Summary by Zuwena De Freitas
Master of Accountancy Program
University of South Florida, Summer 2002
In this paper the authors provide some detail on how the numbers in an EVA and MVA calculation are actually determined. They also demonstrate that the EVA and MVA measures of financial performance can effectively be used in managing a company’s operations, in guiding its strategies and in providing incentives to its employees.
What is EVA?
Economic Value Added (EVA) is a measure of financial performance based on the concept that all capital has a cost and that earning more than the cost of capital creates value for shareholders. It is after-tax net operating profit (NOPAT) minus a capital charge. It is true economic profit consisting of all costs including the cost of capital. If a company’s return on capital exceeds its cost of capital it is creating true value for the shareholder.
EVA = (r-c) x Capital
EVA = (r x Capital) – (c x Capital)
EVA = NOPAT- c x Capital
EVA = operating profits – a capital charge
where: r = rate of return, and
c = cost of capital, or the weighted average cost of capital.
NOPAT is profits derived from a company’s operations after taxes but before financing costs and noncash-bookkeeping entries. It is the total pool of profits available to provide a cash return to those who provide capital to the firm.
Capital is the amount of cash invested in the business, net of depreciation. It can be calculated as the sum of interest-bearing debt and equity or as the sum of net assets less noninterest-bearing current liabilities.
Capital charge is the cash flow required to compensate investors for the riskiness of the business given the amount of capital invested. The cost of capital is the minimum rate of return on capital required to compensate debt and equity investors for bearing risk.
Another perspective on EVA can be gained by looking at a firm’s Return on Net Assets (RONA). RONA is a ratio that is calculated by dividing a firm’s NOPAT by the amount of capital it employs (RONA = NOPAT/Capital) after making the necessary adjustments of the data reported by a conventional financial accounting system.
EVA = (Net Investments)(RONA – Required minimum return)
If RONA is above the threshold rate, EVA is positive.
What Is MVA?
Market Value Added (MVA) is a measure of wealth a company has created for its investors. It is a cumulative measure of corporate performance that looks at how much a company’s stock has added to (or taken out of) investors’ pocketbooks over its life and compares it with the capital those same investors put into the firm. Maximizing MVA should be the primary objective for any company that is concerned about its shareholders’ welfare.
First, all the capital a company took in over its span of existence is added up. This includes equity and debt offerings, bank loans, and retained earnings. Then some adjustments are made that capitalize certain past expenditures, like R&D spending, as an investment in future earnings. This adjusted capital amount is compared to a firm’s total market value, which is the current value of a company’s stock and debt to get MVA or the difference between what the investors can take out and the amount investors put in.
MVA = [(Shares outstanding x Stock price) + Market value of preferred stock + Market value of debt] – Total capital
When calculating EVA and MVA the amount of equity equivalent reserves for certain accounts must be determined first. Equity equivalents are adjustments that turn a firm’s accounting book value into economic book value. This economic book value is a truer measure of the cash that investors have put at risk in the firm and upon which they expect to accrue some returns.
Dierks and Patel recommend making adjustments only in cases that pass four tests:
Is it likely to have a material impact on EVA?
Can the managers influence the outcome?
Can the operating people readily grasp it?
Is the required information relatively easy to track and derive?
An example of an equity equivalent adjustment occurs with R&D expenditures. Under accounting standards, R&D outlays are treaded as operating expenditure and charged off in the period incurred. For EVA purposes all R&D outlays are capitalized and amortized against earnings over the period benefiting from the successful R&D project. R&D is considered an investment and included in a firm’s capital base.
Criticisms of EVA
A major criticism of EVA is that it does not account for real options or growth opportunities inherent in investment decisions. It does not reflect the market’s perception of the value of growth opportunities. EVA is therefore more appropriate for evaluating firms with substantial assets in place in mature industries with few growth opportunities such as public utilities.
To adjust for this problem and capture growth opportunities inherent in companies, companies should focus on both EVA and MVA. As MVA is constructed off the market value of a firm’s securities, it reflects the market’s expectations of future opportunities for the firm. Companies can account for both the year-to-year and long-term changes in value when they use both EVA and MVA to evaluate performance.
Using EVA and MVA within a Company
All managers have the same goal of obtaining capital and a earning rate of return on it that exceeds the return offered by other seekers of capital funds. EVA can be used as a financial management system that allows mangers and employees to focus on how capital is used and the cash flow generated from it. There are two benefits from focusing on growth in EVA; management’s attention is focused more towards its primary responsibility, which is increasing investors’ wealth and secondly, distortion caused by using historical cost accounting data are reduced or eliminated so that managers can spend their time finding ways to increase EVA. This increased awareness of the efficient use of capital will eventually produce additional shareholder value.
Managers can do a better job of asset management and EVA can be used to hold management accountable for all economic outlays whether they appear in the income statement, on the balance sheet or in the footnotes to the financial statements. This is possible because EVA creates one financial statement that includes all the costs of being in business, while making managers aware of every dollar they spend.
Another benefit of using EVA is that it creates a common language for making decisions, especially long-term decisions. Examples are: resolving budgeting issues and evaluating the performance of organizational units and managers. EVA quantification of results in financial terms also helps to energize other management programs such as TQM, quick response and customer development by demanding and getting continuous financial improvement.
Mangers and employees adopt a long-term focus and begin to think more like owners as they start to feel responsible for and take part in the economic value of the firm.
Benefits of EVA incentive plan
One effective way to align employees’ interest with that of investors is to tie their compensation to output from the EVA metric. People are paid for sustainable improvements in EVA. The behavior within a company is changed through the understanding of what drives EVA and economic returns.
Necessary properties for the incentive system to work:
Have an objective measure of performance that cannot be manipulated.
Plan must be simple so everyone in the organization can understand it.
Significant bonus amount to alter employees’ behavior.
Keep target fixed and do not move goalpost after plan gets under way.
Properties that are strongly recommended:
No limits should be placed on the plan.
Not paying the full bonus amount in one year in order to seek substantial performance.
Include cancellation clause whereby banked bonus is lost if a person resigns.
Incorporate long term perspective into the plan.
Structure of the plan should be team based.
Implementing value-added measures into a company is a costly and timely process. Supporters justify the substantial costs and time by pointing out the benefit of optimizing the company’s strategy for value creation. A transition to value-added measurements requires serious commitment of the board of directors and senior management to use these measures to manage the business. Every individual in the company must buy into the plan to make it successful. It will also require extensive training and communication effort directed to everyone in the company. Everyone must be educated on the basic theory underlying the notion of creating economic value. Nonetheless, EVA "should not be viewed as the answer to all things". It doesn’t solve business problems, which is the manager’s responsibility. In conjunction with MVA, it provides a meaningful target to pursue for both internally and externally oriented decisions.
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