Concept of Economic Value Added (EVA)

The onset of liberalization and globalization of the Indian economy over the ten years has resulted in shift of the corporate goals from socio-economic focus to an increasing shareholders value. Therefore, the present day need is to choose the right metrics that would help to measure organizational progress in meeting the above mentioned strategic goal. Although there are few traditional performance metrics like balance sheet measures (namely, rate of return, shareholders’ profit, earning per share) and market driven measures (namely, market capitalization, price earning ratio), these are subject to certain deficiencies. Balance Sheet based measures are veiled in accounting anomalies that generally measure notional profit, not real ones and market driven measures are prone to volatility of the bourses. The need is for a mix and match measure that factor in a market’s assessment of a company’s value. At the same time, it should be a real measure of its financial performance extracted from its financial statements.

Thus, corporate world’s need for a tool to measure value creation has been filled with the emergence of a new concept namely, Economic Value Added (EVA). It has been redefined and popularized by US based Stem Stewart & Company. It is an attempt to resolve the need for a performance measure that is highly correlated to the shareholders wealth and responsive to the actions of the company’s managers. Shareholder value is considered as an essential measure of the corporate performance. It is an accurate reflection of the quantum of incremental value a company generates for shareholders after accounting for its cost of operations, which include the cost of capital. The number of companies that have adopted EVA worldwide is startling. Stem Stewart Management Services (the founders of EVA) claim that more than four hundred companies globally are using Economic Value Added (EVA). Fortune magazine has termed it as today’s hottest financial idea with underlying scope of getting hotter. Management Guru Peter Drucker has described EVA as a vital measure that reflects all the dimensions by which management can increase value. Economic Value Added (EVA) is the financial measure that comes closer than any other measure in capturing true economic profit of an enterprise.

To elaborate, Economic Value Added (EVA) is the same as what economists call as economic profit. In business, revenue comes from customers and is distributed among the shareholders. Suppliers are paid for their goods and services and employees for their services. Depreciation amount is deducted from revenue as it results in loss of the value of assets. Creditors are paid interest while loans and taxes are paid to the government. Ultimately, shareholders are also paid a return. The shareholder’s return is not the usual dividend payment, but iris the return commensurate with the risk undertaken by them by investing money in the business. It is the earning that the shareholders could have earned by investing in similar risk profile investments i.e. they have to be paid their opportunity cost of capital. This differentiates EVA from the accounting model as the accounting model does not acknowledge the cost of equity. After paying to all whatever is left out from revenue is know as EVA. EVA is thus the residual income. As shareholders are the owners of the business, the residual income adds to their wealth.

The current demand for adopting Economic Value Added (EVA) is based on a simple i.e. you cannot know whether your enterprise is creating value for your shareholders until you subtract cost of the capital from income. To the extent EVA is positive; the firm is adding value for its shareholders. But if a firm’s EVA is negative, the firm is destroying value even though it may be reporting a positive or growing earning per share (EPS) or return on investment (ROI). This means that if a firm wants to have an attractive investment, it has to have a return that would exceed other investment options with a similar risk. Though EVA just reiterates the basic tenet behind any enterprise, it is not just any other metric for the firm. It is a framework for complete financial management and compensation system. It can guide every decision a company makes that can a corporate culture and help produce greater wealth for shareholders, customers and themselves.

While creating value for the shareholders is an objective measure of corporate performance, the measure of creation of wealth for the company as a whole is also equally important. The best measure for this is another value add measure, namely, Market Value Added (MVA). MVA is an absolute measure of wealth creation obtained by subtracting the economic capital of an organization (book capital after perfect measure of a company’s ability to create wealth but is as volatile as any market index and so, can be calculated for the company as a whole only. Economic Value Added (EVA) on the other hand is the most accurate measure of economic performance of the company and can be calculated at the level of divisions and product lines. So, while EVA of a company is the excess of its return on capital over its cost of capital, MVA is the difference between company’s total market value and its capital employed. In mature markets, MVA of a company is equal to the net present value of all future EVAs. In countries like India where markets are not efficient, MVA is volatile with no mathematical link with EVA.

In a nutshell, Economic Value Added (EVA) can be described as:

  • Most accurate value based measure of financial performance. A registered trademark redefined and popularized by US based Stem Stewart & Company.
  • Concept, a variation of residual income.
  • Concept, practically the same as economic profit.
  • A measure indicating amount of shareholder wealth created or destroyed during each year.
  • A framework of complete financial management and incentive compensation.