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Economic value-added 2


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Economic value-added 2

  1. 1. Economic Value Added T.P.Ghosh
  2. 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. 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. 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. 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. 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. 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 isnt 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. 8. Common Performance Measuresy -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 "owners earnings": real cash flow after all taxes, interest, and other obligations have been paid.
  9. 9. ROAA. 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, IBMs 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. 10. Discounted Cash Flowy Discounted cash flow is very close to economic value-added, with the discount rate being the cost of capital.
  11. 11. EVA Computation‡ NOPAT/ CE ² WACC = Spread‡ Spread * CE = EVA
  12. 12. Cost of capital‡ Determining a firms 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 investors premium increases the firms cost of capital.
  13. 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 firms 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. 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. 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. 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. 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. 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.