Economic value added (EVA) represents the value added to the shareholders by generating profit in excess of the cost of capital employed. EVA is, therefore, net profit after tax generated by a business minus the cost of the capital it has deployed to generate that cash flow. Shareholders are the providers of long-term funds to the company by way of share capital; they expect to earn a return on that capital. Representing the real profit as compared to paper profit, EVA underlies shareholder value, increasingly the main target of leading companies’ strategies.
The narrower benchmark of measuring shareholders’ value creation is return on net worth. So, one can compute it by dividing the net profit after tax of the company by the shareholders’ wealth. Shareholders wealth or net worth comprises of paid-up capital and free reserves and surpluses. Net worth of the company belongs to the equity shareholders. Therefore, return on net worth focuses on the wealth created to the equity shareholders.
Economic Value Added in Corporate Finance
The concept of Economic Value Added is well established in financial theory. However, but only recently this term has moved into the mainstream of corporate finance. Nowadays, more and more companies adopt it as the base for business planning and performance monitoring. EVA measures whether the operating profit of the company is enough compared to the total cost of capital employed. There is growing evidence that EVA, not earnings, determines the value of a firm. Many of the companies have found that there exists almost perfect correlation between their market value and EVA. Therefore, effective use of capital is the key to value; that message applies to business processes, too.
Profit vs. Value Addition
Profit earned by company after payment of corporate tax and preference dividend belongs to the equity shareholders. The term ‘profit’ includes both the cost of equity and the added value created by the company. That is responsible for many of the ways in which profit is a misleading indicator of company performance, for example, when firms increase profit but subtract value by reinvesting at less than the cost of capital, or enhance earnings per share without adding value by acquiring firms on less elevated price-earnings multiples. Some people think that super normal profit earned by the company as added value.
Computation of Economic Value Added
Cost of Capital
To compute EVA, one has to obtain the cost of capital of the company. Cost of capital for this purpose refers to the weighted average cost of both the equity capital and interest-bearing debt. Determining the 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 securities or investing in other riskier securities. They obviously expect a higher return for higher risk.
Premium on Cost of Capital
According to the concept of EVA, the company must earn a return to the shareholders which compensates the risk taken by them. In other words, the shareholders of a company must receive at least the returns received by similar risky investors in the market. If a company fails to achieve such return, shareholders may infer that the company has not made real profit and the company operates at a loss. Therefore, to attract investors, weaker companies must offer a premium in the form of a lower stock price than stronger companies 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.
A company needs capital to commence its operation. The company invests such capital in fixed assets, e.g., like factory premises, plant and machinery, vehicles and the working capital requirement of the company. Books of accounts of a company are prepared as per the accounting concept. According to the accounting concept, amount incurred by the company on salaries, software development, building rent, staff training, etc. are treated as expenses and charged to income. But according to the concept of EVA, amount incurred for the purposes which give returns to the company for years, e.g., employee training expenses, research and development expenses are also capital assets of the company.
Importance of EVA
EVA is one of the important tools which helps managers to formulate strategies on the basis of value creation potential. The focus of the management should be how to come up with the strategy with the potential to significantly increase the value of a business. Understanding the concept of EVA provides guidance for managers who are actually responsible for creating value over the long-term. Ultimately, value will only be created for shareholders if management is able to demonstrate to the capital markets that it has the ability to deliver financial performance in excess of previous market expectations. In the long term, this will only occur through better strategies in the market for the company’s products and services.
Companies have to reorient themselves towards maximizing shareholders value. While shareholder value is measured in the capital markets, it is created in the product markets. It is important to recognize that value creation is a creative act, not an analytical process. EVA, as described above, measures and displays value creation. It is not the source of value creation. The source of value creation is management thinking, and in particular creative thinking grounded with sound analysis.