X

Sign up for Equitymaster's free daily newsletter, The 5 Minute WrapUp and get access to our latest Multibagger guide (2017 Edition) on picking money-making stocks.

This is an entirely free service. No payments are to be made.


Download Now Subscribe to our free daily e-letter, The 5 Minute WrapUp and get this complimentary report.
We hate spam as much as you do. Check out our Privacy Policy and Terms Of Use.
EVA – Another barometer for corporate performance - Views on News from Equitymaster
 
 
  • PRINT
  • E-MAIL
  • FEEDBACK
  • A  A  A
  • Jul 5, 2000

    EVA – Another barometer for corporate performance

    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

    Where
    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.

    Particulars (Rs m)
    Equity Capital 500
    Reserves 7,500
    Net worth 8,000
    12.5% debentures 2,000
    Capital employed 10,000
    Weight of equity 0.8
    Weight of debt 0.2
       
    NOPAT (as per defination) 1,500.0
    Return on tax free government bonds * 11.0%
    Beta * 1.1
    Market premium * 15.0%
    Corporate tax rate * 33.0%
    Cost of borrowings * 12.5%
       
    Cost of equity 15.4%
    Cost of debt 8.4%
    WACC 14.0%
    NOPAT as a % of capital employed 15.0%
       
    Cost of Capital 1,400
    EVA 100

    * Assumptions

    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’

     

     

    Equitymaster requests your view! Post a comment on "EVA – Another barometer for corporate performance". Click here!

      
     

    More Views on News

    How to Ride Alongside India's Best Fund Managers (The 5 Minute Wrapup)

    Jun 10, 2017

    Forty Indian investing gurus, as worthy of imitation as the legendary Peter Lynch, can help you get rich in the stock market.

    Will They Haul Off Trump's Statue, Too? (Vivek Kaul's Diary)

    Aug 16, 2017

    All across the country, the old gods become devils. New, gluten-free gods take their places...

    This Company Beat the Business World's 'Three Killer Cs' (The 5 Minute Wrapup)

    Aug 16, 2017

    And what it has in common with beating the stock market too.

    5 Steps To Become Financially Independent (Outside View)

    Aug 16, 2017

    Ensure your financial Independence, and pledge to start the journey towards financial freedom today!

    Let's Hope This Correction Continues (The 5 Minute Wrapup)

    Aug 14, 2017

    Last week's correction is making a number of Super Investor stocks look a lot more attractive...

    More Views on News

    Most Popular

    Demonetisation Barely Made Any Difference to Tax Collections(Vivek Kaul's Diary)

    Aug 7, 2017

    The data tells us quite a different story from the one the government is trying to project.

    Proxy Plays: A Smart Way to Bet on 'Off Limits' Companies(The 5 Minute Wrapup)

    Aug 4, 2017

    The small-cap space is full of small players that are clear proxies to great growth stories and Indian megatrends.

    Should You Invest In Bharat-22 ETF? Know Here...(Outside View)

    Aug 8, 2017

    Bharat-22 is one of the most diverse ETFs offered so far by the Government. Know here if you should invest...

    Signs of Life in the India VIX(Daily Profit Hunter)

    Aug 12, 2017

    The India VIX is up 36% in the last week. Fear has gone up but is still low by historical standards.

    7 Financial Gifts For Your Sister This Raksha Bandhan(Outside View)

    Aug 7, 2017

    Raksha Bandhan signifies the brother-sister bond. Here are 7 thoughtful financial gifts for sisters...

    More
    Copyright © Equitymaster Agora Research Private Limited. All rights reserved.
    Any act of copying, reproducing or distributing this newsletter whether wholly or in part, for any purpose without the permission of Equitymaster is strictly prohibited and shall be deemed to be copyright infringement.

    LEGAL DISCLAIMER: Equitymaster Agora Research Private Limited (hereinafter referred as 'Equitymaster') is an independent equity research Company. Equitymaster is not an Investment Adviser. Information herein should be regarded as a resource only and should be used at one's own risk. This is not an offer to sell or solicitation to buy any securities and Equitymaster will not be liable for any losses incurred or investment(s) made or decisions taken/or not taken based on the information provided herein. Information contained herein does not constitute investment advice or a personal recommendation or take into account the particular investment objectives, financial situations, or needs of individual subscribers. Before acting on any recommendation, subscribers should consider whether it is suitable for their particular circumstances and, if necessary, seek an independent professional advice. This is not directed for access or use by anyone in a country, especially, USA or Canada, where such use or access is unlawful or which may subject Equitymaster or its affiliates to any registration or licensing requirement. All content and information is provided on an 'As Is' basis by Equitymaster. Information herein is believed to be reliable but Equitymaster does not warrant its completeness or accuracy and expressly disclaims all warranties and conditions of any kind, whether express or implied. Equitymaster may hold shares in the company/ies discussed herein. As a condition to accessing Equitymaster content and website, you agree to our Terms and Conditions of Use, available here. The performance data quoted represents past performance and does not guarantee future results.

    SEBI (Research Analysts) Regulations 2014, Registration No. INH000000537.

    Equitymaster Agora Research Private Limited. 103, Regent Chambers, Above Status Restaurant, Nariman Point, Mumbai - 400 021. India.
    Telephone: +91-22-61434055. Fax: +91-22-22028550. Email: info@equitymaster.com. Website: www.equitymaster.com. CIN:U74999MH2007PTC175407
     

    Become A Smarter Investor In
    Just 5 Minutes

    Multibagger Stocks Guide 2017
    Get our special report, Multibagger Stocks Guide (2017 Edition) Now!
    We will never sell or rent your email id.
    Please read our Terms

    S&P BSE SENSEX


    Aug 17, 2017 12:10 PM

    MARKET STATS