A CRITICAL EVALUATION OF ECONOMIC VALUE ADDED (EVA)

Category: Accounting

Economic Value Added (EVA) is a financial tool, that identifies the profit (or loss) left after deducting the cost of all types of capital employed (both debt and equity) in an organisation. It mostly helps in knowing the 'real value' of the organisation in a given time or period. "EVA is the one measure that is used to monitor the overall value creation in a business. EVA is not the strategy; it is the way we measure the results. There are many value drivers that need to be managed, but there can be only one measure that demonstrates success. A single measure is needed as the ultimate reference of performance to help managers balance conflicting objectives" (Shinder M, 1999).

The measure was developed and trademarked by the consulting firm Stern Stewart & Company, which claims that EVA is the only true indicator of business and management performance because it captures the true economic profit of a company. In recent times, economic value added can be said to be one of the most popular value based measures, and Investors all over the world have increased the pressure on companies to maximise shareholder's value.

Basically, there is an opportunity cost to people forfeiting the present use of their money in place of investment. EVA is a charge to the company for tying up these investors' money. EVA can however be said to capture this hidden cost of capital that conventional measures ignore.

EVA is not a new discovery. An accounting performance measure called residual income is defined to be operating profit subtracted from capital charge. EVA is thus one variation of residual income with adjustments to how one calculates income and capital. The EVA- concept is often called Economic Profit (EP) in order to avoid problems caused by the trade marking. On the other hand the name "EVA" is so popular and well known that often all residual income concepts are called EVA although they do not include even the main elements defined by Stern Stewart& Co (Mäkeläinen, 1998).

In both management and academic literature, EVA has been a major topic of debate. Although, most of its advocates have not really highlighted the faults of the EVA instead exceptionally praising it as a management tool. On the other hand most criticisms against EVA have kept to fairly insignificant topics from the viewpoint of corporate control (Mäkeläinen, 1998).

CHARACTERISTICS OF EVA

In reality, the entire metric is a development of three simple ideas: cash is king; some expenses are really investments in "disguise"; and the fact that equity capital is expensive.

In essence, EVA measures whether the operating profit is enough compared to the total costs of capital employed. Stewart defined EVA (Stewart, 1990) as Net operating profit after taxes (NOPAT) subtracted with a capital charge:

EVA= NOPAT - CAPITAL COST

EVA = NOPAT - COST OF CAPITAL Ã- CAPITAL employed (1)

Or equivalently, if rate of return is defined as NOPAT/CAPITAL, this turns into a perhaps more revealing formula:

EVA = (RATE OF RETURN - COST OF CAPITAL) Ã- CAPITAL (2)

Where:

Rate of return = Nopat/Capital

Capital = Total balance sheet minus non-interest bearing debt in the beginning of the financial year

Cost of capital = Cost of Equity Ã-Proportion of equity from capital + Cost of debt Ã- Proportion of debt from capital Ã- (1- tax rate). Cost of capital or Weighted average cost of capital (WACC) is the average cost of both equity capital and interest bearing debt. Cost of equity capital is the opportunity return from an investment with same risk as the company has. Cost of equity is usually defined with Capital asset pricing Model (CAPM). The estimation of cost of debt is naturally more straightforward, since its cost is explicit. Cost of debt includes also the tax shield due to tax allowance on interest expenses. If ROI is defined as above (after tax) then EVA can be presented with familiar terms to be:

EVA = (ROI - WACC) Ã- CAPITAL EMPLOYED (3).....(Mäkeläinen, 1998)

The Core Adjustments:

It is important to be consistent throughout the course of calculation: matching an income statement adjustment - in getting NOPAT - to a corresponding balance sheet adjustment - in getting invested capital. This is more important than the number of adjustments made.

The "perfect" economic profit calculation is fully loaded; that is, it captures every amount of invested capital and makes every adjustment to determine the precise level of cash flow. But the need for a perfect economic profit number is questionable. Many academic studies have demonstrated that the incremental information gained beyond a handful of key adjustments is minimal. It is therefore okay to use a few adjustments to arrive at an approximation (Harper, 2005).

The table below shows a list of selected core adjustments. Each income statement adjustment in the left-hand column helps to convert EBIT to NOPAT; each corresponding balance sheet adjustment in the right-hand column helps convert book capital to invested capital.

EVA AS A PERFORMANCE MEASURE

The EVA measure was created to address the challenges companies faced in the area of financial performance measurement. By measuring profits after subtracting the expected return to shareholders EVA indicates economic profitability. It tracks share prices much more accurately than earnings, earnings per share, return on equity or other accounting metrics, as strongly supported by empirical studies, creating sustainable improvements in EVA is synonymous with increasing shareholder wealth (Shinder M, 1999).

To aid further understanding of the EVA, we identify with the performance and wealth metric. A performance metric is a measure that can be controlled by the company, such as earnings or return on capital. While a wealth metric, is a measure of worth placed by the stock market's collective opinion such as price-to-earnings (P/E) multiple. Although these two types of metrics are different, they are also related.

In the long run, every performance metric can influence its corresponding wealth metric. For example, the earnings per share which can be seen as a performance metric is concerned with the allocation of earnings to shareholders, while the P/E multiple its corresponding wealth metric refers to equity market capitalization, which is the value held by shareholders. It should also be noted that the economic value added's corresponding wealth metric is market value added (MVA) (Harper, 2005).

USEFULNESS OF EVA

USED TO:

Assess the performance of the business. Since Economic Value-Added Analysis accounts for the cost of capital used to invest in a business, it provides a clear understanding of value creation or degradation over time within the company. This information also can be linked to management compensation plans.

Test the hypotheses behind business plans, by understanding the fundamental drivers of value in the business. This provides a common framework to discuss the soundness of each plan.

Communicate with shareholders and investors

Determine priorities to meet the business's full potential. This analysis illustrates which options have the greatest impact on value creation, relative to the investments and risks associated with each option. With these options clearly understood and priorities set, management has a foundation for developing a practical plan to implement change.

Help companies enhance their ability to acquire capital, either by demonstrating that they provide superior returns to investors or by identifying where they need to make improvements (Rigby, 2005).

Help determine bonuses. EVA based bonuses to management can turn out to be quite big if management does well. This gives incentive to management to improve profitability and thus the bonuses will be only part of the discretionary value created (this kind of bonuses are good also for owners) (Mäkeläinen, Introduction to Economic Value Added EVA, 1998)

Help the operating people to see how they can influence the true profitability (especially if EVA is broken down into parts than can be influenced) (Mäkeläinen, Introduction to Economic Value Added EVA, 1998)

STRENGTHS AND LIMITATION OF EVA

"In order to understand the strengths of EVA, the limitations of a predecessor metric called return on investment (ROI) must be discussed first. ROI was developed by the DuPont Powder Company in the early 1900s to help manage the vertically integrated enterprise (Johnson & Kaplan, 1987). The intent of this measure is to evaluate the success of a company or division by comparing its operating income to its invested capital. A firm can improve ROI in two ways. First, the profit margin earned per sales dollar can be increased. Second, the sales revenue generated per dollar of invested capital can be increased (this is known as asset turnover)" (Peter .C. Brewer. Gyan Chandra, 1999).

"ROI is usually used to measure income based on capital employed by the company. However, the primary limitation of ROI is that it can encourage managers, who are evaluated and rewarded based solely on this measure, to make investment divisions that are in their own best interests, while not being in the best interests of the company as a whole" (Morse .W, 1996)

The major strength of the EVA is that it highlights the decision aimed at fulfilling both the decision manager and the company's goals. In most cases, the ROI helps managers to take decisions aimed at achieving the firm's goals. So also, if an investment yields higher return than the ROI then it is favourable. But it must be noted that the ROI metric does not always help the manager to make decisions in accordance to the firm's goals because an investment that yields higher return but lower ROI will not be accepted by the manager even though it yields a higher return to the firm. This poses a major reason why employee's performance should not be based on ROI, since it may lead to a waste in resource from available capital lying fallow, which may otherwise have been used to create revenue for the firm. In any case, the firm will suffer losses since the decision manager will want to earn a high performance rating.

On the other hand, both the decision manager and the company will be inclined to take on any investment that will yield an EVA that is greater than zero or will give a higher return than what was invested. They will also both decline any investment that will yield otherwise.

Another main strength is that, because it is a residual performance metric, it conveniently summarises into a single static the value created above and beyond all financial obligations

And by applying a capital charge, it corrects the key deficiency of earnings and earnings per share (EPS): they do not incorporate the balance sheet. Economic profit explicitly recognises - by way of the capital charge - that capital is not free and, if growth is purchased with capital, economic profit recognises that the growth is not free and assigns a charge for the capital used to purchase the growth.

So also, as an operational metric, it helps managers clarify how they create value. Generally, they do it either by investing additional capital that produces returns above WACC, by reducing capital employed in a business, by improving returns by growing revenues or reducing expenses or by reducing the cost of capital (Harper, 2005).

the weaknesses of EVA:

Size Difference: EVA does not control for size differences across plants or divisions (Hansen & Mowen, 1997; Horngren, et al., 1997). In the case of a company having a large capital base or plant size, it will most likely have a higher EVA than a company with a smaller capital base. As discussed earlier, EVA is more allocative efficient in terms of simulating the goals of both decision managers and the firm. But it does not put into consideration size differences like ROI.

Financial Orientation: EVA is a computed number that relies on financial accounting methods of revenue realization and expense recognition. If motivated to do so, managers can manipulate these numbers by altering their decision making processes (Horngren, et al., 1997). However, product quality and customer satisfaction may suffer in cases where the decision manager compromises on certain decisions in order to achieve a higher EVA which will result in better performance evaluation. Basically, EVA fails to accurately depict the true level of effort and performance of managers.

Short-Term Orientation: EVA does not aid compensation for short term ideas in the current period of implementation. Using EVA for employee performance evaluation is highly inefficient as it discourages managers from innovating ideas that may yield higher EVA in the future, because in the short term, the manager gets no compensation for his accomplishments in the current accounting period. "Although innovation, the lifeblood of any vital enterprise, is best encouraged by an environment that does not unduly penalise failure, the predictable result of relying too heavily on short-term financial measures - a sort of managerial remote control - is an environment in which no one feels he or she can afford a failure or even a momentary dip in the bottom line" (Hayes & Abernathy, 1980). EVA can then be said to be a kind of managerial remote control that reduces the innovation rate of ideas that yield long term revenues.

Results Orientation: EVA does not give an explanation for what caused the financial problem in the company. It focuses on accounting performance and not on the non financial issues that may have caused the financial downturn. EVA states the obvious about the financial disappointment of the company but not the root operational defect that could have caused the problem.

Shortsighted information: Lastly, EVA has the limitations of any single-period, historical metric: last year's economic profit will not necessarily give you an insight into future performance. This can be especially true if a company is in a turnaround situation or makes a large lump-sum investment, in which case, economic profit will immediately suffer (due to the higher invested capital base) but the expected future period payoff will not show up as a benefit in the calculation (Harper, 2005).

AN ALTERNATIVE TO EVA

With respect to the limitations of the EVA, the new but famous concept called Balance Scorecard (Kaplan & Norton, 1996) presents that companies should use several different perspectives in measuring performance. The perspectives suggestions are (Kaplan & Norton, 1996, p.9):

Financial (How should we appear to our shareholders?)

Customer (How should we appear to our customers?)

International Business Process (To satisfy our shareholders and customers, what business process must we excel at?)

Learning and Growth (To achieve our vision, how will we sustain our ability to change and improve?)

The relative weight of each group of measures depends heavily on the business field and situation of the company. Professors Kaplan and Norton present that in order to fulfil financial objectives set by shareholders, the company should also concentrate on measures of other perspectives (Mäkeläinen, Economic Value Added as a management tool, 1998).

Conclusion

At operational level, EVA often leads to increased shareholder value through increased capital turnover (Wallace 1997, p.16). It can however be said that using EVA as a performance measure can lead to wealth creation. This has been proven by well known international companies resulting in a major increase in the worth of the organisations.

As indicated earlier, EVA has its shortcomings such as its sensitivity to inflation which may have a minimal impact on the figures but even these impacts can be eradicated with some corrective adjustments thus making it one of the most suitable performance measures. EVA can also be given the credit of helping managers perform better when they have the performance measure and bonus system making them behave like the owners of the company.

In conclusion, "wealth arises from EVA" might be an over statement, and companies should not rely on EVA alone as it is not the only path to wealth creation even though it measures it quite accurately. Eva is just as short- term as other performance measures, and should be used in balance with other measures. Therefore companies should make their ultimate goal linking unique strategies to wealth creation irrespective of the size of the company.

KEY:

EVA= economic value added/ economic profit

CFO= cash from operations

FCFF= free cash flow to firm

FCFE= free cash flow to equity

CVA= cash value added

ROGIC= return on gross invested capital

ROIC= return on invested capital

ROE= return on equity

MVA= market value added

EBIT=

NOPAT= net operating profit after tax