Economic Value Added

By
!! MODERATORS !!

Vikas Chhajed
Ankur Loth
Gaurav Lokhwani
Shubhanshu Soni
Prakash Khatik
June 10, 2009 !! Moderators !! 1
 Topics to be covered
 Journey of Performance Measures
 EVA verses ROI
 How to calculate EVA ?
 What Does EVA Show?
 Project Topics
 Usage of EVA
 EVA Practices in Indian Corporate Sector
 Criticism
 What next after Computing EVA?
June 10, 2009 !! Moderators !! 2
Performance pays, but how do we measure the
performance of a business entity? The first and
foremost measure of performance that comes to
one’s mind is profit- the accounting measure of
performance. Someone has aptly said- profit is
an opinion, not the fact. If this were not case , one
would not have seen the debacle of big
companies like Enron, World Com etc. All such
companies managed their earnings well and have
shown better performance in terms of PAT &
EPS.
June 10, 2009 !! Moderators !! 3
 Journey of Performance
Measures
1920s : Dupont Model - ROI

1970s : Earning Per Share

1980s : Market to Book Value Ratios, Return on

Equity,Return on Assets, Cash
Flow,Quality Management.

June 10, 2009 !! Moderators !! Cont.. 4

Financial & Non-Financial Performance
Measures
1990s : Economic Value Added, Market
value Added,CFROI, Total
Shareholders Return, Balance
Score Card, Customer Satisfaction

2000s : EVA (Stern stewart)

BSC (Robert S Kaplan &Norton)
Intellectual Capital Index (Ross)
Skandia Navigator (Edvinsson)
Intellectual Asset Monitor
(Karl-Eric Svebiey)
June 10, 2009 !! Moderators !! 5
 Return On Investment (ROI)
(From 1920 to 1970)
 The DuPont Powder company formed in
1903. To guide their investment decisions,
the chief financial officer Donaldson Brown
developed ROI in 1920.

 ROI = Operating profit / Sales* Sales

/Capital Employed . OR Operating Profit/
Capital Employed. OR Profit Margin
Ratio*Asset Turnover
June 10, 2009 !! Moderators !! 6
 EVA vs. ROI
1. Technical Shortcoming

Santro Maruti Suzuki

 Ke 10% 10%

 ROI 15% 8%

June 10, 2009 !! Moderators !! 7

 2.The Danger of ROI Control

Quarter ROI Profit Assets

Margin Turnover
Q1 12.6% 17.6% 0.736

Q2 13.4% 20.2% 0.664

Q3 15.4% 22.7% 0.679

June 10, 2009 !! Moderators !! 8

At first glance, the operating performance seems excellent,
with nice increase in ROI each quarter. The
decomposition, however, reveals a sharp increase in profit
margin that overcomes a drop in asset turnover. Upon
investigating the reasons for the increase in profit margin
and decrease in turnover, management learned that the
division manager had greatly increased production in
quarter 2 & 3, with excess production accumulating as
finished goods inventory. The much higher rates of
production enabled period cost to be absorbed into
inventory, allowing for a higher return on sales % on the
goods actually sold. The buildup of inventory relative to
sales was signaled by the decrease in asset turnover ratio.
Thus it is clear that how the division manager had
attempted to manipulate his performance through ROI.
June 10, 2009 !! Moderators !! 9
 EVA vs. Traditional Measures
 Traditional measures ignore the definite
requirement that the rate of return should be
at least as high as the cost of capital.
Conceptually EVA is superior to accounting
profit as a measure of value creation
because it recognizes the cost of capital and
hence, the risk ness of a firms operations.

June 10, 2009 !! Moderators !! 10

Economic Value Added (Residual
Income)
 The limitation and dysfunctional action
associated with using a ratio to evaluate the
performance of a manager or division have
been known and discussed for decades.
Business, such as general electric in the
1950s,and academics have shown how to
overcome these limitations by using an
alternative performance measure, originally
called residual income.
June 10, 2009 !! Moderators !! 11
 But a revolution in thinking occurred starting in the late
1980s,when several consulting firms published studies that
showed a high correlation between the change in companies’
residual incomes and change in stock market valuation.

 The move toward the RI measure received even greater

publicity when it was renamed into a far more accessible and
acceptable term-Economic Value Added- by the Stern Stewart
consulting firm, a prime advocate for the EVA concept.

 Their ideas were published in the journal of Applied Corporate Finance

and culminated in a cover story in september20,1993,issue of fortune
magazine, entitled “EVA- the Real Key to Creating Wealth.”

June 10, 2009 !! Moderators !! 12

 How to calculate EVA ?

EVA= NOPAT – CAPITAL

EMPLOYED * WACC (KO)

June 10, 2009 !! Moderators !! 13

 NOPAT
 Net Operating Profit after tax before
exceptional items and interest i.e. NOPAT
=(Profit after Tax + Non-Recurring
Expenses + Revenue Expenditure on R&D
+ Interest Expenses + Provision for Taxes)
– (Non Recurring Income + R&D
Amortization + cash operating Taxes)
 Cash operating Taxes (Provision for Taxes
+ Tax benefit of non recurring expenses +
Tax benefit of interest expenses - Tax on
non-recurring Income)
June 10, 2009 !! Moderators !! 14
 Capital Employed
 Net Fixed Assets + Investment
+Current Assets – (NIBCLs +
Miscellaneous Expenditure not written
off + Intangible Assets + Cumulative
Non-Recurring Losses + Capital
Expenditure on R&D) – Revaluation
reserve – Cumulative Non-Recurring
Gains.
Source: Business Today,April13,2003.

June 10, 2009 !! Moderators !! 15

 WACC (Ko)
• WACC (Ko) = Ke (weight of equity
Capital+ free reserve) +Kd (weight of
long-term Debt)

 For calculating ‘Ke’ Capital Assets

pricing Model (CAPM) is used

Ke = Rf +Beta (R m + Rf )
June 10, 2009 !! Moderators !! 16
 Technical Adjustments to ROI & EVA
• Ainconsistencies
survey made
in
by Dodd & Johns identified significant
the measurement of EVA. All of the 29
respondents to this survey are of stern stewart & co. clients.
Although a consistent philosophy has been applied, none of the
companies measure EVA the same way.
 Many adjustments have to be made in order to calculate EVA. Alone
NOPAT requires as many as 120 to 164 adjustments to financial
statements compiled in accordance with GAAP.
 According to Stern Stewart adjustment should be based on the
following criteria:
 Materiality: Adjustment should make a material difference in EVA
 Manageability: Adjustment should impact future decision
 Definitiveness: Adjustment should be definitive & objectively determined
 Simplicity: adjustment should not be too complex
 Due to the measurement differences, EVA is a limited tool that
cannot be used for competitive analysis.
June 10, 2009 !! Moderators !! 17
 What Does EVA Show?

 +Ve The Company has Managed to

create Shareholder Value

 Zero This should be treated as the

Shareholders have earned a return
that compensates the risk

 -Ve The Company has destroyed the

Shareholder Value.
June 10, 2009 !! Moderators !! 18
 Usage of EVA
 EVA
– Bonus to employee
– Extra remuneration to management
– Incentive dividend to preference shareholders
– Bonus shares to equity shareholders
 Setting organization goal
 Performance measurement
 Motivation of manager
 Corporate valuation
 Communication with shareholder & Investor

June 10, 2009 !! Moderators !! 19

 EVA Practices in Indian Corporate Sector
In India companies like NIIT, Goderej group and TCS
have implemented EVA as a performance
measurement and evaluation system linked with
incentives. EVA implementation helped Godrej group
in segregating the entire business into several units to
see which of them are creating EVA or not. As a result
of this exercise, Goderej demerged the consumer
products division and turned around low- EVA
activities like chemicals. A number of companies like
Infosys, Satyam, Dr. Reddy’s laboratories, Hindustan
lever report EVA as an additional information in their
annual reports.
June 10, 2009 !! Moderators !! 20
 CRITICISM
 EVA is based on past accounting
performance derived from financial
statements. Accounting based measures like
EVA may not be able to measure value
creation. Overemphasis on EVA may leads
to its manipulation
• On the basis of survey made by Chen and
others, it is found that market may place
higher reliance on audited accounting
earnings than the unaudited EVA metric.
June 10, 2009 !! Moderators !! 21
 EVA can be biased against low return stat-
up investments and can favour business
with heavily depreciated assets as a result of
the adjustments made to compute EVA.
EVA approach can penalize companies that
invest in assets with long term returns.
 EVA overemphasized the need to generate
immediate results,therefore it creates a
disincentive for the managers to invest in
innovative product or process technologies.

June 10, 2009 !! Moderators !! 22

What next after Computing EVA?

 Like most ratios a single EVA value is

meaningless.The easiest way to interpret it
is to express it as % of capital employed. It
can be compared with that of peers to see if
it higher or lower. And a time series can be
used to measure growth in EVA over a long
period. Absolute EVA is not comparable
across industries due to different level of
capitalization.
June 10, 2009 !! Moderators !! 23
 What next after …………EVA?
 Balance score Card.
 Customer Perspective (How do
customer see us?)

 Financial Perspective (How do we look to

Shareholders?

 Internal Business Perspective (What must

we excel at?)

 Innovation & Learning Perspective (Can we

continue to improve & create Value?

June 10, 2009 !! Moderators !! 24

 What next after …………EVA?
 Market Value Added (MVA)
= Market Value – Book Value
 Revised Economic Value Added (REVA)
=NOPAT – Market value of firm*
Ko
 Owners Value added
= PAT before interest + Inflationary
assets – Appreciation
+Appreciation in value of brands &
human resources) – ( actual cost of
equity Capital & borrowing +
Opportunity cost of Reserves)
 Cash Flow Return on Investment
June 10, 2009 !! Moderators !! 25
 Project Topics
 A Comparative Study of New & Old Performance
Measurers of Banking Industry…….
 A Study of Inconsistency in Calculating EVA.
(Gap B/W theory & Practice)
 An Analysis of Shareholder wealth creation in any
industry (Through EVA)
 To examine the relationship between shareholder wealth
(EVA) and certain financial variables
 To examine the comparative study of Traditional and EVA
Measures
 To create a EVA prediction Model
 To rank the Sample units on the basis of EVA or MVA

June 10, 2009 !! Moderators !! 26

 Project Topics
 Analysis of Working Capital Management
Practices In India.
 Trend of Cost of Capital In Indian
Corporate Sector.
 A Study of Valuation and Accounting of
Intellectual Capital practices in Indian
Corporate Sector.
 Analysis of Financial Health of Indian
Corporate Sector.
 Impact of merger and Acquisition on wealth
of shareholders
June 10, 2009 !! Moderators !! 27
 All The Best

June 10, 2009 !! Moderators !! 28