In this essay we will discuss about role of Economic Value Added (EVA) in the cash flow generated by a business. After reading this essay you will learn about:- 1. Meaning of Economic Value Added 2. Importance of Economic Value Added (EVA) 3. Measurement 4. Market Return.
Essay # 1. Meaning of Economic Value Added (EVA):
Earning profit is not sufficient, a business should earn sufficient profit to cover its cost of capital and surplus to grow. Any profit earned over and above the cost of capital is economic value added.
EVA = Net Operating Profit After Taxes (NOPAT) – [Capital × Cost of Capital]
Measurement of corporate performance is traditionally based on Profit After Tax (PAT) and Profit Before Interest After Tax (PBIAT). PAT is an indicator of profit available to the shareholders and PBIAT is an indicator of profit generated using total funds.
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As a relative measure, two commonly used profitability ratios are:
(i) Return on Capital Employed (ROCE) and
(ii) Return on Net Worth (RONW), which show comparative profitability of companies within an industry or across the industry.
However, traditionally used profit indicators are ineffective parameters in explaining whether reported profit covers cost of capital of a company. Age-old profit concept fails to calibrate profit adequacy vis-a-vis cost of funds that have been deployed to earn that profit. In effect maximization of shareholders wealth is linked to a basic proposition that return on capital employed is better than cost of capital: ROCE > Ko.
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In a nutshell, capital employed highlights long-term capital and cost of capital represents weighted average cost of capital that includes opportunity cost of equity rather than dividend servicing cost.
Traditionally, PAT is shown in the profit and loss account to indicate profit available to the shareholders, both preference and equity. Ability to maintain dividend is not a test of profit adequacy. Ability to generate economic value added is the only test of profit adequacy. Any surplus generated from operating activities over and above the cost of capital is termed as Economic Value Added (EVA). It is a new measure of corporate surplus.
Thus EVA is defined as – Excess Profit of a firm after charging cost of capital.
It is corporate surplus that should be shared by the employees, management and shareholders. Emergence of the idea of sweat equity in Indian context needs a supportive value sharing concept which EVA can answer better than any other traditional profit parameters. Efficiency bonus, profit sharing schemes, managerial remuneration over and above a minimum sustenance salary, issue of bonus shares to the equity shareholders and incentive dividend (dividend over and above the agreed coupon rate) to the preference shareholders can be better linked to EVA.
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The Intellectual Capital and Intangible Report of Balrampore Chini Mills Ltd., explains that – “What makes EVA potentially potent is in its application: it can be based to structure employee remuneration or increments in proportion to the act of their creation/destruction of wealth. When applied through the organization, the separate divisions are able to break down their expenses/income structure more analytically than if the exercise were carried out by a centralized accounting head.”
Essay # 2. Importance of Economic Value Added (EVA):
Economic Value Added (EVA) is the after-tax cash flow generated by a business minus the cost of the capital it has deployed to generate that cash flow. Representing real profit versus paper profit, EVA underlies shareholder value, increasingly the main target of leading companies’ strategies. Shareholders are the players who provide the firm with its capital; they invest to gain a return on that capital.
The concept of EVA is well established in financial theory, but only recently has the term moved into the mainstream of corporate finance, as more and more firms adopt it as the base for business planning and performance monitoring. There is growing evidence that EVA, not earnings, determines the value of a firm. The chairman of AT&T stated that the firm had found an almost perfect correlation over the past five years between its market value and EVA. Effective use of capital is the key to value; that message applies to business processes, too.
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AT&T, Boise Cascade, Briggs & Stratton, Bank One, Centura Banks, Coca-Cola, CSX, Equifax, Eli Lilly, Olin Corpn., Rand NcNally, Smith Kline Beecham, Telecom New Zealand, Quaker Oats, Wall-Mart Stores and Whirlpool are some of the nearly 300 companies that have successfully adopted EVA.
Investors like EVA because it is a running score showing how well managers are performing their primary task and creating wealth. When a company uses EVA to set compensation, it seems to be a powerful tool that gets managers to deploy capital for maximum gain.
The main differences between EVA, earnings per share, return on assets, and discounted cash flow, the most common calculations, as a measure of performance are as follows:
i. Earnings per share tells nothing about the cost of generating those profits. If the cost of capital (loans, bonds, equity) is, say, 15 per cent, then a 14 per cent earning is actually a reduction, not a gain, in economic value. Profits also increase taxes, thereby reducing cash flow, so that engineering profits through accounting tricks can drain economic value. As Bennett Stewart, the leading authority on EVA, comments, the real earnings are the equivalent of the money that owners of a well-run mom-and-pop business stash away in the cigar box. Renowned investor Warren Buffett calls these “owner’s earnings”: real cash flow after all taxes, interest, and other obligations have been paid.
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ii. Return on assets is a more realistic measure of economic performance, but it ignores the cost of capital. In its most profitable year, for instance, IBM’s return on assets was over 11 per cent, but its cost of capital was almost 13 per cent. Leading firms can obtain capital at low costs, via favourable interest rates and high stock prices, which they can then invest in their operations at decent rates of return on assets. That tempts them to expand without paying attention to the real return, economic value-added.
iii. Discounted cash flow is very close to economic value-added, with the discount rate being the cost of capital.
Determining a firm’s cost of capital requires making two calculations, one simple and one complex. The simple one figures the cost of debt, which is the after-tax interest rate on loans and bonds. The more complex one estimates the cost of equity and involves analyzing shareholders’ expected return implicit in the price they have paid to buy or hold their shares.
Investors have the choice of buying risk-free Treasury bonds or investing in other riskier securities. They obviously expect a higher return for higher risk. To attract investors, weak firms must offer a premium in the form of a lower stock price than stronger firms can command. This lower price amounts to the equivalent of a higher interest rate on loans and bonds; the investor’s premium increases the firm’s cost of capital.
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Cash flow and the cost of capital employed to generate that flow have become the key determinants of business performance, with earnings per share increasingly a misleading or even damaging target for strategy and investment. When a firm switches from FIFO (first in, first out) to LIFO (last in, first out), its cost of goods assumes the price of the most recent purchases of materials in inventory.
This typically reduces its profits because the older purchases cost less than the more recent ones. Yet the firm’s stock price will rise, even though its reported profits drop, because it pays less in taxes, thus increasing its after-tax cash flow. The money spent to acquire the goods in inventory is exactly the same regardless of which method is used, but LIFO increases economic value- added.
The key business processes of the firm are capital. That fact is obscured by accounting systems that expense salaries, software development, rent, training, and other ongoing costs that are integral to a process capability and that treat the cost of displacing workers a frequent byproduct of process re-engineering, downsizing, and the like as an “extraordinary item” on the income statement. By treating processes as capital assets or liabilities, firms can and should ensure that they directly contribute to economic value-added.
Essay # 3. Maintaining Shareholders Value:
Although maximizing shareholders value is focused as the primary goal of corporate management in financial literature it was not adequately focused until recently. EVA brought this fundamental idea to the forefront. A company cannot ignore secondary market operations of its equity. It has to defend the average of the closing market price – if not the average of fifty-two weeks high, the target should be to maintain market price at a level that gives competitive return to the investors.
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Fundamental concept of competitive return on equity investments suggests that:
Return to Equity Shareholders = Risk Free Rate + Risk Premium
RI = RF + RP
Ri = Return to shareholders of the I-th shares,
RF = Risk Free Rate, and
RP = Risk Premium.
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Risk free rate is taken as average return on the 364 days Treasury bill and risk premium is derived from the capital market.
So return to the equity shareholders is determined by external factors – both the risk free rate and risk premium are externally determined. Responsibility of the management is to track the return.
Return to the shareholders comes basically in three forms:
a) Dividend – cash or bonus
b) Right
c) Capital gain.
It is difficult to maintain shareholders return through cash dividend alone. A high cash dividend will not allow the company to grow through internally generated funds which has been traditionally used as cheap source of capital. At the same time growth through shareholders funds should reflected in the market place in the form of growth in market capitalization. A company is growing in terms of assets, sales and net worth, but it may not grow in terms of market capitalization. This happens simply because of inadequate profit. Shareholders value cannot be maintained in that situation.
A company that enjoys positive EVA is expected to add shareholders value. In business planning it may not be so important to understand the historical relationship between past EVA and current market price as this only corroborates expectation theory, a manager has to focus on current EVA and its maintenance which will generate future market value.
Essay # 4. Measurement of EVA:
EVA is a measure of economic efficiency of a company. Profit is contributed by land, labour, capital and management. In industrial situation land may be excluded from the contributory factor – major contributory factors of profit are labour, capital and management.
Compensation to labour and management is charged in the profit and loss account. Cost of debt fund is also charged to the profit and loss account. Only dividend is treated as appropriation to profit. This is because of traditional ownership concept. In economic term profit is the clear surplus to the company after even meeting the cost of equity share capital.
EVA is a measure of corporate surplus. While conceptualizing EVA Stewart used NOPAT as a basis. As per Stewart NOPAT stands for Net Operating Profit After Tax. It is suggested to deduct depreciation while computing NOPAT since depreciation is an economic expense.
EVA is given by:
[Return on Operating Capital – Weighted Average Cost of capital] × Capital [ROOC – WACC] × Capital
The difference between ROOC and WACC is the spread. The spread is applied on total capital (both operating and non-operating) to find out EVA.
EVA is regarded as a comprehensive measure of performance; the principles can be applied to each business segment within a company.
EVA is regarded as a comprehensive measure of performance; the principles can be applied to each business segment within a company.
In other words, an EVA statement can be prepared as follows:
It will be interesting to observe the difference between traditional spread in which Indian companies mostly rely and the EVA spread. Traditional spread is the difference between ROOC and WACC, computed using dividend as a cost of equity. Whereas EVA spread is the difference between ROOC and WACC, computed on the basis of market cost of equity. What should be accepted as spread? It will be a self-gratification if a company looks into traditional spread and ignores EVA spread.
Fallacy of NOPAT:
The complication involved in the idea of NOPAT does not match with the idea of diversification. Usually non-trade investments are considered as non-trade investments are considered as non-operating assets. But they are not. When a company faces high business risk that arises out of highly volatile return in its main line of business, management should attempt to diversify the risk either by choosing different line of business with negatively correlated cash flow series or investing in shares of such business.
It is also possible to manage business risk talking shelter under fixed income securities. If considered from the risk management perspective no part of the income is non- operating excepting extraordinary items. So NOPAT should be considered as PAT net of extraordinary items, which is given in the CMIE Prowess as part-nnrt.
So ROOC should be considered as Return on Capital Employed (ROCE) – capital employed means total sources of funds net of Miscellaneous Expenditure and Losses and ROCE is given by—
Cost of Debt- WACC is the market value based weighted average of cost of debt and equity.
Cost of debt can be approximated using the following formula:
[Interest × (1 – Effective Tax Rate)]/Debt × 100
Book value of debt may be approximated as market value in absence of broad price quotation.
Cost of Equity:
On the other hand, cost of equity is calculated applying Capital Asset Pricing Model (CAPM). Under this approach expected return to the shareholders is taken as the cost of equity to the company.
Expected to return to the shareholders should be:
RI = RF + RP
i.e. RI = RF + β(RM – RF)
β = Slope of regression line of market return RM and return on the share R1
RM = Return on the market index
R1 = Return on share of I-th company in the capital market.
Thus risk premium is measured with reference to excess return in the market over risk free rate (RM – RF) multiplied by beta (β). Beta is the responsiveness of a share to the index.
What risk premium should be added to the risk free rate that is not necessarily guided by the ex-ante beta of a company. Empirical analysis proves that beta of Indian companies are highly volatile over the year. If this highly volatile beta is used to measure cost of capital, it is unlikely to reach a reasonable conclusion about the EVA. Rather a confusing EVA profile is likely to be developed that will mislead the decision maker. It is necessary to benchmark beta for determining cost of capital.
The proper approach for’ determining risk premium should be to target higher of the two:
u βc(RM – RF)
u βT(RM – RF)
βc = Company beta, and βT = Target beta.
Some companies may attempt to benchmark excess market return i.e. (RM – RF). But in case of low profile industries which is predominant in India, it may not be practicable to benchmark excess market return. Even the shareholders may like to remain in the low risk industries. So it may be more appropriate to benchmark beta of the market leader. Alternatively, a company may benchmark maximum beta over a period of five years as benchmark beta.
Risk Premium used in the CAPM is the excess average return on select stocks over average return on risk free securities over the measurement period. Damodaran has suggested use of long run average taking the measurement period of at least ten years. There is also disagreement as regards type of mean to be used. Arithmetic mean is justified as it is more consistent with the mean-variance framework of the CAPM.
Whereas the geometric mean is justified on the grounds that it takes compounding into account and that is a better predictor of the average premium in the long term. There can be significant difference in premiums depending upon the choice of average. For computing risk premium, it is possible to take return on broad based market index over risk free rate.
Variants on the Risk Free Rate:
Damodaran explained use of three variants of risk free rate for computing cost of equity:
i. Short term Government security rate:
This may be justified in the CAPM framework which is considered as a one-period model;
ii. Short term forward rate:
This is based on superiority of the forward rate in forecasting future short term rate; and
iii. Current long-term Government bond rate:
This takes a strict view of matching the duration of the risk free security with the duration of assets being analysed.
Damodaran has finally used long-term rate for computing risk free rate.
Variants on the risk free rate:
Damodaran explained use of three variants of risk free rate for computing cost of equity:
a. Short term Government security rate:
This may be justified in the CAPM framework which is considered as a one – period model;
b. Short term forward rate:
This is based on superiority of the forward rate in forecasting future short term rate; and
c. Current long term Government bond rate:
This takes a strict view of matching the duration of the risk free security with the duration of assets being analyzed.
As per National Stock Exchange data base long term Zero Coupon Yield Curve was 6.97% as on 31-3-2003 which can be used as risk free rate for computing EVA for the year 2002-03.
What is Beta?
Beta is used as risk indicator in the market model. It is responsiveness of stock return or portfolio return to the market return. Index is the capital market barometer. Volatility in the market return indicates the degree of market risk. If the change in share price exactly corresponds to the change in the index, a stock is considered as at par with the market as regards risk. In this case beta will be approaching to unity. If the share price on an average moves in the opposite direction as compared to the index, then the share is negatively correlated with the index.
When the share price moves in the same direction as index does, then it is positively correlated with the index. Nature of correlation only explains whether beta is negative or positive. Value of beta depends on the degree of corresponding changes in share price when index changes. It is slope of the regression line or regression coefficient.
High Correlation with Market Index:
Market changes are reflected through changes in index as well as in a particular scrip. Correlation coefficient simply indicates the corresponds of one with the other. If the target is to track the index, then a high positive correlation between daily market return (on an index, say, BSE Sensex) and daily return of a scrip is desirable. Correlation coefficient 1 indicates an ideal situation which is hardly a reality. However, it is possible to maintain high positive correlation with market return.
Low or Negative Correlation with Market Index:
A negative or low correlation between market return and stock return is another extreme situation in which the price of a stock moves in the opposite direction. Sometime this divergence is preferred. So long the average stock return is at par with the market return or better than it, a shareholder may not care for such a negative or low correlation of the stock price behaviour. What is important in such a situation is to appreciate the coefficient of variation (CV). A stock having negative or low correlation with high CV is considered as riskier than the market.
β = 1, this means risk premium of a share is simply the excess return in the market (RM – RF). This indicates that a company belongs to average systematic risk category.
β > 1, this means risk premium of a share is more than excess return in the market (RM – RF). This is because the share of the company is more risky as compared to the average level of market risk. If there is 2% decrease in the index, share price will decrease by more than 2%. This indicates that a company belongs to above average systematic risk category.
β < 1, if the beta is less than 1 but non-negative, the share is risky in the sense that it cannot make profit at par with the market return. In that case cost should be calculated giving risk premium at least equal to the excess return. This indicates that a company belongs to below average systematic risk category.
β < 0, if beta is negative the share is risky in the sense that it is opposite to the market force. When there is a market profit, the share will show loss. Higher the negative beta, higher is the level of risk of moving away. So negative beta should be treated in absolute term.
Estimating Betas:
Beta is a measure of market related risk.
There are at least three methods of estimating beta:
a) Estimating historical betas strictly on ex post return data;
b) Estimating ex ante betas based upon explicit probability distributions; and
c) Estimating ex ante betas by adjusting historical betas.
Historical Betas:
Beta is the slope of the regression line and is calculated as:
COVim is the covariance of return of individual share with index return and σ2m is variance of market return.
This can also be written as:
Pim is the correlation coefficient of share return and index return σi is the standard deviation of share return and σm is the standard deviation of market return.
The following steps are followed for calculating beta:
i. Calculate market return on the basis of closing index value:
ii. Calculate market return of the share:
iii. Compute market return and stock return for the year on daily basis.
iv. Find out beta:
Go to Microsoft Excel, click fx, then click statistical, then click slope, give range of X series (which is market return) and Y range (which is stock return), click finish and get beta.
Market Return:
Market return is the average return derived from an appropriate broad based market index like BSE Sensex, BSE 200, S&P Cnx Nifty, and S & P Cnx 500.
S & P Cnx Nifty data is analysed below for determining market return.
Deriving Annual Return:
Annual market return should be derived on the basis of daily, monthly, quarterly or yearly Nifty data. It is preferable to take the closing index because this is derived on the basis of the closing prices of the constituents shares in the index. The closing price reported in the NSE is the volume weighted average of the last thirty minutes. Market return should be calculated with reference to closing index which reflects the day’s sentiment. But computing market return using daily stock price may not be meaningful, as it off set gain/loss.
Annualized monthly return is best suited for this purpose as this represents a moderate frequency of the data base. Given below in the Table 7.1 is the annualized monthly return during 1990-2003. You may observe market return is highly volatile. See also Figure 7.1.
Long Run Approach:
The volatility of the market index is very high. So it is difficult to derive a stable market return on the basis of annualisation of monthly return. A negative market return or very low return represents downfall in the stock market. This does not mean that a company’s cost of equity is also reducing. While determining a cost equity applying market model, a company should take a long run view. Market return should reflect the long run average return in the stock market. Use of long average may not suitable because of extreme market returns.
It is logical to take return of latest completed business cycle. Study Nifty movement given in figure 7.2. Check the arrow marked portion which indicates the latest completed business cycle. The cycle began in November 1998 and ended in September 2001. However, problem of setting return also occurs in a full business cycle. Therefore, you may take 70% of the downturn. See the results presented below in Table 7.2.
So we may finally select 14.06% as market return.
