Economic Value Added (EVA)

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Julian Mitchell
5 years ago
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1 Economic Value Added (EVA), 2018 Definition Features and problems Computation

2 Economic Value Added (EVA) EVA is promoted by a consulting firm Stern Steward & Co., which was established in 1982 and pioneered the EVA concept in 1989 EVA is a performance measure that captures the true economic profit of an enterprise EVA is used by over 300 successful companies 3 EVA What is EVA? How to define EVA? Which concept is involved in EVA? Is EVA the same as earnings (net income)? Why use EVA? Where to apply EVA? How to increase EVA? Any real examples? Potential problem in EVA? 4

3 What is EVA? EVA = after-tax operating profits total costs of capital after-tax operating profits = net income + after-tax interest expenses total costs of capital are the required profits to give a competitive return on the capital employed, i.e, total capital (in $)* WACC If EVA > 0, benefit to shareholders 5 After-Tax Operating Profits After-tax operating profits = EBIT (1 tax rate) = net income + after-tax interest expenses Sales - Cost of goods sold - Selling, General & Administrative expenses - Depreciation Operating income + Interest income - Interest expense - Taxes Net income Why add back interest expense to after-tax operating profits? 6

4 EVA and Residual Income EVA is one kind of residual income measure Residual income = net operating profit after tax (NOPAT) total cost of capital (TCC) = (ROIC WACC) * TC = Net income $ amount of cost of equity 7 Is EVA the same as Profits? What s the difference between EVA and net income (accounting profit)? 8

5 EVA Features EVA is not new. It just considers a fact that equity (retained earnings) is costly EVA makes managers earn more than the cost of capital, not just cost of debt. EVA can be applied to divisions and business service firms EVA corrects some distortion in accounting earnings 9 How to Increase EVA? 10

6 Why EVA system works? Use less capital to save cost given capital is costly Let managers know whether they are making profits Focus on high margin products Use cheaper capital, such as leverage 11 Problems of EVA EVA does not consider future cash flows EVA depends on current level of earnings EVA penalizes projects with longer lives For example, negative EVA in the first few years doesn t mean negative NPV EVA penalizes start-up firms for their low initial profits 12

7 Market Value Added (MVA) Market value book value = MVA MVA is the present value of future EVA MVA = EVA 1 / (WACC g) If MVA is greater than 0, price-to-book ratio (M/B) is greater than 1 13 Example of EVA Information from balance sheet/income statement: Equity $138.6 million Long-term debt $ 96.3 million Income from operations $ 12.3 million Interest income $ 1.1 million Interest expense $ 9.0 million Income taxes $ 1.3 million After-tax income $ 3.1 million Market information: Interest rate: 9.3%, beta:1.0, risk-free rate: 7% 14

8 What s Required Return on Equity? We can estimate required return on equity based on CAPM: r e = r f + b (r m r f ) Generally, we can assume that (r m r f ) is equal to historical market risk premium. Let s use 7% (12%- 5%) the Best Practice article r e = r f + b (r m r f ) = 7% + 1* 7% = 14% Alternative approach is based on constant growth dividend discount model: D1 D1 P0 re g r g P e 0 15 What is WACC? WACC = D *(1 T D E D = 96.3, E = 138.6, so D/(D+E) = 0.41 EBT (earnings before tax) = = 4.4 Tax rate = 1.3/4.4 = WACC = 0.41 * ( )* 9.3% + (1-0.41)*14% = 10.95% C E ) rd + * re D E 16

9 EVA Computation After-tax operating profits = EBIT (1 tax rate) = Net income + after-tax interest expense = 13.4 * ( ) = * ( ) = 9.45 Total cost of capital (in $ amount) = WACC * total capital = 10.95% * ( ) = million EVA= = EVA and Residual Income Why EVA is negative in previous example? EVA = (ROIC WACC) * TC ROIC = After-tax operating profits / total capital = 9.45 / = 4.02% < WACC = 10.95% 18

10 Stock Performance 19 Do EVA Work? 20

11 Questions Does EVA better explain stock returns than accounting earnings? Does EVA better motivate managers to increase shareholder wealth? Does EVA lead to a subsequent superior performance? 21

Economic Value Added (EVA)

Economic Value Added (EVA), 2018 Definition Features and problems Computation EVA EVA is promoted by a consulting firm Stern Steward & Co., which was established in 1982 and pioneered the EVA concept in