Presentation on

Economic Value Added (EVA)

 Reliance - 1997
• In Everything that we do we have only one supreme goal
i.e. to maximise your wealth as member of India’s largest
investor family.

Tata Steel
Enhancing Shareholder Value Vision 2007
• To seize the opportunities of tomorrow and create a future
that will make us EVA positive Company.

• I think the soundest management advise I have heard

is the old saying - “What gets measured gets done”
– Tom Peters
 Background of EVA
• New Value based performance measure
developed by a New York Consulting
firm, Stern Steward & Co in 1982

• The object of EVA is to promote value-

maximizing behavior in corporate
managers
 What is EVA
• EVA is single, value based measure
that was intended to evaluate

– Business strategies

– Capital projects

– Maximizing the long-term shareholders

wealth
 What is EVA (contd..)
• EVA establishes clear and Shareholders Returns
accountable links among

– Economic Return:
strategic thinking, capital
investment
EVA
– Accounting Returns:
operating decisions and
Accounting Economic
– Shareholders Returns: returns Returns
shareholder value
 Why EVA

• EVA sets managerial performance target

and links it to reward system which
motivates the managers to behave like
owners.

• EVA allow managers to have discretion

and free range creativity keeping the
long term object in mind.
 EVA Concept of Profitability

• A successful firm should earn atleast its cost of

capital.
• Firms that earn positive/higher returns than
financing costs benefit shareholders and
enhance shareholder value.

“Until a business returns a profit that is greater

than its cost of capital, it operates at a loss”
– Peter F Drucker in an article in Harward Business Review
 Composition & Mechanics of EVA
• EVA represents Net operating profit after tax
(NOPAT)
MINUS
• Cost of Capital employed to generate the operating
profits.

Where NOPAT is obtained by adding interest expenses

after tax back to net income after taxes and other
adjustments depending on company-specific activities
e.g. R& D Expenses, amortization of goodwill etc.
 Formulas - EVA
EVA : NOPAT - Cost of Capital (WACC)

NOPAT Net Operating profit after tax

Cost of Capital: Post Tax cost of debt + Cost of Equity

Cost of Debt: Avg. Interest RateX (1-Tax rate) X Avg. borrowed fund

Cost of Equity(Rate): Risk Free Debt Cost + (Market Premium X Beta Variant)

Cost of Equity: Equity rate X Equity and Reserves

Market Premium Expected Return from the market - Risk free debt cost

Beta Variant : Standard Deviation of the script X Co-relation Co-efficient

Standard Deviation of the Sensex/ Index
 Why Beta Variant?
• Beta Factor describes the movement in a Stock’s Return
in relation to that of the Market Returns. It measures
the Volatility of a Security relating to Broad Market
Index (Sensex)

• Beta
– Greater than one means that the Stock is more Volatile
than the Sensex

– Less than one means that the Security is Less Volatile

“than the Sensex”
 Operating Profit
• Operating Profit can be calculated in two ways:-
– Accounting concept: Income is measured by
deducting expenses incurred to earn the
income during that period.

– Economic Concept: Operating profit

considered to be the maximum amount which
the business is capable of distributing to its
shareholders while still remaining in the same
position at the end of the period as it was at
the beginning.
 E V A T R E E

O p e r a t in g p r o f it

N e t o f

T a x e s

C o s t o f c a p it a l E m p lo y e d

C o s t o f E q u it y C o s t o f D e b t

A v e r a g e T a n g ib le CN oe st t W o of er t qh u i t y p e r c e n t a gA ev e r a g e b o r r o w P e o d s tf u t an dx c o s t o f

R is k f r e e d e b t c o s t

M a r k e t P r e m iu m

B e t a V a r ia n t

S t a n d a r d D e v ia t io n o f S t o c k / s c r ip t

S t a n d a r d d e v ia t io n o f S e n s e x

C o - e f f ic ie n t o f c o - r e la t io n
 Object of EVA is to know

• Whether the Entrepreneurs are really increasing

the Net Worth of the Organization or they are
destroying it gradually

• The Real growth Entrepreneurs have added to

the Shareholders’ Wealth.
 Concept of EVA

Shareholders’ Value is created by

MAXIMIZING

“ECONOMIC PROFITS”
 What it measures
• Creating value
– The Company which earns Higher
Returns (Net Operating Profit After
Tax) than the Cost of Capital

ARE CONSIDERED AS
HAS “CREATED THE VALUE”
What it measures cont..
• Destroying value
– The company which earns Lower
Return (Net Operating Profit After Tax)
than the Cost of Capital

ARE CONSIDERED AS
Destroyers of Shareholders’ Value
 Strategies for increasing EVA

• Increase the return on existing projects

(improve operating performance)
• Invest in new projects that have a return greater
that the cost of capital
• Use less capital to achieve the same return
• Reduce the cost of capital
• Liquidate capital or curtail further investment in
sub-standard operations where inadequate
returns are being earned.
• Hence in the EVA there are four way to
increase value
– Operate: Improve the return earned on existing
capital
– Build: Invest as long as returns exceeds cost of
capital
– Harvest: Divest capital when returns fail to
achieve cost of capital
– Optimize: Reduce cost of capital by optimizing
capital structure
 EVA v/s Other performance measures
• Cost of capital is charged in EVA calculation at a rate that
compensates investors for bearing the firm’s explicit business
risk, as indicated by the historical variance in its stock price and
the extent to which the firm is leveraged. In case of Traditional
accounting cost of capital is internal cost, which may be lower
than the cost of capital in EVA. The judgement taken on the
basis of historical measure may not give correct result.

• EVA requires 164 potential adjustments to eliminate the the

GAP in GAAP including adjustment for inventory valuation, R&D
expenses,

• EVA’s advantage over other measures lies in its capacity to

align executive, employee and shareholders interest.
• Income Statement variables : Operating
profit, earnings, net income
– The investors are interest to know what kind of resources
(Capital) are require to produce the given profit. A profit figure
without capital base is irrelevant .

• Capital cost into income statement

– When the cost of capital shown in income statement operating
people are able to see the importance of capital from view
point of profitability.

– After realising the true cost of capital operating people are

often able to decrease the excess capital employed.

– EVA is much easy concept of profitability than ROI and further

more it can be translated into day to day operations.
 EVA as a unifying measure
EVA based
Traditional Financial
Financial
Measurement
Management
Firm Goal Revenues, Profits, EPS EVA
Business plan Revenues, Profits, EPS EVA
Divisional Performance
Divisional Profits, ROI EVA
Measurement
Capital Budgeting DCF EVA
Performance target Negotiated Profit EVA linked target
Unlimited and
Incentive compensation Small & Range Bound
EVA linked
 Goal Setting Financial Planning

Shareholder Performance
Communication Measurement

Capital
Budgeting Incentive
Compensation

EPS ROI NPV IRR ROE RONA

 Performance
Goal Setting Measurement
Financial
Planning
Shareholder
Communication
Incentive
Compensation

Capital
Budgeting

EVA
 EVA and market value of the
company
• Theoretically EVA is much better than conventional
measures in explaining the market value of the
company. Financial theory suggests that the market
value of a company depends directly from the future
EVA - Values:

The market value of a company = Book Value of

Equity + Present value of future EVA
 Advantages of EVA
• EVA is more than performance management,. It is
motivational, compensation based management system
that facilities economic activity and accountability at all
levels in the firm.

• EVA eliminates the GAP in GAAP as 164 adjustments are

required to compute the EVA

• As compared to historical tools for evaluaiton e.g. ROI,

EPS- EVA is better tool to assess the company as it
takes into account the cost of capital
 Advantages of EVA

• EVA covers all aspects of the business cycles

• EVA aligns and speeds decision making, and

enhances communication and teamwork

• EVA decouples bonus plans from budgetary

targets
 Limitations of EVA
• EVA does not control for size differences across plants or divisions
• EVA is based on financial accounting methods that can be
manipulated by managers by using different method of accounting.
– There are different ways to calculate NOPAT and COC as there are
numerous fundamental differences exist with regard to calculation of
NOPAT and COC
– There are 164 adjustment which is really cumbersome exercise
– EVA may focus on immediate results which diminishes innovation
• EVA is biased against new assets
• EVA is in favour of large companies
• EVA favours more debt compared to equity
• It is difficult to implement
• Implementation includes significant cost
• EVA does not study business drivers like consumer satisfaction or
learning and growth.
 Statistical information
• Total number of listed companies in India - 7199 (30/11/2005-
BSE )

• Companies implemented EVA - Below 30 (TCS, Infosys,

Godrej, Tata Steel, Tata Tea, ITC, MARICO, Aditya Birla Group,
Indian Hotels, Dr, Reddy’s Laboratories,

• Companies implemented EVA in other countries

– US - 80 (Citi Corp., Coca Cola, Bausch & Lomb, Dun & Bradstreet
corp., Eli Lilly & Co, US Postal Service etc.)
– Canada - 6
– Europe - 9
– Maxico - 4
– Brazil - 9
– South Africa - 12

• Total Companies implemented EVA in world is about 250. The

EVA implementation has resulted in better stock valuation.
 List of few Companies in India
implementing EVA and its objective
• INFOSYS - EVA is used as information tool to tell its clients that the
value delivered by INFY is great than what the clients pays for.

• MARICO - As a signaling device to tell its employees that capital is

important

• DR. REDDY’S LABORATORIES - As a qualifying criterion to grant

rewards such as variable pay, stock option and performance bonuses

• TCS - EVA is linked to compensation.

• Godrej - EVA was chosen as strategic management tool.
 Why EVA is implemented by only
few companies
• Implementation of EVA is costly affair
• The process is challenging and time consuming and too
complicated for small business
• Especially the key persons (Top and middle managers) have
to understand and commit to EVA thoroughly which is
difficult
• Switching over to EVA from the earlier traditional methods of
bonus system may create resistance in the employees
• EVA does not have system of Minimum and maximum cap
for bonus as the traditional methods have.
 Why EVA is implemented by only
few companies
• Although some have achieved substantial success with
EVA, it is wise to approach the metric with some
caution. It is after all, only one measure, which will
never substitute for thorough, analytical thinking.

“ EVA does not solve business problem;

managers do,”

Mark Gressle, a founding partner of Sten Stewart & Co

 Implementation of EVA needs

• The key persons (Top and middle managers) have to understand and
commit to EVA thoroughly
– Without the full support of Managers there will not be substantial
results
– Good understanding helps to tailor EVA to the specific need of a
company
• EVA will be most beneficial if broken down into small parts
• Integration to incentive systems for all the employees is a good way
to make all the employees to work for common goal
• Human resources department should engage in careful communication
of what the firm hopes to achieve by switching to EVA, the manner in
which employees and management may improve EVA, and the way in
which employees compensation is tied to EVA.
Market Value Added (MVA)

• is the difference between the current market value

of a firm and the capital contributed by investors
• If MVA is positive, the firm has added value. If it
is negative, the firm has destroyed value.
• The amount of value added needs to be greater
than the firm's investors could have achieved
investing in the market portfolio, adjusted for the
leverage (beta coefficient) of the firm relative to
the market.

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• The formula for MVA is: MVA = V- K
• where:
• MVA is market value added
• V is the market value of the firm, including the
value of the firm's equity and debt
• K is the capital invested in the firm

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• MVA is the present value of a series of EVA
values. MVA is economically equivalent to the
traditional NPV measure of worth for evaluating
an after-tax cash flow profile of a project if the
cost of capital is used for discounting.

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Thanks