Economic Value-Added (EVA) – Means to Measure Shareholders Value Criteria
The conventional approach to measure profit will deduct the cost of loan capital in arriving at a profit, but there is no similar deduction for the cost of shareholders. Critics of the conventional approach point out that a business will not make a profit, in an economic sense, unless it covers the cost of all capital invested, including shareholders’ funds. Earnings per share tells nothing about the cost of generating those profits. If the cost of capital (loans, bonds, equity) as saying, 15 percent, then a 14 percent earning is actually a reduction, not again, in economic value. Profits also increase taxes, thereby reducing cash flow.
Return on assets is a more realistic measure of economic performance, but it ignores the cost of capital. 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. This tempts them to expand without paying attention to the real return, economic value-added.
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 underlines 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.
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. There is a difference between EVA, earnings per share, return on assets, and discounted cash flow, as a measure of performance.
Discounted cash flow is very close to economic value-added, with the discount rate being the cost of capital.
There are two key components to EVA. The net operating profit after tax (NOPAT) and the capital charge, which is the cost of capital times the amount of capital. In other words, it is the total pool of profits available to provide a cash return to those who provided capital to the firm. The capital charge is the product of the cost of capital times the capital tied up in the investment. In other words, the capital charge is the cash flow required to compensate investors for the riskiness of the business given the amount of capital invested. On the one hand, the cost of capital is the minimum rate of return on capital required to compensate debt and equity investors for bearing risk-a a cut-off rate to create value and capital is the amount of cash invested in the business, net of depreciation (Dierks and Patel, 1997).
In formula form,
EVA = (Operating Profit) – (A Capital Charge)
EVA = NOPAT – (Cost of Capital x Capital)
Implementing EVA in a company is more than just patting one additional row in the income statement. It is of course some kind of change process which should be given some management effort. However, if the right actions are taken straight from the beginning then implementing EVA should be one of the easiest change processes that a company goes through. The actions might include e.g.:
– Gaining the understanding and commitment of all the members of the management group through training and discussing and using this support prominently during the process.
– Training of the other employees, especially all the key persons.
– Adopting EVA at all levels of the organization.