Economic Value Added is a residual income variable. It is defined as Net operating profit after taxes subtracted with the cost of capital tied in operations. Standard EVA corresponds mathematically the standard DCF formula because it is a modified version of DCF. EVA's equivalence with DCF and NPV holds in valuations although DCF and NPV are based only on cash flows and EVA is based also on historical accounting items. This peculiar characteristic of EVA is due to the fact that book value is irrelevant i.e. it can be canceled out in valuation formula of EVA. In periodical performance measurement EVA can however in some occasions give misleading information because it suffers from the same shortcomings as accounting rate of return (ROI). Inflation can distort the values of EVA. Furthermore EVA suffers from wrong periodization. In most cases the impacts of these shortcomings are however fairly small. They can also usually be eliminated for major parts with some corrective adjustments.
In spite of its faults, EVA seems to have importance for companies as a performance measurement and controlling tool. First of all it is fairly simple measure but still measures well the ultimate aim of any given company, the increase or decrease in shareholders' wealth. Maximizing traditional performance measures like ROI is not theoretically in line with maximizing the wealth of shareholders. Therefore EVA is superior to conventional performance measures. The premise behind EVA - that businesses must cover their capital costs - is neither new nor peculiar. Putting it into practice can still be eye-opening. EVA shows financial performance with a new pair of glasses or offers new approach especially for the companies where equity is viewed as free source of funds and performance is measured by some earnings figure. At best EVA helps with creating a mind-set throughout the organization that encourages managers and employees to think and behave like owners.
At operational level this new approach leads often to increased shareholder value through increased capital turnover (Wallace 1997, p.16). In many companies everything has been done in cutting costs but the capital efficiency has been ignored. EVA has been helpful because it forces to pay attention to capital employed and especially to excess working capital. Allocating the capital costs to their originators i.e. individual functions of organization can further reinforce this impact.
One of EVA's most powerful features is its suitability to management bonus systems. This have been empirically proofed to be good way to increase shareholder value (Wallace 1997). The good feasibility for this purpose is due to the nature of EVA as excess return to shareholders. When EVA is maximized also shareholder value is maximized. The idea of EVA bonuses is that if management can be paid some bonuses, the shareholders have always earned higher return on their capital than they can expect. This kind of bonus system is usually beneficial both to management and the shareholders, because the performance level is likely to rise after introducing EVA bonus system. EVA bonus paid is far from a cost to shareholders, because it is often a share in the discretionary value created. With well designed bonus plan, the higher the bonuses that are paid, the better it is for the shareholders. In order to be successful, EVA based bonus systems should be long-term, based mainly on changes of EVA and offer considerable bonuses for considerable shareholder value improvements.
With implementation it is important to understand the EVA-concept thoroughly and tailor the concept to the unique situation of each company or business unit. EVA is at its best as an overall measure and organizational approach with strong link to payroll of managers and other employees. That kind utilization can not succeed without deep understanding and commitment achieved with proper training.
Substantial shareholder value increases and true success stories arise always from outstanding strategy, quick response, great ideas and good predicting of future. EVA helps in quantitative assessing of different strategies but that is all. Wealth does not arise from EVA alone. EVA only measures changes of wealth. It is also as short-term as all other periodic performance measures. Therefore all companies should rely also on other performance measures. Especially important this is e.g. for new growth phase companies. However we have to bear in mind that the success or failure of any given company is measured ultimately as created shareholder value. Therefore EVA is important measure also for those companies that use primarily other tools is assessing the achievement of their strategic goals.
References to this study / Back to main EVA page / EVA-questions.
Author: Esa Mäkeläinen 23.12.1997 ( Esa.Makelainen@kyyppari.hkkk.fi )
All rights reserved. Last updated on 18.2.1998.
1 Economic Value Added, EVA is a trademark of American consulting firm Stern Stewart & Co.
2 From the Wallace (1997) list of references: Marshall, A. 1890. Principles of Economics. The MacMillan Press Ltd
3 Like EVA also MVA is a registered trademark of Stern Stewart & Co.
4 As well known, there are occasions on which rules based on rate of return comparisons are not equivalent to present value maximization. IRR has also an implicit assumption that all the cash flows from project can be invested with the same rate of return as the underlying project. This implicit assumption might not be theoretically sound in all circumstances. However these theoretical weaknesses can be ignored in this context, since they do not cause almost any harm here.
5 Probably the "Normal mean weighted with assets" is the most relevant because it describes best the situation in practice. That is because ROI is the relation between operating profit and all net assets and thus investments with almost depreciated i.e. very small capital base are of little importance.
6 This term is formulated according to Gordon model of infinite and constant cash flows. (Brealey&Mayers 1991, p.53)
7 In the end of 1997
8 Share prices do rise from this kind of NPV negative investments even though the increase in share prices is not so big as the amount of money invested in the company. So although share prices increase somewhat shareholders still suffer.
9 That is because otherwise DCF and EVA would not be equivalent.
10 E.g. when taking about stock returns we always compare the change in value in relation to the initial investment and not in relation to the value in the end.
11 The tax shield of debt is ignored in this example in order to keep it simple. It does not change the pattern.