4. EVA concept
‡ The chairman of AT&T stated that
the firm had found an almost perfect
correlation over the past five years
between its market value and EVA.
‡ Effective use of capital is the key to
value; that message applies to
business processes, too.
5. Bennett Stewart
explains
‡ Economic Value Added is the financial performance
measure that comes closer than any other to capturing the
true economic profit of an enterprise. EVA® also is the
performance measure most directly linked to the creation
of shareholder wealth over time. Stern Stewart & Co.
guides client companies through the implementation of a
complete EVA-based financial management and incentive
compensation system that gives managers superior
information - and superior motivation - to make decisions
that will create the greatest shareholder wealth in any
publicly owned or private enterprise.
‡ EVA = Net Operating Profit After taxes ( NOPAT) ² [
Capital X Cost of Capital ]
6. Drucker on EVA
‡ Peter Drucker put the matter in a Harvard
Business Review article, "Until a business returns
a profit that is greater than its cost of capital, it
operates at a loss. Never mind that it pays taxes
as if it had a genuine profit. The enterprise still
returns less to the economy than it devours in
resources«Until then it does not create wealth; it
destroys it." EVA corrects this error by explicitly
recognizing that when managers employ capital
they must pay for it, just as if it were a wage.
7. Aligning decisions with
shareholder wealth
‡ Stern Stewart developed EVA to help managers incorporate two
basic principles of finance into their decision making. The first is
that the primary financial objective of any company should be to
maximize the wealth of its shareholders. The second is that the
value of a company depends on the extent to which investors
expect future profits to exceed or fall short of the cost of
capital. By definition, a sustained increase in EVA will bring an
increase in the market value of a company. This approach has
proved effective in virtually all types of organizations, from
emerging growth companies to turnarounds. This is because the
level of EVA isn't what really matters. Current performance
already is reflected in share prices. It is the continuous
improvement in EVA that brings continuous increases in
shareholder wealth
8. Common Performance
Measures
y -Earnings per share tells nothing about the cost of generating those
profits.
y -If the cost of capital (loans, bonds, equity) is, say, 15 percent, then a 14
percent earning is actually a reduction, not a gain, in economic value.
y -Profits also increase taxes, thereby reducing cash flow, so that
engineering profits through accounting tricks can drain economic value.
y -As Bennett Stewart, the leading authority on EVA, comments, the real
earnings are the equivalent of the money that owners of a well-run mom-
and-pop business stash away in the cigar box.
y -Renowned investor Warren Buffett calls these "owner's earnings": real
cash flow after all taxes, interest, and other obligations have been paid.
9. ROA
A. Return on assets is a more realistic measure of economic
performance, but it ignores the cost of capital.
B. In its most profitable year, for instance, IBM's return on
assets was over 11 percent, but its cost of capital was
almost 13 percent.
C. Leading firms can obtain capital at low costs, via
favorable interest rates and high stock prices, which they
can then invest in their operations at decent rates of
return on assets.
D. That tempts them to expand without paying attention to
the real return, economic value-added.
10. Discounted Cash Flow
y Discounted cash flow is very close to
economic value-added, with the
discount rate being the cost of
capital.
12. Cost of capital
‡ Determining a firm's cost of capital requires making two
calculations, one simple and one complex.
‡ The simple one figures the cost of debt, which is the after-tax
interest rate on loans and bonds.
‡ The more complex one estimates the cost of equity and involves
analyzing shareholders' expected return implicit in the price they
have paid to buy or hold their shares.
‡ Investors have the choice of buying risk-free Treasury bonds or
investing in other, riskier securities.
‡ They obviously expect a higher return for higher risk. To attract
investors, weak firms must offer a premium in the form of a lower
stock price than stronger firms can command.
‡ This lower price amounts to the equivalent of a higher interest
rate on loans and bonds; the investor's premium increases the
firm's cost of capital.
13. Accounting Policy
Implications
‡ Cash flow and the cost of capital employed to generate that flow
have become the key determinants of business performance, with
earnings per share increasingly a misleading or even damaging
target for strategy and investment.
‡ When a firm switches from FIFO (first in, first out) to LIFO (last
in, first out), its cost of goods assumes the price of the most
recent purchases of materials in inventory.
‡ This typically reduces its profits because the older purchases cost
less than the more recent ones.
‡ Yet the firm's stock price will rise, even though its reported
profits drop, because it pays less in taxes, thus increasing its
after-tax cash flow.
‡ The money spent to acquire the goods in inventory is exactly the
same regardless of which method is used, but LIFO increases
economic value-added.
14. Accounting Policy
Implications
‡ The key business processes of the firm are capital.
‡ That fact is obscured by accounting systems that expense
salaries, software development, rent, training, and other
ongoing costs that are integral to a process capability and
that treat the cost of displacing workers-a frequent by-
product of process reengineering, downsizing, and the like-
as an "extraordinary item" on the income statement.
‡ By treating processes as capital assets or liabilities, firms
can and should ensure that they directly contribute to
economic value-added.
‡ The following quotation summarizes the issues here. For
"operations" in the first sentence, we can just as accurately
substitute "business processes."
15. Risk Premium
‡ Risk Premium used in the CAPM is the excess average return on
select stocks over average return on risk free securities over the
measurement period.
‡ Damodaran has suggested use of lone run average taking the
measurement period of at least ten years. There is also
disagreement as regards type of mean to be used .
‡ Arithmetic mean is justified as it is more consistent with the mean
² variance framework of the CAPM .
‡ Whereas the geometric mean is justified on the grounds that it
takes compounding into account and that is a better predictor of
the average premium in the long term.
‡ There can be significant difference in premiums depending upon
the choice of average. For computing risk premium , it is possible
to take return on broad based market index over risk free rate.
16. Risk Free Rate
‡ Variants on the risk free rate - Damodaran explained use
of three variants of risk free rate for computing cost of
equity :
‡ Short term government security rate : This may be
justified in the CAPM framework which is considered as a
one ² period model;
‡ Short term forward rate : This is based on superiority of
the forward rate in forecasting future short term rate; and
‡ Current long term government bond rate : This takes a
strict view of matching the duration of the risk free
security with the duration of assets being nalyzed.
‡ Damodaran has finally used long term rate for computing
risk free rate.
17. Risk Free Rate
‡ As per Indian Fixed Income Securities
Market , National Stock Exchange , April
2002 issue Yield on Government Securities
of maturity range over 10 years was 8.05%
in February 2002 , 8.06% in March 2002
and 7.79% in April 2002.
‡ So for illustrative purpose 8.06% is taken
as risk free rate, which is maximum of the
latest yield.
18. Market return
‡ During April 1993 ² March 2000 for
determining market return. Average
of 84 monthly return is 12.37%.
Thereafter , no trend of market
return during April 2001 ² March
2002 can set. So 12.37% is taken as
long term market return.
