Economic Value Added by liwenting


									Economic Value Added
            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.
          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.
         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.
        Bennett Stewart
• 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) – [
  Capital X Cost of Capital ]
         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.
    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 isn't 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
      Common Performance
   -Earnings per share tells nothing about the cost of generating those

   -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.

   -Profits also increase taxes, thereby reducing cash flow, so that
    engineering profits through accounting tricks can drain economic value.

   -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.

   -Renowned investor Warren Buffett calls these "owner's earnings": real
    cash flow after all taxes, interest, and other obligations have been paid.
A.   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, IBM's 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.
  Discounted Cash Flow
 Discounted cash flow is very close to
  economic value-added, with the
  discount rate being the cost of
    EVA Computation
• NOPAT/ CE – WACC = Spread
• Spread * CE = EVA
              Cost of capital
•   Determining a firm's 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 investor's premium increases the
    firm's cost of capital.
           Accounting Policy
•   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 firm's 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.
         Accounting Policy
• 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."
                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
    – 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.
           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 – 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.
        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.
       Market return
• During April 1993 – March 2000 for
  determining market return. Average
  of 84 monthly return is 12.37%.
  Thereafter , no trend of market
  return during April 2001 – March
  2002 can set. So 12.37% is taken as
  long term market return.

To top