Presentation on Economic Value Added (EVA) Reliance - 1997 • In Everything that we do we have only one supreme goal i.e. to maximise your wealth as member of India’s largest investor family. Tata Steel Enhancing Shareholder Value Vision 2007 • To seize the opportunities of tomorrow and create a future that will make us EVA positive Company. • I think the soundest management advise I have heard is the old saying - “What gets measured gets done” – Tom Peters Background of EVA • New Value based performance measure developed by a New York Consulting firm, Stern Steward & Co in 1982 • The object of EVA is to promote valuemaximizing behavior in corporate managers What is EVA • EVA is single, value based measure that was intended to evaluate – Business strategies – Capital projects – Maximizing the long-term shareholders wealth What is EVA (contd..) • EVA establishes clear and accountable links among – Economic Return: strategic thinking, capital investment – Accounting Returns: operating decisions and Accounting Shareholders Returns EVA – Shareholders Returns: shareholder value Economic Returns returns Why EVA • EVA sets managerial performance target and links it to reward system which motivates the managers to behave like owners. • EVA allow managers to have discretion and free range creativity keeping the long term object in mind. EVA Concept of Profitability • A successful firm should earn atleast its cost of capital. • Firms that earn positive/higher returns than financing costs benefit shareholders and enhance shareholder value. “Until a business returns a profit that is greater than its cost of capital, it operates at a loss” – Peter F Drucker in an article in Harward Business Review Composition & Mechanics of EVA • EVA represents (NOPAT) MINUS • Cost of Capital employed to generate the operating profits. Where NOPAT is obtained by adding interest expenses after tax back to net income after taxes and other adjustments depending on company-specific activities e.g. R& D Expenses, amortization of goodwill etc. Net operating profit after tax Formulas - EVA EVA : NOPAT Cost of Capital: Cost of Debt: NOPAT - Cost of Capital (WACC) Net Operating profit after tax Post Tax cost of debt + Cost of Equity Avg. Interest RateX (1-Tax rate) X Avg. borrowed fund Cost of Equity(Rate): Risk Free Debt Cost + (Market Premium X Beta Variant) Cost of Equity: Market Premium Beta Variant : Equity rate X Equity and Reserves Expected Return from the market - Risk free debt cost Standard Deviation of the script X Co-relation Co-efficient Standard Deviation of the Sensex/ Index Why Beta Variant? • Beta Factor describes the movement in a Stock’s Return in relation to that of the Market Returns. It measures the Volatility of a Security relating to Broad Market Index (Sensex) • Beta – Greater than one means that the Stock is more Volatile than the Sensex – Less than one means that the Security is Less Volatile “than the Sensex” Operating Profit • Operating Profit can be calculated in two ways:– Accounting concept: Income is measured by deducting expenses incurred to earn the income during that period. – Economic Concept: Operating profit considered to be the maximum amount which the business is capable of distributing to its shareholders while still remaining in the same position at the end of the period as it was at the beginning. E V O A p N e T R r a E E p r o f it t in g o a o f f x e s e t T C C A v e r a g e T a n g o ib s t le o CN f E q u it y o f is k M B S S C t a a e n d t a o e t qh u i t y r f r e r k e t a a t V r d a r d e P a D d d r e r ia e p e o s t c a p it a l E m p lo C y e o r r o d s t o f D e b t c o s t o f oe st t W o R e b m r c e t n t a s t g ev e A r a g e b o w P e o d s tf u t a dx n c o iu m n t v ia e v ia o f t io t io c o n n o o - r e f f la S S t o e t io c k / n s e n s c r ip x t n d - e f f ic ie n t Object of EVA is to know • Whether the Entrepreneurs are really increasing the Net Worth of the Organization or they are destroying it gradually • The Real growth Entrepreneurs have added to the Shareholders’ Wealth. Concept of EVA Shareholders’ Value is created by MAXIMIZING “ECONOMIC PROFITS” What it measures • Creating value – The Company which earns Higher Returns (Net Operating Profit After Tax) than the Cost of Capital ARE CONSIDERED AS HAS “CREATED THE VALUE” What it measures cont.. • Destroying value – The company which earns Lower Return (Net Operating Profit After Tax) than the Cost of Capital ARE CONSIDERED AS Destroyers of Shareholders’ Value Strategies for increasing EVA • Increase the return on existing projects (improve operating performance) • Invest in new projects that have a return greater that the cost of capital • Use less capital to achieve the same return • Reduce the cost of capital • Liquidate capital or curtail further investment in sub-standard operations where inadequate returns are being earned. • Hence in the EVA there are four way to increase value – Operate: Improve the return earned on existing capital – Build: Invest as long as returns exceeds cost of capital – Harvest: Divest capital when returns fail to achieve cost of capital – Optimize: Reduce cost of capital by optimizing capital structure EVA v/s Other performance measures • Cost of capital is charged in EVA calculation at a rate that compensates investors for bearing the firm’s explicit business risk, as indicated by the historical variance in its stock price and the extent to which the firm is leveraged. In case of Traditional accounting cost of capital is internal cost, which may be lower than the cost of capital in EVA. The judgement taken on the basis of historical measure may not give correct result. • EVA requires 164 potential adjustments to eliminate the the GAP in GAAP including adjustment for inventory valuation, R&D expenses, • EVA’s advantage over other measures lies in its capacity to align executive, employee and shareholders interest. • Income Statement variables : Operating profit, earnings, net income – The investors are interest to know what kind of resources (Capital) are require to produce the given profit. A profit figure without capital base is irrelevant . • Capital cost into income statement – When the cost of capital shown in income statement operating people are able to see the importance of capital from view point of profitability. – After realising the true cost of capital operating people are often able to decrease the excess capital employed. – EVA is much easy concept of profitability than ROI and further more it can be translated into day to day operations. EVA as a unifying measure Traditional Financial Measurement Firm Goal Business plan Divisional Performance Measurement Capital Budgeting Performance target Incentive compensation Revenues, Profits, EPS Revenues, Profits, EPS Divisional Profits, ROI DCF Negotiated Profit Small & Range Bound EVA based Financial Management EVA EVA EVA EVA EVA linked target Unlimited and EVA linked Goal Setting Shareholder Communication Financial Planning Performance Measurement Capital Budgeting Incentive Compensation EPS ROI NPV IRR ROE RONA Goal Setting Performance Measurement Financial Planning Shareholder Communication Incentive Compensation Capital Budgeting EVA EVA and market value of the company • Theoretically EVA is much better than conventional measures in explaining the market value of the company. Financial theory suggests that the market value of a company depends directly from the future EVA - Values: The market value of a company = Book Value of Equity + Present value of future EVA Advantages of EVA • EVA is more than performance management,. It is motivational, compensation based management system that facilities economic activity and accountability at all levels in the firm. • EVA eliminates the GAP in GAAP as 164 adjustments are required to compute the EVA • As compared to historical tools for evaluaiton e.g. ROI, EPS- EVA is better tool to assess the company as it takes into account the cost of capital Advantages of EVA • EVA covers all aspects of the business cycles • EVA aligns and speeds decision making, and enhances communication and teamwork • EVA decouples bonus plans from budgetary targets Limitations of 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 by using different method of accounting. – There are different ways to calculate NOPAT and COC as there are numerous fundamental differences exist with regard to calculation of NOPAT and COC – There are 164 adjustment which is really cumbersome exercise – EVA may focus on immediate results which diminishes innovation • • • • • • EVA is biased against new assets EVA is in favour of large companies EVA favours more debt compared to equity It is difficult to implement Implementation includes significant cost EVA does not study business drivers like consumer satisfaction or learning and growth. Statistical information • Total number of listed companies in India - 7199 (30/11/2005BSE ) • Companies implemented EVA - Below 30 (TCS, Infosys, Godrej, Tata Steel, Tata Tea, ITC, MARICO, Aditya Birla Group, Indian Hotels, Dr, Reddy’s Laboratories, • Companies implemented EVA in other countries – US - 80 (Citi Corp., Coca Cola, Bausch & Lomb, Dun & Bradstreet corp., Eli Lilly & Co, US Postal Service etc.) – Canada - 6 – Europe - 9 – Maxico - 4 – Brazil - 9 – South Africa - 12 • Total Companies implemented EVA in world is about 250. The EVA implementation has resulted in better stock valuation. List of few Companies in India implementing EVA and its objective • INFOSYS - EVA is used as information tool to tell its clients that the value delivered by INFY is great than what the clients pays for. • MARICO - As a signaling device to tell its employees that capital is important • DR. REDDY’S LABORATORIES - As a qualifying criterion to grant rewards such as variable pay, stock option and performance bonuses • TCS - EVA is linked to compensation. • Godrej - EVA was chosen as strategic management tool. Why EVA is implemented by only few companies • Implementation of EVA is costly affair • The process is challenging and time consuming and too complicated for small business • Especially the key persons (Top and middle managers) have to understand and commit to EVA thoroughly which is difficult • Switching over to EVA from the earlier traditional methods of bonus system may create resistance in the employees • EVA does not have system of Minimum and maximum cap for bonus as the traditional methods have. Why EVA is implemented by only few companies • Although some have achieved substantial success with EVA, it is wise to approach the metric with some caution. It is after all, only one measure, which will never substitute for thorough, analytical thinking. “ EVA does not solve business problem; managers do,” Mark Gressle, a founding partner of Sten Stewart & Co Implementation of EVA needs • The key persons (Top and middle managers) have to understand and commit to EVA thoroughly – Without the full support of Managers there will not be substantial results – Good understanding helps to tailor EVA to the specific need of a company • EVA will be most beneficial if broken down into small parts • Integration to incentive systems for all the employees is a good way to make all the employees to work for common goal • Human resources department should engage in careful communication of what the firm hopes to achieve by switching to EVA, the manner in which employees and management may improve EVA, and the way in which employees compensation is tied to EVA. Market Value Added (MVA) • is the difference between the current market value of a firm and the capital contributed by investors • If MVA is positive, the firm has added value. If it is negative, the firm has destroyed value. • The amount of value added needs to be greater than the firm's investors could have achieved investing in the market portfolio, adjusted for the leverage (beta coefficient) of the firm relative to the market. 33 • • • • The formula for MVA is: MVA = V- K where: MVA is market value added V is the market value of the firm, including the value of the firm's equity and debt • K is the capital invested in the firm 34 • MVA is the present value of a series of EVA values. MVA is economically equivalent to the traditional NPV measure of worth for evaluating an after-tax cash flow profile of a project if the cost of capital is used for discounting. 35 Thanks
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