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The EVA Concept of Profitability

Economic Value Added is a profitability figure that shows the shareholders, that the

management was able to create value during a given period. Primarily, the EVA-concept

should lead to higher profitability for the shareholders, but it is also a performance

measure for managers. EVA is intended to overcome the short-term scope of profitability

figures like ROI, usually measured on a yearly basis. Managers who invest in the future

of the company get lower ROI-percentages in the short run because they have more

depreciation and more fixed costs to carry. Value is created when the difference between

realised profitability and the market-oriented cost of capital is positive. The calculation of

capital costs is the same as with shareholder value using the WACC-formula (WACC =

Weighted Average Cost of Capital) as a market-orientated interest rate. The relevant

profit figure is profit after taxes but before deduction of interest. To take investments in

the future of the company into consideration, expense for research & development,

marketing and product introduction is added to the above profit figure and then written

off over several years. The resulting depreciation is then deducted from the profit figure.

This leads to a higher profit volume, which in turn leads to a higher tax volume. The

following formula is the result:

EVA can thus also be described as the surplus profit over the WACC demanded by the

capital market.

The net operating assets are also corrected, starting from the balance sheet total. First, the

liabilities for which no interest is paid (mainly accounts payable) are deducted. The

resulting figure is the capital employed. Then the value of the not yet depreciated expense

for research & development, marketing and product introduction is added to the working

capital

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EVA is based on the concept that a successful firm should earn at least its cost of capital.

Firms that earn higher returns than financing costs benefit shareholders and account for

increased shareholder value. In its simplest form, EVA can be expressed as the following

equation:

EVA = Net Operating Profit After Tax (NOPAT) - Cost of Capital

NOPAT is calculated as net operating income after depreciation, adjusted for items that

move the profit measure closer to an economic measure of profitability. Adjustments

include such items as: additions for interest expense after-taxes (including any implied

interest expense on operating leases); increases in net capitalized R&D expenses;

increases in the LIFO reserve; and goodwill amortization. Adjustments made to operating

earnings for these items reflect the investments made by the firm or capital employed to

achieve those profits. Stern Stewart has identified as many as 164 items for potential

adjustment, but often only a few adjustments are necessary to provide a good measure of

EVA.[1]

Measurement of EVA

Measurement of EVA can be made using either an operating or financing approach.

Under the operating approach, NOPAT is derived by deducting cash operating expenses

and depreciation from sales. Interest expense is excluded because it is considered as a

financing charge. Adjustments, which are referred to as equity equivalent adjustments,

are designed to reflect economic reality and move income and capital to a more

economically-based value. These adjustments are considered with cash taxes deducted to

arrive at NOPAT. EVA is then measured by deducting the company's cost of capital from

the NOPAT value. The amount of capital to be used in the EVA calculations is the same

under either the operating or financing approach, but is calculated differently.

The operating approach starts with assets and builds up to invested capital, including

adjustments for economically derived equity equivalent values. The financing approach,

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on the other hand, starts with debt and adds all equity and equity equivalents to arrive at

invested capital. Finally, the weighted average cost of capital, based on the relative values

of debt and equity and their respective cost rates, is used to arrive at the cost of capital

which is multiplied by the capital employed and deducted from the NOPAT value. Theresulting amount is the current period's EVA.

EVA Calculation and Adjustments

When we calculate EVA, we need to calculate the cash equivalent of income (NOPAT)

and the cash equivalent equity that has been invested in the business (adjusted capital).

This requires that we remove many of the accounting distortions that have

blurred cash flow. In his book Quest for Value, Bennett refers to these adjustments as

"equity equivalents" so that we can restate book values to economic values. When the

market value of an organization exceeds the economic value of the organization, this is

Market Value Added (MVA).

In order to calculate NOPAT, we will add back to income current year's equity

equivalents that have distorted cash flows. Cumulative equity equivalents will be added

back in arriving at adjusted capital. In Quest for Value, Bennett describes the ollowing

equity equivalent adjustments:

Deferred Taxes: The Income Statement reflects tax expenses which may or may not be

paid. The difference between what has been expensed and what has paid is called

deferred taxes. By adding deferred taxes back to capital, we reverse out the distortion for

taxes not paid. An increase to deferred taxes in the current year would be added back to

income in arriving at NOPAT (Net Operating Profits After Taxes).

LIFO Reserve: LIFO (Last In First Out) is used to price inventories on

the Balance Sheet. Under LIFO, investments in inventory are subject to understatement.

A LIFO Reserve Account captures the difference between LIFO and FIFO (First In First

Out). This amount is added back to capital since we want to reflect the total amount of

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capital invested. An increase to the LIFO Reserve in the current year would be added

back in arriving at NOPAT.

Amortization of Goodwill: Non-cash expenditures such as goodwill will distort

capital deployed. We are trying to measure the cash return on all cash invested into the

business. Therefore, we would add back the total amount amortized for goodwill in

arriving at capital and we would add back the current year's amortization in arriving at

NOPAT.

Capitalized Intangibles: Intangibles such as Research & Development expenditures

provide a long-term economic benefit. These transactions are capitalized under EVA as

opposed to expensing the entire amount within traditional accounting. The original R &

D expense is reversed out and replaced with a Net Capitalized Intangible (NCI). The total

amount for R & D less the amount amortized is the NCI and this represents an adjustment

to capital. The amount amortized in the current year would be adjusted to earnings in

arriving at NOPAT.

Other Reserves and Allowances: Besides the LIFO Reserve, we may have material

amounts related to other types of reserves and allowances. Examples include Reserve for

Inventory Obsolescence and Allowance for Doubtful Accounts.

These accounting transactions would be treated similarly to the LIFO Reserve.

In summary, we are trying to arrive at earnings that are close to cash and compare this

return to a capital base that is expressed in cash equivalent terms. This means that we

recognize economic values, such as expenditures that provide long-term benefits and

reverse out non-cash entries as well as reserve account balances. Also, we must express

the asset base (capital) in terms of replacement capital. This requires removing distortions

like goodwill write offs, asset write offs, and highly depreciable fixed assets that have a

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carrying (book) value substantially different than market or replacement values. In Quest

for Value, Bennett summarizes the following adjustments

While the above adjustments are common in EVA calculations, according to Stern

Stewart, those items to be considered for adjustment should be based on the following

criteria:

Materiality: Adjustments should make a material difference in EVA.

Manageability: Adjustments should impact future decisions.

Definitiveness: Adjustments should be definitive and objectively determined.

Simplicity: Adjustments should not be too complex.

If an item meets all four of the criteria, it should be considered for adjustment. For

example, the impact on EVA is usually minimal for firms having small amounts of

operating leases. Under these conditions, it would be reasonable to ignore this item in the

calculation of EVA. Furthermore, adjustments for items such as deferred taxes and

various types of reserves (i.e. warranty expense, etc.) would be typical in the calculation

of EVA, although the materiality for these items should be considered. Unusual gains orlosses should also be examined and eliminated if appropriate. This last item is

particularly important as it relates to EVA-based compensation plans.

Strategies for increasing EVA:

Increase the return on existing projects (improve operating performance)

Invest in new projects that have a return greater than the cost of capital

Use less capital to achieve the same return

Reduce the cost of capital

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Liquidate capital or curtail further investment in sub-standard operations where

inadequate returns are being earned

Advantages of EVA

EVA is more than just performance measurement system and it is also marketed as a

motivational, compensation-based management system that facilitates economic activity

and accountability at all levels in the firm.

Stern Stewart reports that companies that have adopted EVA have outperformed their

competitors when compared on the basis of comparable market capitalization.

Several advantages claimed for EVA are:

EVA eliminates economic distortions of GAAP to focus decisions on real economic

results

EVA provides for better assessment of decisions that affect balance sheet and income

statement or tradeoffs between each through the use of the capital charge against NOPAT

EVA decouples bonus plans from budgetary targets

EVA covers all aspects of the business cycle

EVA aligns and speeds decision making, and enhances communication and teamwork

Academic researchers have argued for the following additional benefits:

Goal congruence of managerial and shareholder goals achieved by tying compensation of

managers and other employees to EVA measures (Dierks & Patel, 1997)

Better goal congruence than ROI (Brewer, Chandra, & Hock, 1999)

Annual performance measured tied to executive compensation

Provision of correct incentives for capital allocations (Booth, 1997)

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Long-term performance that is not compromised in favor of short-term results (Booth,

1997)

Provision of significant information value beyond traditional accounting measures of

EPS, ROA and ROE (Chen & Dodd, 1997)

Limitations of EVA

EVA also has its critics. The biggest limitation is that the only major publicly-available

sample evidence on the evidence of EVA adoption on firm performance is an in-house

study conducted by Stern Stewart and except that there are only a number of single-firm

or industry field studies.

Brewer, Chandra & Hock (1999) cite the following limitations to EVA:

EVA does not control for size differences across plants or divisions

EVA is based on financial accounting methods that can be manipulated by managers

EVA may focus on immediate results which diminishes innovation

EVA provides information that is obvious but offers no solutions in much the same way

as historical financial statement do

Also, Chandra (2001) identifies the following two limitations of EVA:

Given the emphasis of EVA on improving business-unit performance, it does not

encourage collaborative relationship between business unit managers

EVA although a better measure than EPS, PAT and RONW is still not a perfect measure

Brewer et al (1999) recommend using other performance measures along with EVA and

suggest the balanced scorecard system. Other researchers have noted that EVA does not

correlate as strongly with stock returns as its proponents claim. Chen & Dodd (1997)

found that, while EVA provides significant information value, other accounting profit

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measures also provide significant information and should not be discarded in favor of

EVA alone. Biddle, Brown & Wallace (1997) found only marginal information content

beyond earnings and suggest a greater association of earnings with returns and firm

values than EVA, residual income, or cash flow from operations.

Finally, a key criticism of EVA is that it is simply a retreaded model of residual income

and that the large number of "equity adjustments" incorporated in the Stern Stewart

system may not be necessary (Barfield, 1998; Chen & Dodd, 1997; O'Hanlon & Peasnell,

1998; Young, 1997). The similarity between EVA and residual income is supported by

Chen and Dodd (1997) who note that most of the EVA and residual income variables are

highly correlated and are almost identical in terms of association to stock return.

Improving EVA

What insight does EVA provide about financial performance of a business and how to

improve it? First, like any financial measure, the trend may be more valuable than the

absolute value of EVA. Even if EVA is positive, a declining EVA suggests that financial

performance is deteriorating over time, and if this trend continues EVA will become

negative and financial performance unacceptable. A negative EVA indicates that the firm

is not compensating its capital resources adequately, and corrective action should be

considered if this negative EVA persists over time.

So what are some corrective actions? First, operating performance with respect to

operating profit margins or asset turnover ratios could be improved to generate more

revenue without using more capital. Second, the capital invested in the business might be

reduced by selling under-utilized assets; this strategy will simultaneously improve

operating performance through a higher asset turnover ratio, as well as a reduced capital

charge against those earnings because of a reduced debt or equity capital investment.

Third, redeploy the capital invested to projects and activities that have higher operating

performance than the current projects or investments are exhibiting. And fourth, if thebusiness is not highly leveraged, change the capital structure by substituting lower cost

debt for higher cost equity. Although this last strategy will decrease net income because

of the higher interest cost, it will improve the EVA of the business because the total cost

of debt and equity is reduced, and EVA measures the value created after all costs of

capital (debt and equity) have been taken into account.

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some corrective actions that can be taken are: