The liberalisation of the Indian economy has led to a paradigm shift in the corporate goals of public and private companies. The focus is now being primarily on enhancing the shareholder value in a company.
It was Stern Stewart & Co. who devised an accounting method called Economic Value Added (EVA) which measures whether the company is generating adequate profits to reward its shareholders. EVA is the registered trademark of Stern Stewart & Co. It is the financial performance measure that captures the true economic profit of an enterprise. It is also one of the measure most directly linked to the creation of shareholder wealth over time.
So how do you define EVA?
To put in a simple terms EVA is the profits generated by any economic entity over its cost of capital employed. The entity can be a company, country or the entire human civilization. If the difference between the above two parameters is positive than the entity is said to be creating wealth for its stakeholders. A negative EVA on the other hand indicates the company is a destroyer of value.
So now the next question arises how do I go about in calculating EVA.
EVA = Net Operating Profit After Tax (NOPAT) – Cost of Capital
NOPAT = Profit Before Tax + Interest – Tax + Tax shield on interest
In other words NOPAT is the profits generated from the core operation of the company.
Cost of Capital: It is the weighted average cost of borrowings and equity as on the balance sheet date.
- Cost of borrowings: The cost of borrowing depends on the rate of interest on borrowings.
- Cost of equity: To define the term in a simple term it is
Risk free cost of bank lending rate + Market premium on the risk free equity investment * Beta variant
(R + B * M).Where Beta is the relative price movement of the stock vis a vis the market. In simple terms the greater the volatility, the more risky the share and the higher the Beta. Let’s take a simple example, a company having a Beta of 1.5 times implies that if stock market increases by 10%, the company’s share price will increase by 15% and vice versa.
For example an investment of Rs 1,000 in a soaps and detergent shop produces 7% return, while the similar amount invested elsewhere earns returns of 15%. EVA can be defined as a spread between a company’s return on capital employed and cost of capital (similar to the opportunity cost of investing elsewhere) multiplied by the invested capital. The EVA from this case would be
EVA = (7%-15%) * Rs 1,000 = (Rs 80)
An accountant measures the profit earned while an economist looks at what could have been earned. Although the accounting profit in this example is Rs 70 (7% * Rs 1,000), there was an opportunity to earn Rs 150 (15% * Rs 1,000). So in this case the company can be called as a destroyer of wealth.
Thus, the litmus test behind any decision to raise, invest, or retain a Rupee must be to create more value than the investor might have achieved with an otherwise alternative investment opportunity of similar risk.
Now consider this example based on the formula explained above. You can put different balance sheet and profit figures to know your own EVA.
|Weight of equity
|Weight of debt
|NOPAT (as per defination)
|Return on tax free government bonds *
|Market premium *
|Corporate tax rate *
|Cost of borrowings *
|Cost of equity
|Cost of debt
|NOPAT as a % of capital employed
|Cost of Capital
As calculated in the above example the company has generated EVA of Rs 101 m. That means maintenance of shareholder value will require the company to earn NOPAT over Rs 1,400 m. In other words the % of NOPAT to capital employed should be greater or atleast equal to the % of WACC.
Where do I use the concept
In the present market scenario every second company is making an attempt to impress the investors, with their excellent financial performance showing the high growth rate. With the limited resources available the investor is confused as to who is better and why? Here comes the concept of EVA, which helps the investors in simplifying investment decision making. Apart from looking at only P/E or EPS of the company, EVA helps the investors to see whether the valuation of the company really justifies the high or low P/E.
EVA & P/E
EVA is the measure and reflection of a good management. A good management is one which can ‘Create value, Give value and Get value’. To achieve this the management of the company has to deploy more and more capital to those activities wherein the amount of NOPAT generated by the activities is greater than the amount of WACC. Then only they will be able to generate real wealth for their stakeholders. So who are these stakeholders – they are our mutual funds, pension plans, life insurance policies, and many small investors, which represent the vast majority of stock ownership. Our largest institutional investors represent the savings of everyday citizens. Investors invest their savings and bear risk, in the hopes of the best return possible.
There are very few companies in India, which are successful in generating EVA. As a reason these companies have been given premium valuation on the bourses. HLL, Infosys and Dr. Reddy’s have been given the premium valuations by the market not only based on their EPS performance but also on the basis of their ability to consistently increase shareholders wealth.
The graph hereunder presents the growth pattern of EVA of Infosys and HLL, two companies that have been successful in generating wealth and this is also reflected in their market cap.
The corporates, which were paying lowest preference to the shareholders interest, are now giving the highest preference to it to generate value for shareholders. The true example of this is the software viral, which affected investors in the past few months. Even though in short term these software companies might provide a good return to investors, in the long term only those companies will be able to survive which are actually generating the returns.
EVA is too sophisticated a tool for lay investors to use. They may not indulge in the exercise of computing it but must try to understand from the numbers reported by the company whether it is generating a positive or negative EVA. Investors should be cautious enough in selecting companies, which have high EPS but low EVA and consequently lower ROCE and RONW.
So only those companies can be called as Real Wealth Creators, which know the above principals. As it is rightly said by someone ‘ You only get richer if you invest money at a higher return than the cost of that money to you. Everyone knows that but many seem to forget it’