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The goal of all companies is to maximize the shareholder’s value. The shareholder’s wealth is measured by the returns they receive on their investment. Returns are in two parts, first is in the form of dividends and the second in the form of capital appreciation reflected in market value of shares.
Currently investors world are demanding shareholder’s value than just high returns. In India, the concept of shareholder value is gaining ground, particularly after the liberalization on foreign holdings in Indian companies.
Foreign institutional investors emphasized and demanded focus on shareholder’s value then other parameters.
The shareholder’s activism reached an unforeseen level in the United States in the 1980s. Investors in Europe have also increased the pressure on companies to maximize shareholder value .The New York based Financial advisory Stern Stewart and Co. postulated a concept of economic income in 1990 in the name of ‘Economic Value Added’. EVA is a modified version of residual income concept.
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EVA has provided financial discipline in many U.S. companies and encouraged managers to act like owners and boosted shareholder’s returns and the value of their companies. In the present article an attempt has been made to discuss the various aspects of Economic Value Added viz, Evolution of Economic Value Added, what is EVA, How to calculate EVA, difference between EVA and net income, when EVA increased and decreased, Limitations of EVA, Importance of EVA and Functions of EVA.
Accounting is mainly concerned with external reporting to stockholders’ governments, creditors and other outside parties.
The two basic financial statements which are required to be prepared by concerned under company’s act 1956 are profit and loss account and balance sheet. Other supplementary financial statements are also prepared during an accounting year, which is required for investing and financial decisions.
Now a days maximizing shareholder values has always been the ultimate aim of every company but traditional performance measure like return on investment (ROI) and earning per share (EPS) have failed to indicate the shareholder creation. Hence, value based measures have received a lot of attention in the recent years. There are several value based measures such as cash flow return on investment (CFROI) developed by Boston Consulting Group, cash value added (CVA) by Holt Value Associates, shareholder value added (SVA) created by Alfred Rappot and LEAK/ALCAR consulting group, market value added (MVA) by Academicians in the field of Accounting and Economic Value Added (EVA) developed by Stem and Stewart Consulting Company. Among these ‘EVA’ is the most widely used and popular concept because it happens to be an easier concept compared to others and above all it is cost effective.
Therefore, in recent years another financial statement known as Economic Value Added Statement (EVA Statement) finds its place in the annual reports of many leading companies. Keeping in view the growing awareness of existing and perspective shareholders and emergence of EVA as performance indicator same corporate giants in our country like Infosys, BPL, Hindustan Lever Ltd., Colgate Palmolive (India) Ltd., Nestle (India) Ltd. And Godrege Consumer Products Ltd have started to present EVA statement voluntarily as supplementary statement in their annual reports in recent times.
EVA is not a new concept. The idea of EVA has been used around 400 years ago. To overcome the limitation of accounting based financial performance New York (US) based advisory firm Stem Stewart & Company introduced concept of economic income in 1990 in the name of economic value added and EVA is patent of the company. EVA eliminates many of ROIs inherent limitations.
EVA is one variation in accounting performance measure called Residual Income with necessary adjustment in capital and income. In 1890 Alfred Marshall mentioned residual income concept as Economic Profit. He defined economic profit as total net gain less the interest on capital invested at the current rate. The idea of residual income was introduced first in Accounting Literature by Church in 1917 and in 1924 by Scovell and appeared in Management accounting Literature in 1960s.
Till 1970 or earlier residual income did not get wide publicity and was not regarded as performance measure by corporate sector. Then after economic value added was marketed with a concept of market value added and it did offer theoretical sound like market valuations. EVA is a company’s net operating profit after tax and cost of capital. It represents the value added to shareholders wealth by generating operating profits in excess of the cost of capital employed in the business. It is based on residual income after charging the cost of capital provided by leaders and shareholders.
If the capital cost is lower than the NOPAT – the firm is able to create value for over a period but if it higher than the NOPAT – the firm is not able to generate value for over the period but it can be said it has worked as value destroyed even though it may be reporting positive and growing EPS or Return on Capital Employed.
It is a performance metric that calculates the creation of shareholder value. It distinguishes itself from traditional financial performance metrics such as net profit and EPS: EVA is the calculation of what profits remain after the costs of a company's capital - both debt and equity - are deducted from operating profit. The idea is simple but rigorous: true profit should account for the cost of capital.
EVA is net operating profit minus an appropriate charge for the opportunity cost of all capital invested in an enterprise. As such, EVA is an estimated of true “economic” profit, or the amount by which earning exceed or fall short of the required minimum rate of return that shareholders and lenders could get by investing in other securities of comparable risk.
To understand the difference between EVA and its older cousin, net income, let's use an example based on a hypothetical company, Ray's House of Crockery. Ray's earned 100,000 on a capital base of 10,00,000 thanks to big sales of stew pots. Traditional accounting metrics suggest that Ray is doing a good job. His company offers a return on capital of 10%. However, Ray's has only been operating for a year, and the market for stew pots still carries significant uncertainty and risk. Debt obligations plus the required return that investors demand for having their money locked up in an early-stage venture add up to an investment cost of capital of 13%. That means that, although Ray's is enjoying accounting profits, the company lost 3% last year for its shareholders.
Conversely, if Ray's capital is 100 million - including debt and shareholder equity - and the cost of using that capital (interest on debt and the cost of underwriting the equity) is 13 million a year, Ray will add economic value for his shareholders only when profits are more than 13 million a year. If Ray's earns 20 million, the company's EVA will be 7 million.
EVA can be calculated using the formula:
EVA=NOPAT−(TCE×WACC)EVA=NOPAT−(TCE×WACC)
Where:
WACC=(VE)×Re+(VD)×Rd×(1−Tc)
Where:
It refers the quantum of net operating profit remained in the business after the payment of tax. It can be derived from the income statement. Its calculation based on accounting concept. The non-operating items like dividend/interest on securities invested outside the business, non-operating expenses etc. will not be considered.
Stem Stewart & Company has identified 164 adjustments that have to make. These because much complicated amongst these 10 to 15 adjustments are enough for calculation. Like written off R&D expenses, methods of valuing inventory LIFO, FIFO, Deferred taxes, excessive depreciation, certain marketing expenses, goodwill written off etc.
The capital employed can be calculated through the assets side of the balance sheet or the liability side. From the assets side capital employed is the current assets less the non-interest bearing current liabilities i.e. the net working capital plus the net fixed assets. From the liability side it is the sum of interest bearing debt and net worth less any non-operating assets.
For calculating EVA use the beginning of the year capital employed as the capital available to the management to earn the returns and it helps in evaluating capital budgeting decisions. It is prudent to use the book value figure in the EVA calculations, as the amount that has been entrusted to the management to employ in the business. The market value of a firm is the investor’s capital and it is not the same as the firm’s capital. The capital employed that earns operating profits is the book value of net assets and not the market value of a firm’s stock.
Table 1: Key Financial Metrics for EVA Calculation
| Metric | Description |
|---|---|
| NOPAT | Profit a company makes after all expenses and taxes, excluding the costs of capital. |
| TCE | Capital that a company uses to generate revenue, calculated from the balance sheet. |
| WACC | Average rate that a company is expected to pay to its security holders to finance its assets. |
| EVA | Economic value a company generates from its capital, indicating real financial performance. |
Table 2: Difference Between EVA and Net Income
| Aspect | EVA | Net Income |
|---|---|---|
| Definition | Measure of a company's financial performance that accounts for the cost of capital. | Company's total earnings or profit. |
| Focus | Value creation beyond the required return on capital. | Accounting profit without considering capital cost. |
| Calculation | NOPAT - (TCE x WACC) | Revenues - Expenses |
Consider a hypothetical company, XYZ Ltd, with the following financials:
Using the EVA formula:
EVA=$200,000−($1,000,000×10%)=$200,000−$100,000=$100,000EVA=$200,000−($1,000,000×10%)=$200,000−$100,000=$100,000
Therefore, XYZ Ltd has created an economic value of $100,000 for its shareholders.
Economic Value Added (EVA) emerges as a superior metric for assessing a company's financial performance and its ability to create value beyond the cost of capital. Unlike traditional financial metrics such as net income, which do not account for the cost of capital, EVA provides a more comprehensive and realistic view of a company's profitability and efficiency in generating shareholder wealth. By incorporating the cost of capital into the calculation, EVA encourages companies to focus on projects that truly add value, promoting financial discipline and aligning the interests of managers with those of shareholders. The adoption of EVA as a performance metric can drive companies towards more value-accretive decisions, enhancing shareholder returns and improving market competitiveness. As the concept of shareholder value continues to gain prominence, especially in emerging markets, tools like EVA become indispensable in steering companies towards sustainable growth and long-term value creation.
Formula for Calculating Economic Value Added (EVA). (2024, Feb 18). Retrieved from https://studymoose.com/document/formula-for-calculating-economic-value-added-eva
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