Shantanu's Blog

Economic Value Added (EVA)

Introduction:
Investors use various different valuation tools to assess the attractiveness of stocks. So far, a large number of investors were primarily focussing on the Price/Earnings or the Price/Cash Flow valuation parameters, to pick out stocks. A new approach that investors have now started looking at is the concept of Economic Value Added, popularly known as EVA (tm). Traditional valuation parameters such as Price/Earnings and Price/Cash Flow can be very easily influenced and even manipulated by accounting practices. In addition these approaches are static and do not show whether management has been creating or destroying value.
EVA is defined as Economic Profit or residual income and is simply the operating after tax profit less a charge for that capital.. Representing real profit versus paper profit, EVA underlies shareholder value, increasingly the main target of leading companies' strategy. In essence it therefore is the best valuation parameter that addresses the financial strategy of the firm and the fact whether that strategy is value enhancing or destroying. Shareholders are the players who provide the firm with its capital; they invest only to gain a return on that capital.

Difference between EVA and Traditional methods:

The main differences between EVA and the traditional are as follows:
» Earnings per share alone tell nothing about the cost of generating those profits. In addition the company's earnings could be manipulated by accounting adjustments. It has often been seen that during the time, the company's EPS has been increasing, its EVA has been consistently declining.
» Return on assets is relatively, a more realistic measure of economic performance, but ignores the cost of capital. EVA addresses this inconsistency.

EVA as a Concept
The basic equation for calculating EVA is:
EVA= NOPAT- Cost of Capital
NOPAT: Net Operating Profits After Taxes
This is the operating profit less taxes but before financing costs and non-cash entries (although not depreciation).
Cost of Capital:
This is the charge for the use of capital. It includes interest on the debt and a charge for the equity capital based on a cash equivalent- equity times cost of equity rate.
The idea behind EVA is rooted in economic income as opposed to accounting income. In order to calculate economic income from the accounting income a lot of adjustments need to be made.

Adjustments Required to Calculate NOPAT
+ Increase to Deferred Taxes
+ Increase to LIFO (full form) Reserve
+ Goodwill Amortized in Current year
+ Increase to Net Capitalized Intangibles
+/- Unusual loss or (Gains) net of tax
+ Increase to other Reserves &Allowances
Adjustments Required to Calculate Capital
+ Deferred Taxes
+ LIFO Reserve
+ Total Goodwill Amortized till date
+ Net Capitalized Intangibles
+/- Cumulative loss or (Gains) net of tax
+ Other Reserves &Allowances

Here an attempt is made to calculate earnings that are close to cash and this is compared to a capital base that is expressed in cash equivalent terms.
Market Value = Book Value + Present Value of Future EVA

Using EVA
EVA provides management with three options to create value
* Growth
Invest capital in projects that earn a return higher than the cost of capital.
* Process Improvement
Increase returns through better efficiencies, cost of control and higher productivity.
* Asset Management
Improve the management of assets by selling off non-performing assets and increasing asset efficiency. Improving cash tied up in receivables and inventory would be a basic approach of increasing EVA.
EVA is useful as a valuation tool as it helps to
· Evaluate the true performance of business units and the overallorganization.
· Determine how the stock will perform in the future.
· Trace inconsistencies between the economic and the accounting earnings that cannot be unveiled by the traditional EPS comparisons between companies.

Limitations of EVA:
EVA calculates the economic earnings using the traditional accounting model that is not adjusted for inflation. In itself, EVA is not an absolute measure for the valuation of a company. Any company with a positive EVA could have a declining share of value within the market place and hence may have poor valuations. EVA is a more comprehensive valuation methodology to calculate value and is a step closer in measuring value approximates.