Economic Value Added (EVA) and Shareholders Value Maximization

Almost in all books on financial management, the very first chapter introduces the fact that the goal of financial decisions is to maximize shareholder’s value. But why only shareholder’s value and what about others stakeholders like employees, customers, creditors? If one focuses on the shareholder value creation other stakeholder’s interests will automatically become the sub-goals and achieving these sub goals becomes crucial to the achievement of the overall goal i.e. shareholder value maximization. For example, the firm’s profit depends a lot on how the employees perform and to motivate them the firm needs to satisfy their needs and constantly upgrade their knowledge and skills by proper training. Similarly the firm would be required to pay its creditors on time so that they keep providing them credit whenever needed in the future and the credit availability does not hamper the operations of the firm. So a firm’s goal to maximize wealth of the shareholders can be taken to be a reasonable overall goal.

In general, the shareholder value is the present value of the anticipated future stream of cash inflows from the business plus the terminal value of the company. The positive shareholder value is created when these cash inflows are greater than the investors’ risky investment over the same time frame. Shareholder’s value is measured by the returns they receive on their investments. A return are in two parts, first is in the form of dividends and second in the form of capital appreciation reflected in the market value of shares, of which market value is the dominant part. But the management of a firm influences the market value of shares. However, one factor, which has a significant influence on the market value, is the expectation of the shareholders regarding the return on their investment. The share prices are influenced by the extent to which the management is able to meet  the expectations of the shareholders. Shareholders are the ultimate owners of the corporate organization, who keep the management as agent for them. The destruction in value, that is consistent fall in the market value of shares, is making the shareholders unable to get the initial issue price of shares and it is compelling them to offload their shareholding.

If the shareholders start selling their shares and there is no buyer then the company is bound to windup its existence. The interest of the shareholders is well maintained if the prices of the shares of the company in the stock market go on adding value to the shareholders. That is, over a period of time shareholders want an increase in the market price of the shares they are holding. In a nutshell, shareholder’s value of a company may be defined as the Market Value of its Equity shares. Market Value of Equity shares is represented in the Market Capitalization. It is a multiple of number of shares issued by the company and the market value per share of the company. The other way of measuring Market Capitalization of a company is Market Value Added (MVA) plus total Capital of the company. As total capital is more or less static and changes only through retained earnings/loss, Market Capitalization of a company depends on its MVA.

Economic Value Added (EVA) is the performance measure most directly linked to the creation of shareholder wealth over a period of time. EVA gives manager superior information and superior motivation to make decisions that will create the greatest shareholder private enterprise. EVA is used to identify firms those are creating value for shareholders. Favorable changes in stock prices will increase stock prices as the equity holders residual claim decreases, while debt holders should realize capital gains on their securities through credit upgrades. EVA also can be used to design value and growth-oriented investment strategies. EVA encourages managers to focus on the balance sheet, just as the market does. In practice, many investors look primarily at the income statement, which can result in being misled as to whether or not value is truly created. Economic Value Added (EVA) can be used not only to “back out” investors’ expectations about key variables in the current stock price, but also can be used to reveal expectations that are unreasonably high or those that are temporarily under priced by the market.