Market Value Added –

The difference between the market value of a company and the capital contributed by
investors (both bondholders and shareholders). In other words, it is the sum of all capital
claims held against the company plus the market value of debt and equity.

The higher the MVA, the better. A high MVA indicates the company has created
substantial wealth for the shareholders. A negative MVA means that the value of the
actions and investments of management is less than the value of the capital contributed
to the company by the capital markets, meaning wealth or value has been destroyed.

What is the difference between economic value added and market value added?
Economic value added (EVA) is a performance measure developed by Stern Stewart &
Co that attempts to measure the true economic profit produced by a company. It is
frequently also referred to as "economic profit", and provides a measurement of a
company's economic success (or failure) over a period of time. Such a metric is useful for
investors who wish to determine how well a company has produced value for its
investors, and it can be compared against the company's peers for a quick analysis of how
well the company is operating in its industry.

Economic profit can be calculated by taking a company's net after-tax operating profit
and subtracting from it the product of the company's invested capital multiplied by its
percentage cost of capital. For example, if a fictional firm, Cory's Tequila Company
(CTC), has 2005 net after-tax operating profits of $200,000 and invested capital of $2
million at an average cost of 8.5%, then CTC's economic profit would be computed as
$200,000 - ($2 million x 8.5%) = $30,000. This $30,000 represents an amount equal to
1.5% of CTC's invested capital, providing a standardized measure for the wealth the
company generated over and above its cost of capital during the year.

Market value added (MVA), on the other hand, is simply the difference between the
current total market value of a company and the capital contributed by investors
(including both shareholders and bondholders). MVA is not a performance metric like
EVA, but instead is a wealth metric, measuring the level of value a company has
accumulated over time. As a company performs well over time, it will retain
earnings. This will improve the book value of the company's shares, and investors will
likely bid up the prices of those shares in expectation of future earnings, causing the
company's market value to rise. As this occurs, the difference between the company's
market value and the capital contributed by investors (its MVA) represents the excess
price tag the market assigns to the company as a result of it past operating successes.
All About EVA
The goal of all companies is to create value for the shareholder. But how is value
measured? Wouldn't it be nice if there were a simple formula to figure out whether a
company is creating wealth?

A growing number of analysts and consultants think there is an answer. Like many
economic formulas, the measure - Economic Value Add (EVA) - is both intriguingly
clever and maddeningly deceptive. Does EVA simplify the task of finding value-
generating companies or does it just muddy the waters?

What Is EVA?
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.

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 $1,000,000 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.

In other words, EVA charges the company rent for tying up investors' cash to support
operations. There is a hidden opportunity cost that goes to investors to compensate them
for forfeiting the use of their own cash. EVA captures this hidden cost of capital that
conventional measures ignore.

Developed by the management consulting firm Stern Stewart, EVA really caught fire in
the 1990s. Big corporations, including Coca-Cola, GE and AT&T, employ EVA internally
to measure wealth creation performance. In turn, investors and analysts are now
scrutinizing company EVA just as in the past they observed EPS and P/E ratios. Stern
Stewart has gone so far as to trademark the concept.
The Calculation
There are four steps in the calculation of EVA:

1. Calculate Net Operating Profit After Tax (NOPAT)

2. Calculate Total Invested Capital (TC)
3. Determine a Cost of Capital (WACC)
4. Calculate EVA = NOPAT – WACC% * (TC)

The steps appear straightforward and simple. But looks can be deceiving. For starters,
NOPAT hardly represents a reliable indicator of shareholder wealth. A firm NOPAT might
show profitability according to the GAAP (generally accepted accounting principles), but
standard accounting profits rarely reflect the amount of cash left at year end for
shareholders. According to Stern Stewart, literally dozens of adjustments to earnings and
balance sheets - in areas like R&D, inventory, costing, depreciation and amortization of
goodwill - must be made before the calculation of standard accounting profit can be used
to calculate EVA. To protect its trademark, Stern Stewart doesn't fully disclose the
adjustments - making the job of using the metric even more difficult.

Figuring out the cost of capital (WACC) is even more thorny. WACC is a complex
function of the capital structure (proportion of debt and equity on the balance sheet), the
stock's volatility measured by its beta, and the market risk premium. Small changes in
these inputs can result in big changes in the final WACC calculation.
That said, if carried out consistently, EVA should help us identify the best investments,
that is, the companies that generate more wealth than their rivals. All other things being
equal, firms with high EVAs should over time outperform others with lower or negative
EVAs.

But the actual EVA level matters less than the change in the level. According to research
conducted by Stern Stewart, EVA is a critical driver of a company's stock performance. If
EVA is positive but is expected to become less positive, it is not giving a very good
signal. Conversely, if a company suffers negative EVA but is expected to rise into a
positive territory, a good buying signal is given.

Of course, Stern Stewart is hardly unbiased in its assessment. New research challenges
the close relationship between rising EVA and stock price performance. Still, the growing
popularity of the concept reflects the importance of EVA's basic principle: the cost of
capital should not be ignored but kept at the forefront of investors' minds. Best of all,
EVA gives analysts and anyone else the chance to look skeptically at EPS reports and
forecasts.
Value-added measures of performance

Notes prepared by Pamela Peterson-Drake,Florida Atlantic University

I. Introduction
A. Many companies have embraced -- and others have felt obligated to look
at -- performance measures that depart from the traditional accounting
based measures such as earnings per share and return on investment.
B. These new "value-based" measures include economic-value-added (which
is Stern Stewart's registered EVA method), shareholder value increase,
economic value creation, and market-value-added.
C. Related measures include Holt Value Associates' and Boston Consulting's
CFROI and Alcar's Discounted Cash Flow Analysis.
D. Many variants of value-added measures have been spawned and many
consulting firms are selling value-based products.
E. These measures have been used in compensation arrangements, capital
decision-making, and in financial disclosures.
II. What is value-added?
A. Terminology
1. We say that a firm has added value over a period of time when it
has generated a profit in excess of a firm's cost of capital.
2. This profit is typically referred to as the economic profit, a concept
developed by economists in the 19th century. [Exhibit 1 -- top].
This is also referred to as economic value added (EVAâ, a
registered trademark of Stern Stewart ).
3. A related concept is market value added (MVA) , which is the
difference between the market value and the book value of a firm's
capital. [Exhibit 1]
B. Basic principles
1. Calculating economic profit requires first the calculation of net
operating profit after taxes.
1. To calculate NOPAT, accounting numbers are adjusted to
reflect operating earnings without accounting distortions
[Exhibit 2]
2. Note: These adjustments may differ among firms (and
among consultants' metrics).
2. Second, we determine the amount of capital, starting with the book
value of common equity and adding different debt components and
adjustments. [Exhibit 3]

One of the keys is to make sure that you are consistent

between the adjustments to arrive at NOPAT [Exhibit 2]
and capital [Exhibit 3].
2. Third, we determine the cost of capital
 As I will discuss later, this is not as straightforward as
purported.
3. Finally, we subtract the dollar cost of capital from Net Operating
Profit After Tax
But, as you can see, we could do all this in a return form
as well.
B. Historical basis
1. Economic profit was established long ago. As an example,
consider the writing of Alfred Marshall over 100 years ago.

When a man is engaged in business, his profits for the year are the excess of his receipts
from his business during the year over his outlay for his business. The difference between
the value of the stock of plant, material, etc. at the end and at the beginning of the year is
taken as part of his receipts or as part of his outlay, according as there has been an
increase or decrease of value. What remains of his profits after deducting interest on his
capital at the current rate ... is generally called his earnings of undertaking or
management."

[Alfred Marshall, Chapter 4, Income, Capital, Book II Some Fundamental Notions, The
Principles of Economics, 1890].

A.
1. Today we see this concept developed in every principles of
economic text. The idea of economic profit is the basis of the
capital budgeting techniques of net present value and the internal
rate of return, which can be found in finance texts over the past
thirty years.
2. Economists have been preaching the concept of economic profit
for over 100 years and finance professors have been putting
students through the rigor of net present value and internal rate of
return for thirty years.
3. In the texts of the late-1960s and early 1970s, the cost of capital is
referred to as the "minimum acceptable return," or the "minimum
revenue required". Profit is defined as earnings in excess of the
cost of capital.
4. Along with promotion of the concept of economic profit,
economics and finance professor have been discouraging the use of
accounting-based performance measures for many years.
5. So why the change in heart? Most of this change can be credited to
Stern Stewart's efforts to develop a product that has its foundation
in economic and financial theory.
B. Examples
1. Value-added and cost of capital:
a. Let's look at the basics of determining value added.
Suppose a firm has an accounting profit of $100 million. If
the firm has a cost of capital (in dollar terms ) of $75
 million, the firm has added $25 million of value during the
period. If, on the other hand, the firm has a cost of capital
of $125 million, the firm has destroyed $25 million in
value.
b. The cost of capital is the return required by the suppliers of
capital. This cost reflects both the time value of money and
compensation for risk -- the more risk associated with a
firm, the greater the firm's cost of capital. Factoring in the
cost of capital tells us whether the accounting profit of
$100 million is sufficient to keep the suppliers of capital
(the creditors and the owners) from moving their funds
elsewhere.
2. Let's look at another example of calculating economic profit
[Exhibit 4]
a. If the firm generates $900 million and its cost of capital is
10%, we say that the firm has added value ($10 million)
during the period.
b. Looking at the calculation of market value added [Exhibit
5], we see that it requires book and market values of the
different elements of capital (debt and equity).
c. In practical applications, however, what is really done is
include only the market value of equity -- the preferred
stock and debt are taken at book value (and included in the
market value of capital as such).
3. Looking at actual figures of EVAâ and MVA (as reported in
Forbes) we get a more realistic picture. [Exhibit 6]. Here we see
that:

It is possible to have a positive MVA and a negative

EVAâ (TRW in 1996 & 1995)
If is possible to have a negative MVA and a positive
EVAâ (Ford in 1996 & 1995)
The MVA figure corresponds very closely to the
difference between the market value of equity and the book
value of equity (therefore, MVA is due mostly to the
market-book difference).

Coca-Cola, 1995 (determines 1996 ranking):

market value of equity $92,961 mm
book value of equity $ 5,392 mm
difference $87,569 mm
I. How does a firm add value?
A. The secret to creating value.
1. Let step back a moment and look at where this value-added comes
from. Value is not created out of thin air. In fact, if product and
 factor markets are perfectly competitive, there should be no excess
profits. (this is basic economic theory)
2. It is only through market imperfections that firms can earn excess
profits -- that is, invest in positive net present value projects.

Keys to a perfectly competitive market:

 Costless entry and exit

 Undifferentiated products
 Increasing marginal costs of production

I.
A. The odds of creating value.
1. Creating value requires an advantage that prevents investments
from being priced fairly and economic profits driven to zero. We
should not expect value creation from every business for every
period of time.
2. If we observe "value-creation", we should inquire:
 Is this measurement error?
 If not, what is the source?
B. Sources of value-added
1. The sources of value-added are from basic economics:

Economies of scale : a given increase in production,

marketing or distribution results in less than proportional
increase in cost (i.e., there are cost advantages to being large
and there are high capital requirements); [e.g., IBM with
mainframes in 1960's].
Economies of scope : efficiencies are gained when an
investment can support many activities [e.g., 3M and its
adhesives technology]
Cost advantages : companies enjoy cost advantages that
are not available to new entrants [e.g., McDonald's and its
locations; Microsoft and its Windows operating system]
Product differentiation : invest in capacity to differentiate
products, through patents, reputation (brand name),
technologically innovative, service [e.g., Coca-Cola
(advertising), Disney, McDonald's]
Access to distribution channels : well-developed
distribution channels provide a competitive advantage.
Government policy : government regulations can limit
entry of potential competitors.
2. Note: These advantages are often referred to as "drivers"
II. Dimensions of value-added methods
A. Using EVAâ-like methods for compensation
1. The basic idea
 One of the most widely touted uses of economic profit
metrics is to determine compensation.
There is some dissatisfaction with current compensation
practices, whether tied to accounting metrics or using options.
The basic idea is to tie compensation to a measure of
economic profit.
Examples
 Eli Lilly (stock price has done quite well since
adopting in 1994)
 Coca-Cola (still uses some non-EVA Â option
awards)
 SPX (uses a bonus bank system)
 Georgia Pacific (no bonuses for 1996)
 R. Donnelly (no bonuses for 1996)
 Quaker Oats (stock is essentially flat-lined since
adoption)
 AT&T (did poorly after adopting it, done well after
"re-evaluating its use")
Problems in measuring success of adopting EVAâ for
compensation:

There has not been sufficient time to measure

success. Further, there has been a relatively low cost of
capital and an "up" stock market, so we have not seen
what happens when the cost of capital increases.
There is anecdotal evidence on both successes
and failures.
a. It is difficult to distinguish firms on the basis
of the "extent" to which the program is
applied
b. Issues: Does EVA-based compensation
apply to all managers? Are different metrics
used for different management groups? Are
other compensation methods (e.g., options)
also in place?
B. Using EVAâ principles throughout financial decision-making

A. The basic idea

Economic value-added-principles include not only tying

compensation to economic profit, but changing financial policy
-- especially capital structure policy.
A greater use of debt financing is advocated (i.e.,
repurchase of common stock financed with debt). This is
consistent with financial theory that touts the benefits from
debt financing.
 B. The issues
First, I should note that this aspect of economic profit
does not appear to have been widely adopted.
We should be cautious in applying financial theory
directly to practice.

For example, financial theory cannot prescribe

how much debt is too much.
Further, these EVA-based policies have not been
tested in high-interest environments.
B. Using value-added measures for investment strategies

1. There are several concerns about using value-added measures as

a metric for determining investment strategies.
2. Economic profit is measured with error (see below).
3. The empirical evidence suggests that value-added measures are
really not much better than traditional measures (e.g., return on
investment) (see below)
II. Determining value-added
A. Conceptual Issues
1. Time horizon

Over what period is added value measured?

Decisions are made today that, hopefully, generate future
cash flows of a firm.
How do we measure performance over a recent period of
time whose benefit may not be realized until some time in the
future? One approach is to look at current periods' economic
profit.

 If we calculate economic profit for a period of

time, we are measuring income from an historical
period.
Have we captured the benefit from this period's decisions
on future period's income? Probably not. Only under
specialized circumstances have we captured future benefits.
Short sighted versus far-sightedness

Using economic profit, have we encouraged management

to become far-sighted instead of short-sighted? Probably not.
Have we improved upon accounting profit as a measure
of performance? Probably.
What we have done by using economic profit in place of
accounting profit is make the firm's management more
accountable to the suppliers of equity capital.
Momentum
 How defined?

Instead of looking at single-period measures, we

could look at multiple periods, focusing on year-to-
year changes and "momentum".
Issues: However, "momentum" is a vague concept
(2 years' improvement? 3 years'?)
As more time is considered, there is more chance
that management has changed.
What does it tell us?
Momentum tells us that the firm has generated
economic profit in the past. This does not tell us
that the firm will generate economic profit in the
future.
Using economic theory, one may argue that firms
that have generated economic profit in the past are
less likely to generate them in the future (since
barriers to competition tend to fall over time).
B. Computational Issues
1. Adjustments to accounting income

Calculating NOPAT [Exhibit 2]

One of the primary concerns that we have with

accounting principles is that there is one set of
principles (with few choices) that is applied to many
different types of firms.
Are the adjustments required for economic value-
added subject to the same criticism?
The adjustments require many assumptions and
estimations.

Some of these adjustments are not

palatable.
Many of these adjustments differ among
consultants.
Calculating amount of capital [Exhibit 3]

Adjustments are made (e.g., add back LIFO reserve)

to book values.
Some estimations are required (e.g., present value
of non-capitalized leases)
Many book values are used in the calculation of
capital. But just how good a number is a book value
of an asset?
Cost of capital calculations
 Issues

a. There is no general agreement on the

"correct" method of calculating the cost of
capital.
b. The cost of capital is sensitive to the
method of calculation. Issues that arise:
a. Dividend valuation method vs.
CAPM?
b. If CAPM, which beta to use? We
know that individual security betas
are unstable over time.
c. Risk-free rate of return? Which rate
to use? 5%? 6%?
c. And economic profit is, in turn, sensitive
to the calculation of the cost of capital.
d. Using the figures in Exhibit 6, if the cost
of capital differed from what was presented
by 3% (e.g., for Coca Cola in 1996, if the
cost of capital was 9%-15%, the resulting
economic profit is quite different:
e.

Economic Economic
profit profit
if cost of if cost of
NOPAT capital capital
Company ($mm) +3% -3%
Coca-Cola +$3,253 +$1,862 +$2,418
TRW $743 -$97 +$237
Ford $7,078 -$89 +$3,271
1. Ambiguities
a. Do we use an imbedded rate or an expected
cost of capital?
b. That is, do we measure performance on how
the firm covers its cost of capital that it has
incurred (imbedded) or do we measure
performance on how the firm covers its
future cost of capital? Are suppliers of
capital forward-looking?
c. What if decisions are made today for future
investments that will increase the cost of
capital. Do we use today's cost of capital or
do we use a higher cost of capital.
2. Fama and French (Journal of Financial
Economics,1997) document the imprecise nature of
 the cost of equity for industries and speculate on the
greater imprecision for individual firms' cost of
equity.

I.
II. Empirical evidence on value-added measures vs. traditional measures
A. The key to understanding a performance metric is to see how well it
performs in rigorous testing. Are the firms that add value (per the value-
added metric) also the firms that benefit shareholders the most? The
answer is empirical.
B. The difficulty is that there is a great deal of anecdotal evidence that touts
the success of metrics, but much of this is provided by consulting firms.
C. Peterson and Peterson show that value-added metrics do not outperform
traditional measures (i.e., what ever edge the value-added metrics have it
is slight).
D. Others

Bacidore, Boquist, Milbourn and Thakor (Financial Analysts

Journal, May/June 1997) show that EVAâ explains 1% of variation in
abnormal returns (i.e., R-squared of 1%). (Their proposed measure,
REVA explains 3%)
Kramer and Pushner (Financial Practice and Education,
Spring/Summer 1997) regress MVA on EVAâ and find an R-square of
10% (Note: removing "outliers" increases this to 30%). Conclude that
the market focuses more on earnings than EVAâ.
II. Recommendation
A. Use both traditional metrics and value-added metrics.
B. Reliance on a single measure is not warranted.

I.
II. Future research
A. Rigorous and independent testing of value metrics
 Need to apply thorough testing to see whether value metrics help
investment performance. Need to control for market movements
and risk.
B. Rigorous and independent testing of value-added approach to financial
management
C. Challenges:

How are value-added principles applied? How do you quantify

the difference between a firm that uses, say EVAâ, for compensation
for top management only with a firm that uses EVAâ for all
management levels?
How do you account for the different adjustments that individual
companies make? How do account for the degree of discretion
regarding making adjustments?