Research Article

focuses on the analysis and resolution of managerial issues based on analytical

and empirical studies.

Linkage between Economic Value Added and Market Value:

An Analysis
Ashok Banerjee
Introduction
Maximizing shareholder value has become the new
corporate paradigm. Although shareholder wealth
maximization has traditionally been recognized by
managers and researchers as the ultimate corporate
goal, the maxim has gained new dimension in recent
years, thanks to the concept of Economic Value
Added (EVA) coined and registered by Stern Stewart
& Co, New York. EVA is a residual income that
subtracts the cost of capital from the operating profits
generated by a business. Corporations in the US
started disclosing EVA information from the beginning of 90s. Since then, the number of companies
adopting EVA has increased (Wallace, 1997). More
than 300 companies, with revenue approaching a
trillion dollars a year, have implemented EVA
framework for financial management and incentive
compensation (Ehrbar, 1998). Adopting EVA philosophy forces a company to find ingenious ways to
do more with less capital (Tully, 1993).

Maximizing shareholder value has become the

new corporate paradigm. Corporations in the
US have started disclosing EVA information
from the beginning of 90s as a measure of
corporate performance. It is believed that
market value of a firm (hence shareholder
wealth) would increase with the increase in
EVA. Various studies done in the US also
confirm this belief. EVA (a term coined and
registered by Stern Stewart & Co. New York)
is a residual income that subtracts the cost of
capital from the operating profits generated by
a business. The present study makes an at
tempt to find the relevance of Stewart's claim
that market value of the firm is largely driven
by its EVA generating capacity in the Indian
context. Based on a sample of 200 firms over
a period of five years, the study shows that
market value of a firm can be well predicted
by estimated future EVA streams. The study
has also found that market value of most of
the firms in the sample is explained more by
current operational value than future growth
value of firms.

This does not mean EVA concept retards growth.

It only suggests that so long as a company is earning
a return on its investment in excess of the cost of
investment, there is no limit to growth. It is only
when the earning is insufficient to meet the cost of
funds tied up, there arises a need to unlock the fund
and thereby avoid or minimize bad or uneconomic
investments. EVA is a modified version of shareholder value theory. The shareholder value theory
places shareholders at the top in analysing the
economic performance of a business. The shareholder value approach (Rappaport, 1986) estimates
the economic value of an investment by discounting
forecasted cash flows by the cost of capital. These
cash flows, in turn, serve as the foundation for
shareholder returns from dividend and share price
appreciation. EVA is different from shareholder
value theory in the sense that it deducts depreciation
to compute its residual income and also it makes
certain adjustments to convert accounting profit to
economic profit. It is believed that market value of
a firm, at any given moment, is the summation of

Ashok Banerjee is Associate Professor in the Accounting

and Finance Area of the Indian Institute of Management,
Lucknow.

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beginning invested capital and present value of

future stream of expected EVAs. Stewart (1991)
emphasized that to get significant benefits, EVA
should be fully integrated into a company linking
executive compensation to improvement in EVA.
Stewart maintained that if executives' bonus and
other incentives were linked to traditional parameters [e.g., Earnings per share (EPS), turnover,
Return on Net Worth (RONW), etc.], EVA would
fail as a performance measure. This is because
corporate executives, in that case, would have no
incentive to maximize EVA. EVA, thus, is not merely
a financial computation reported at the end of the
year but is a part of the fully integrated management
system. Implementation of EVA system in an organization takes a long time as EVA does not mean
only laying down measurement or computational
techniques. Stewart mentions in Ehrbar (1998) that
there are four Ms in the implementation process
Measurement, Management System, Motivation, and
Mindset. Thus, Stewart (1991) argues that market
value of a firm is largely driven by its EVA generating
capacity. The present study makes an attempt to find
the relevance of Stewart's claim in the Indian
context. The relationship between EVA and market
value is tested on a sample of 200 companies. The
results of the study confirm Stewart's claim.

maximize ROCE, it may reject the project. But,

actually, the project would have added two per cent
economic surplus to the wealth of the firm. Consider
another example. Suppose the present ROCE of the
firm is ten per cent and cost of capital 16 per cent.
The firm receives a new investment proposal with
an estimated ROCE of 12 per cent, with no change
in cost of capital. The firm would accept the proposal
to maximize ROCE. But this decision would destroy
the firm's wealth. EVA compares ROCE with the
cost of invested capital and a firm, with the objective
of EVA maximization, would accept all fresh investment proposals so long as the expected spread is
positive.

Definition of EVA
EVA essentially seeks to measure a company's actual
rate of return as against the required rate of return.
To put it simply, EVA is the difference between Net
Operating Profit after Tax (NOPAT) and the capital
charge for both debt and equity (overall cost of
capital). If NOPAT exceeds the capital charge, EVA
is positive and if NOPAT is less than capital charge,
EVA is negative.
The definition of EVA can be mathematically shown
as below:

It is believed that EVA is a better performance

measure than traditional measures like Earning per
Share (EPS), Return on Capital Employed (ROCE),
or Return on Net Worth (RONW). EPS depends
largely on the vagaries of accounting policies followed by a firm. Thus, EPS is as much reliable as
the accounting profit. Accounting profit (PAT) depends, inter alia, on the firm's capital structure. A
lowly geared firm would return a higher PAT than
a highly geared firm, given the same level of
operating profit earned by both the firms. In
computing accounting profit, only one part of cost
of capital (i.e., borrowing cost) is deducted. As a
result, PAT does not reflect the true economic profit.
EVA, on the other hand, is the residual profit after
deducting full cost of capital from operating profits.
ROCE or RONW considers only one side of the
performance. Exclusive reliance on ROCE or RONW
may lead to rejection of economically profitable
projects or acceptance of unviable projects. Both
would lead to destruction of shareholder value.
Consider a firm with a present ROCE of 22 per
cent and an overall cost of capital of 18 per cent.
The firm receives a new investment proposal with
an estimated ROCE of 20 per cent, cost of capital
remaining unchanged. If the firm's objective is to
Vol. 25, No. 3, July-September 2000

EVA = NOPAT- Capital Charge ............. ( Eq. 1)

= NOPAT- (WACC * Invested Capital)
= (r * Invested Capital)-(c * Invested Capital)
EVA = (r-c) * Invested Capital
EVAt = (r-c) * Invested Capital (M) ................... (Eq.2)
Where,
WACC
= Weighted Average Cost of
Capital
Invested Capital = Invested Capital at the
Beginning of the Year
r
= NOPAT/Invested Capital
c
= WACC
t
= Time Period
The spread (r-c) shows whether a company has
earned a return from its business that is more than
its total cost of capital. If the spread is positive, EVA
would also be positive. The logic for taking beginning invested capital for calculating periodic EVA
is that a company would at least take a year's time
to earn a return on investment. Given a particular
level of spread, EVA would depend on the beginning
invested capital. Given a particular level of invested
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capital, EVA would depend on spread. Thus, there

are two factors that drive EVA the spread and the
invested capital. The spread denotes the relative
profitability and invested capital denotes the size or
growth. If a company has negative profitability (i.e.,
spread), growth in size would reduce EVA. To reduce
the impact of negative EVA, invested capital should
be economized. On the other hand, if the spread
is positive, growth in firm size would indicate higher
EVA. However, it is true that for skill-based companies (e.g., companies in the Information Technology sector) growth does not involve commensurate
increase in invested capital. This may prompt some
people to conclude that EVA would not be a useful
variable to explain stock price movements of a
research-based or skill-driven company. But, Stewart
(1991) defended EVA on this count. Thus, the
message of the EVA formula (Eq. 2) is that if the
return (r) of a company is not adequate enough to
cover the cost of capital (c) in full, more investment
in the business would mean more negative EVA. In
such a situation, the company should try to either
increase the 'r' or reduce the capital invested to
improve EVA. The idea behind EVA is that shareholders must earn a return that compensates the risk
taken. A zero EVA indicates that the return earned
is just sufficient to compensate the risk. EVA holds
a company accountable for the cost of capital it uses
to expand and operate its business and attempts to
show whether a company is creating real value for
its shareholders.

However, the actual number of adjustments

would depend on prevailing GAAP of a country.
In order to avoid complexity in the calculation of
NOPAT, Stewart (1991) suggested four common
adjustments to be made Adjustments for Deferred
Tax Reserve, Last-in-First-Out (LIFO) Reserve, Goodwill
Amortization and R&D Cost Amortization. These items
are called Equity Equivalents.* Equity Equivalents are
added to invested capital and periodic change is
taken to NOPAT. These adjustments make NOPAT
a realistic measure of yield generated for investors
for recurring business activities. It is believed that
these adjustments would truly convert accounting
profit to economic profit.

Stewart (1991) defines NOPAT as the "profits

derived from the company's operations after taxes
but before financing costs and non-cash-book keeping entries." But, in eliminating the impact of "noncash-book keeping" entries, Stewart makes an exception. Depreciation is subtracted to arrive at
NOPAT. Stewart argues that depreciation is subtracted because it is "a true economic expense." In
other words, NOPAT is equivalent to income available to shareholders plus interest expenses (after tax).
It may be noted that Stewart has considered regular
non-operating income (e.g., interest/dividend on
investment) as part of NOPAT. This is a deviation
from traditional definition of operating profit. Also,
to compute NOPAT properly, Stewart identified 120
adjustments (Ehrbar, 1998) to be made to accounting
profit as reported in the profit and loss account.
These adjustments, it is argued, would eliminate
potential distortions in accounting results based on
Generally Accepted Accounting Principles (GAAP)
of a country.

Invested capital refers to total assets (net of

revaluation) net of non-interest bearing liabilities.
From an operating perspective, invested capital can
be defined as Net Fixed Assets (i.e. net block), plus
investments plus Net Current Assets. Net Current
Assets denote current assets net of Non-InterestBearing Current Liabilities (NIBCLS). From a financing perspective, the same can be defined as Net
Worth plus total borrowings. Total borrowings denote
all interest bearing debts. Stewart (1991) mentioned
that adjustments for four Equity Equivalents mentioned above should be made. The adjustments for
Equity Equivalents are intended to arrive at the
economic value of invested capital. Equity Equivalents eliminate accounting distortions. Net worth is
defined as paid up share capital plus reserves and
surplus (net of revaluation reserves) less miscellaneous expenditure less accumulated losses, if any. One

Vol. 25, No. 3, July-September 2000

However, for the purpose of this study, the

computation of NOPAT has been further modified.
NOPAT has been defined as below:
NOPAT = PBIT (nnrt) * (1-T)
Where, PBIT (nnrt) =

Profit Before Interest and

Taxes (net of non-recurring transactions)

= Profit After Tax (PAT)+

Provision for Tax + Interest Expense + Lease RentExtraordinary Income+
Extraordinary Expenses.
T = Effective Tax Rate (Provision for Tax/PBT).

'For a detailed discussion on Equity Equivalents and their

treatment, interested readers may refer to Stewart, B III (1991),
The Quest for Value, Harper Business Publications.

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may argue that this method of calculating invested

capital is not free from depreciation distortions.
Since net block of depreciable assets is considered,
different corporate depreciation policy would affect
the invested capital and hence EVA. Stewart (1991)
tackles it by prescribing a uniform method of
charging depreciation. He mentions that a straightline depreciation or annuity method of depreciation
would minimize the distortions. Such adjusted invested capital (after adjusting for Equity Equivalents
and depreciation) would be called economic capital.
However, invested capital for the purpose of the
study is defined as follows:
Invested Capital

the parameters in the computation of EVA, we now

look at the last factor i.e., WACC.
WACC has been defined in the study to include
three specific costs, viz., cost of equity shares, cost of
preference shares, and cost of borrowings (debt).
Cost of Debt (Kd) is calculated -by multiplying the
pre-tax debt cost with (1-t). It may be noted that
't' denotes the effective tax rate.
Cost of Preference Shares (Kp)= (Preference dividend/
Beginning preference share capital) * 100. Corporate
dividend tax has not been considered because it was
not in vogue during the period under study.
Cost of Equity (Ke) is an opportunity cost equal to
the total return that an investor in a company's equity
could expect to earn from alternative investments
of comparable risk. Cost of equity is not an explicit
cost like cost of debt. The dividend-based approach
or earning-based approach of finding out cost of
equity is not a valid way of calculating the return
expected by equity shareholders. These approaches
only measure the explicit cost of servicing equity.
But, the true measure of equity cost is not what a
company offers but what investors expect. The
opportunity cost of equity capital has been calculated
by following Capital Asset Pricing Model (CAPM)*
(Sharpe, 1964).

= Net Worth + Total Borrowings

Where, Net Worth = Share Capital + Reserves and

Surplus - Revaluation Reserve-Accumulated Losses Miscellaneous Expenditure
Total Borrowings = Long-term Interest-bearing
Debt + Short-term Interestbearing Debt
Adjustments for Equity Equivalents are not
considered in the present study because these are
largely non-existent or inapplicable in Indian conditions (Banerjee, 1999).

EVA and Net Present Value (NPV)

Thus, the computational methodology of EVA

is not unique. Ehrbar (1998) talked about an EVA
spectrum. At one extreme is what is called "Basic
EVA." This is a rudimentary form of EVA arrived
at without making any adjustments. Then follows
"Disclosed EVA." It is the EVA computed by Stern
Stewart & Co to rank companies. "Disclosed EVA" is
computed by making about "a dozen of standard
adjustments to publicly available accounting data."
Next is "Tailored EVA." An insider can calculate this
EVA by making tailor-made adjustments peculiar to
the organization concerned. At the other extreme
of the spectrum is "True EVA."This is the theoretically correct and accurate measure of EVA calculated
with all relevant adjustments to accounting data and
using the precise cost of capital of each division of
an organization. It is extremely difficult to compute
"True EVA."

It is widely tested that the value of a firm is given

by the present value of future stream of free cash
flows. Cash flow is the value driver. Of course, cash
flow also depends on certain operating value drivers.
The NPV method of measuring firm value is used
by Rappaport (1986) in defining shareholder value
of a firm. EVA proponents claim that the firm value
can be measured by discounting future EVAs instead
of future cash flows. A question may naturally arise
- will the firm value differ under EVA and cash flow
approaches? As Table 1 illustrates, the life-time value
of the firm would be the same in the EVA method
of valuation as in the NPV method. We take a simple
*CAPM recognizes the risks associated with equity instruments
and proposes that an investor in this instrument would expect
a risk premium over and above the risk-free rate of return
prevailing in the market. Such a risk premium woutd depend
on the volatility of returns of the equity scrip vis-a-vis that of
market (usually represented by an index). Higher the volatility,
greater would be the risk premium. According to CAPM, the
expected return on equity (i.e., opportunity cost of equity capital)
= Rf + P[E(RJ - R(], where f$ represents volatility, Rf the riskfree rate and E(R m ) the expected market return.

Truly speaking, "Tailored EVA" is the ideal EVA

measure. But, it is difficult for an outsider to use
this definition of EVA for sheer lack of information.
Therefore, in the present study, EVA has been
calculated in a manner that lies in between "Basic
EVA" and "Disclosed EVA." Having defined most of
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example to illustrate the similarity by considering

a firm with a single line of business having five-year
life and a cost of capital of 18 per cent (Table 1).

figure. Thus, new economy firms may be better

valued with EVA.
The advantage of EVA over cash flows' is also
echoed by Sirower and O'Byrne (1998). They
advocated the use of EVA in place of cash flows
to measure periodic operating performance. They
observed that the main shortcoming of free cash flow
(FCF) as a measure of periodic operating performance is that "it subtracts the entire cost of an
investment in the year in which it occurs.... EVA
effectively capitalizes instead of expensing such
corporate investment, and then holds management
accountable for that capital by assigning a capital
charge."

The critical issue, therefore, is: Why should

we use EVA? EVA is better because it is an annual
measure as well as a life-time measure. NPV only
measures the life-time value of a firm. NPV or cash
flow-based method cannot return a reliable annual
performance measure. A firm with high growth
potential would show negative annual cash flows
in the years of growth due to heavy investments.
NPV method deducts the entire investments made
for future growth in one year and thereby reports
a negative cash flow figure for high-growth firms.
EVA, on the other hand, deducts only a capital
charge on such investments from NOPAT. A
dotcom firm, for example, would show huge
negative cash flows in the first few years of its
existence in spite of high revenue. But, the share
price of the firm may still go up. In such a
situation, the cash flow-based model may fail to
explain the share price movements. Also, it may
be difficult to project future cash flows on the basis
of past negative cash flows. EVA measure would
deduct a capital charge on massive investments
made by the dotcom firm in initial years and hence
would return a more reliable annual performance

EVA and Market Value Added:

Relationship
EVA theory simply emphasizes that earning a return
greater than the cost of capital increases the value
of a company and earning less than the cost of capital
decreases the value. Stewart (1991) has introduced
another measure of shareholder value called Market
Value Added (MVA). MVA tells us how much value
the market adds over the book value of invested
capital. MVA, therefore, denotes the confidence of

Table 1: A Comparison of NPV and EVA Methods

Period

Invested Capital

Operating Profit before Depreciation

Depreciation

NOPAT

200

75

90

15

2
3
4
5

120
130
145
130

49.5
27.23
14.97
8.24

70.5
102.77
130.03
121.76

(10.06)*

'Realizable value of assets at the end of five years.

NPV (Method)
Period

Cash Flows

EVA (Method)
P V o f Cash
Flows

NOPAT

Invested
Capital

Cost of
Capital

EVA

PV of EVA

-200

-200

75

63.56

-15

200

36

-51

-43.22

120

86.18

70.5

110

19.8

50.7

36.41

130

79.12

102.77

60.5

10.89

91.88

55.92

145

74.79

130.03

33.27

5.99

124.04

63.98

140.06

61.22

121.76

18.30

3.29

118.47

51.78

Value of the Firm

Vol. 25, No. 3, July-September 2000

164.87

164.87

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considered as independent variables and MVA has

been considered as dependent variables. The relationship between independent and dependent variables was tested in nine industries over a period
of six years (1992-93 to 1997-98). In addition to
conducting regression analysis on each industry
separately, the same analysis is carried on all
companies across the nine chosen industries (crosssectional analysis) for each year. The study failed
to conclude convincingly about the superiority of
EVA over other independent variables in explaining
MVA. The study, however, singled out EVA as the
common significant explanatory variable across
industries. The study could only show that of the
five independent variables, EVA is the better of the
lot.

depends on the rate of return of a company. If a

company's rate of return exceeds its cost of capital,
the company will sell in the stock market with a
premium compared to its book value of capital. On
the other hand, companies that have rate of return
smaller than their cost of capital will sell with
discount compared to their book value of capital.
This principle also applies to EVA. Thus, it is said
that positive EVA also means positive MVA and vice
versa (Stewart, 1991). Maximizing MVA, therefore,
should be the primary objective for any company
that is concerned about its shareholders' welfare.
Thus, EVA is the internal measure of corporate
performance and MVA is the external measure of
corporate performance. MVA reflects how much the
capital market is putting value on the invested
capital.

The objective of the present study is to examine

whether the market value of a firm is best predicted
by expected EVAs. In other words, Stewart's talked
about relationship of market value as equivalent to
the sum of present value of future stream of expected
EVAs is examined. The market value of a firm is
always futuristic. It captures information about a firm
not yet operationally materialized and hence not
present in its income statement. Explaining change
in market value of a firm on the basis of one-year
EVA value may not be quite correct. Stewart (1991)
also mentions that MVA is the present value of future
stream of EVAs. Stewart coined the term Market Value
Added to measure shareholder wealth. MVA is
defined as absolute rupee spread between a company's market value and its invested capital. In other
words, MVA is the difference between a company's
market value of invested capital and book value of
invested capital. The market value of debt is not
readily available, as debts are mostly not traded.
Therefore, the definition of MVA can be modified
as below:

Hence, market value is deemed to be predicted

well with stream of future expected EVAs and not
only with current year EVA. The sample size
considered for the present study is 200 and the
relationship between EVA and market value is tested
over a five-year period data (1993-94 to 1997-98).

Previous Studies
The empirical research of academics to date on this
subject is limited. The results of these studies are
mixed. Stewart (1991) has first studied the relationship with market data of 618 US companies. Stewart
observed that the relationship between EVA and
MVA is highly correlated among US companies.
Lehn and Makhija (1996) in their study of 241 US
companies over two periods (1987-1988 and 19921993) observed that both measures (EVA and MVA)
correlate positively with stock returns and that the
correlation is slightly better with EVA than that with
traditional performance measures like return on
assets (ROA), return on equity (ROE), etc. On the
predictive power of EVA in explaining MVA or
shareholder wealth, several researchers (for example,
Uyemura, Kantor and Petit, 1996; McCormack and
Vytheeswaran, 1998; O'Byrne, 1996; Milunovich
and Tsuei, 1996; Grant, 1996) observed that EVA
is better correlated with MVA or shareholder wealth
than other traditional parameters like ROCE, RONW,
EPS, etc. However, there are adverse findings too.
Dodd and Chen (1996) found that return on assets
(ROA). explained stock returns better than EVA.
Hamel (1997) was critical about the superiority of
EVA. He opined that EVA reveals little about a
company's share of new wealth creation.

MVA = Market Capitalization - Equity Share Capital + Reserves and Surplus - Revaluation
Reserves-Accumulated Losses - Miscellaneous Expenditure.
................ (Eq-9)
It can be observed from the above modified
definition that MVA is almost similar to market pricebook value (p/b) ratio. The only difference is that
MVA is an absolute measure and p/b ratio is a
relative measure. If MVA is positive, it implies that
p/b is greater than one. Negative MVA implies a
less than one p/b ratio. Successful companies add
their MVA and thus increase the value of capital
invested in the business. It is argued that MVA
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Research Methodology

of estimating cost of equity. Use of corporate beta

on the basis of daily share prices may not be
prudent. The basic limitation of taking daily values
is that two companies from the same industry may
not be traded on the same day. Also, the number
of days traded would be different for different
companies. It would be different even for a particular company in different years. In the present study,
beta figures for companies have been estimated
using monthly stock and index returns instead of
daily returns. Most estimation services in US use
five years of data. Our length of estimation period
is also five years, i.e. sixty monthly return figures
to calculate each beta.

It has already been mentioned that:

Cost of Borrowings (KJ = (Total Interest Expense/
Beginning Total Borrowings) * (1-T) * 100
............. (Eq. 10)
It may so happen that Kd calculated according
to Equation 10 may return an abnormally high figure.
This is because the total interest expenses may be
too high compared to the beginning total interestbearing debts. This would give a distorted borrowing
cost figure. The borrowing cost number can show
an artificially high figure because of the following
reasons:
Loans taken during the current year have been
repaid.
Loans taken at the beginning of the current year
so that it does not appear at the denominator
of Kd calculation.
Rescheduling of loan repayment.
Hence, a control variable "normal yearly borrowing cost" has been considered. This is taken as
the Prime Lending Rate (PLR) of the concerned year
of State Bank of India. The SBI's PLR for the period
under study is shown in Table 2 (RBI, 1996-97, 199798).
If the computed K d in any year is more than
the control variable (after-tax), the after-tax control
variable has been considered as the borrowing cost
of that year. This has been done to see whether the
borrowing cost represents the prevailing lending
rates of the banks. If the computed K d in any year
is less than the control variable (after-tax), no
adjustment is made to Kf This is to recognize the
innovative financing routes followed by companies
to minimize borrowing costs.

Another reason for taking five years as the

length of estimation period is that the long-term risk
premium for the purpose of estimating cost of equity
has been estimated on the basis of five-yearly
average figure. Thus, beta for 1993-94 has been
calculated on the basis of past sixty months stock
return figures. It has been found that betas,
calculated on monthly returns, are less volatile
than betas calculated on daily return basis.
MVA has been calculated as the difference
between market capitalization and net worth (net of
adjustments). The market capitalization figures are
normally calculated as number of outstanding
shares multiplied by closing market price on the
last day of the year. This method of computing
market capitalization is subject to high volatility
because it is based on the share price of a single
day, whereas net worth is a cumulative figure and
the increment in net worth occurs throughout the
year. Kondragunta (2000) pointed out that the
average market value should be considered instead
of closing price. So, MVA has been computed by
suitably adjusting market capitalization as
below:
Market Capitalization = Mean Closing Adjusted
Market Price (of Last 30 Trading Days) *
Number of Outstanding Shares

An earlier study on EVA (Banerjee, 1999) used

daily stock returns to compute beta for the purpose
Table 2: SBI's Prime Lending Rate (PLR)
Year

SBI's PLR(%)

1992-93
1993-94
1994-95
1995-96
1996-97
1997-98

19.0
19.0
15.0
16.5
14.5
14.0

Vol. 25, No. 3, July-September 2000

Since MVA attempts to capture the value

added by the capital market at the end of the
year on the basis of a firm's performance, average
adjusted market price of last 30 days (instead of
the whole year) is taken. Adjusted market price
refers to share price after adjustment for bonus
issues and rights issues. It is believed that this
method of computing market capitalization would
reduce its volatility and hence MVA would be
more reliable.
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Sample Selection

EVA improvements (DEVA). Thus the above equation shows that if a firm has no future growth
prospect, its market value would be largely dependent on current operational value. On the other hand,
a growth firm would derive its market value mostly
from future growth value. Therefore, a look at the
value of COV and FGV would tell us whether the
firm in question has market-perceived growth potential.

To test our hypothesis that EVA is a better predictor

of market value, we need a sizeable sample drawn
from different industries. We also need necessary
data for a period covering one business cycle. We
have selected 200 companies across industries. The
criterion for sample selection has been availability
of necessary information for the period under study
(1993-94 to 1997-98). The companies are chosen in
such a way that there does not exist any industry
bias. Companies represent industries like Automobile Ancillaries, Drugs and Pharmaceuticals, Cotton
and Blended Yarn, Finished Steel, Paper and Paper
Products, Tea and Coffee, Cement, Tyres, Heavy
Commercial Vehicles, Computer Hardware and
Software, Cosmetics and Toiletries, Paints and Varnishes, Tobacco, and also a Diversified Group. Thus,
companies have been selected from mature as well
as growing industries.

The computation methodology of COV and

FGV is shown in Table 3 with two companies from
our sample Abbott Laboratories (Drugs and
Pharmaceutical industry) and HINDALCO (Diversified Group).
The computation of COV and FGV (for Abbott
Laboratories) is shown below:
COV = Invested Capital at the End of First Year
(1993-94) + Capitalized Value of Current
(1993-94) EVA
= 12.85+1.16/0.1222 = 22.34 ...... (Eq.12)

Computational Methodology

FGV = Present Value of Incremental EVAs for the

Period 1994-95 till 1997-98 + Present Value
of Residual Value
= (0.39* 0.8911 -3.19*0.7941 + 3.02 *
0.7076 + 0.79* 0.6305) * (1+0.122)/0.122
= 4.15
.........(Eq.13)

The above relationship shows that market value of

a firm (given by market value of equity and book
value of interest-bearing debt) is a function of two
components Current Operational Value (COV)
and Future Growth Value (FGV). COV, in turn,
depends on book value of beginning invested capital
and capitalized value of current year's EVA. FGV
is the summation of present value of future expected

To put it simply, FGV is the capitalized value

of present value of future stream of expected

Table 3: COV and FGV Computations

Company

Beginning
Invested
Capital

Current
EVA
(94-93)

Current
Future
Current
WACC
Returns(r) Operational
(94-93)(%) (%)
Value

Incremental
EVA

(Rs Crore)
Future
Growth
Value

Abbott Laboratories

1993-94
1994-95
1995-96
1996-97
1997-98
HINDALCO
1993-94
1994-95
1995-96
1996-97
1997-98

12.85(end
1.16
of 1993-94)
12.85
15.04
23.93
20.73

12.22

1188.96
1188.96
1919.22
2457.70
2840.07

15.79

Vol. 25, No. 3, July-September 2000

49.95

22.34
24.25
1.33
18.01
22.72

1.55-1.16=0.39
-1.64-1.55=-3.19
1.39+1.64=3.02
2.18-1.39=0.79

4.15

130.77-49.95=80.82
133.12-130.77=2.35
15.06- 133.12=-118.04
103.08-15.06=88.02

326.01

1505.21
26.79
22.73
16.41
19.42
31

Vikalpa

improvements in EVA. The present value of future

incremental EVAs is computed on the basis of
WACC of 1993-94. Hence, for Abbott Laboratories,
the above mathematical relationship can be finally
shown as below:
Market Value
(1993-94 end)
60.18

Market Value = a + b, * COV + b2* FGV ....(Eq.16)

Where,
Market Value = Actual Market Value of a Company
at the End of 1993-94,
= Market Capitalization (End of 199394) + Preference Share Capital (End
of 1993-94) + Total Borrowings (end
of 1993-94)
.............. (Eq.17)

= COV + FGV + e
= 22.34 -I- 4.15 + e .........(Eq.14)

For HINDALCO, the relationship is

2384.93

Equation 17 attempts to show that estimated

market value of a company is highly correlated with
actual market value. Estimated market value is
largely a function of FGV of a company. The above
regression result would show how much of the
variation in market value of different companies is
explained by COV and FGV. It may be reiterated
that EVA of 1993-94 has been considered as current
EVA and present value of incremental EVAs (199495 to 1997-98), discounted by weighted average cost
of capital of 1993-94, is the FGV (end of 1993-94).
Therefore, a high correlation between independent
variables and market value would indicate that
current and future EVAs significantly explain the
market value of a company. A company can increase
its market value by ensuring a sustained improvement in EVA.

= 1505.21 + 326.01 -I- e ......(Eq.15)

(Where e stands for the error term)

We can observe from Table 3 that Abbott

Laboratories experienced very high volatility in its
returns. It was 24.25 per cent in 1994-95, dropped
to a paltry 1.33 per cent in 1995-96 and again rose
to a respectable 18.01 per cent in 1996-97. Abbott's
profit before interest and tax (net of non-recurring
items) was only Rs 0.20 crore in 1995-96 as
compared to Rs 5.4 crore in 1994-95 and Rs 4.31
crore in 1996-97. The main reasons for such a dismal
performance in 1995-96 were higher wage cost
[14.07% of net sales as compared to 10.97%(199495) and 5.66%(1996-97)] and a high general and
administrative overheads (16.86% as compared to
13.43% in 1994-95 and 9.44% in 1996-97). Such poor
return in 1995-96 resulted in negative EVA and
hence a lower FGV.

Regression Results and Interpretations

The computed values of independent and dependent
variables are given in Appendix 1. Regression results
are encouraging. The results of the regression equation are summarized in the Box. The results show
that independent variables (COV and FGV) significantly explain the variations in market value

A similar computational technique is followed

for other companies in the sample. Based on computed values of EVA, the following linear regression
has been drawn to establish the relationship between
EVA and Market Value:

Box: Regression Results of EVA and MVA Relationship

1

Product-Moment Correlation (Sample Size: 200)

Market Value
(MV)

COV

FGV

Market Value (MV)

1.000

0.821

-0.279

COV

0.821

1.000

-0.592

FGV

-0.279

-0.592

1.000

Regression Results
MV = 63.578 + 2.057 * COV + 0.986 * FGV
(1.101)
(22.380***)
(7.047***)
Note: Figures in parenthesis indicate t-statistic.
*** indicates significance at 1 per cent level.
Vol. 25, No. 3, July-September 2000

(R 2 = 0.740, Adj.R 2 = 0. 737, F-statistic

279.991*** Durbin-Watson Statistic 2.047)

32

Vikalpa

(Adjusted R-squared '= 73.7%). This confirms our

hypothesis that market value estimated on the basis
of current operational value and future growth value
is highly correlated with actual market value. It has
already been noted that future growth value depends
on expected EVA improvements. In the present
study, no projection has been made to estimate
future EVAs. The year 1993-94 has been considered
as the current year and actual data for next four
years (1994-95 to 1997-98) are considered to calculate
the future growth value. To calculate EVA for the
four-year period (1994-95 to 1997-98), weighted
average cost of capital of 1993-94 has been considered. However, the same regression can be carried
on the basis of estimated EVAs for future periods.
For that purpose, a number of assumptions are to
be made to project growth.
A look at the COV and FGV figures would tell
us the market implied growth potential of a company.
Consider a few examples as listed in Table 4.

current state of affairs and future growth potential.

It sends a clear message it is important to earn
positive EVA but it is more important to achieve
a sustained improvement in EVA. The market value
(end of 1993-94) of TISCO is significantly higher
than its COV. This does not imply that the share
price of TISCO was increasing throughout. In fact,
share price of TISCO, which was Rs 193.75 as on
March 31, 1994, had fallen to Rs 149.20 as on March
31, 1998. The negative FGV of TISCO captures
this fall in share price.
The t-statistics of COV and FGV is significant
at one per cent level and the constant is insignificant.
This implies that COV and FGV significantly explain
the market value of the sample. The Durbin-Watson
value also justifies the relationship. An important
feature to be noted in this result is that the coefficient
of EGV is lower than that of COV. It implies that
market value of most of the firms in our sample is
a reflection of more of current operational value and
less of future growth value. It further implies that
the firms in our sample have less market implied
growth potential.

Table 4: COV, FGV, and Market Value of

Some Companies
Rs Crore

COV

Ashok Leyland
Hindustan Lever
Ltd. (HLL)
Procter & Gamble
India Ltd. (P&G)
TISCO
Wipro Ltd.

FGV

Market Value

788.27

-598.65

2282.15

958.08

1976.42

7562.65

41.73
3866.62
112.22

133.02
-594.24
218.68

717.71
10296.28
82.46

Conclusion
However, Appendix 1 also reveals a darker side.
There exists a huge gap in many cases between actual
market value and the sum total of COV and FGV.
For example, in case of HLL, the market value (end
of 1993-94) was Rs 7562.65 crore and the FGV was
only Rs 1976.42 crore. It implies that FGV has failed
in these cases to capture the growth potential
factored in the market value of HLL. Another
possible explanation for FGVs poor predictive power
could be that FGVs are calculated here on the basis
of actual operating results of the firms during the
period 1994-95 to 1997-98. A longer time horizon
and calculation of FGV on the basis of expected
future EVAs might produce a better relationship
between FGV and market value. The market capitalization factors in a longer time horizon and
capilatizes the growth potential of a firm during the
future period. Computing FGV only on the basis
of four-year data (1994-95 to 1997-98) might have
led to underestimation of future growth potential.
We have not attempted here to estimate future EVAs
simply because that exercise would involve more
assumptions. In the absence of published information about equity analysts' future projections of firms'
performance, it would have been very difficult to
estimate economic parameters .of these 200 sample

HLL, P&G, and Wipro have future growth

potential. FGV is twice that of COV for HLL and
W i p r o . F o r P & G , F G V i s mo r e t h a n t h r e e t i me s
of COV. The improvement in EVA is greater for
P&G. Ashok Leyland and TISCO, on the other
hand, have negative FGV figures. In case of Ashok
Leyland, the negative FGV is more than 70 per cent
of COV figure. It implies that whatever current EVA
the company has been able to achieve, it could not
generate positive EVAs for future years (1994-95 to
1997-98, in this case). The company does not have
encouraging growth prospects. TISCO also shows
negative growth prospect. But, its current operational value (for 1993-94, in this case) is quite high.
TISCO signifies a typical case of a steel company
i n I n d i a i n 9 0 s . E v e r y c o mp a n y i n t h i s i n d u s t r y
is passing through a difficult phase excess capacity, inventory pile up, dumping by foreign players,
etc. The FGV figure tells that story. Appendix 1,
therefore, gives a better picture of a company's
Vol. 25, No. 3, July-September 2000

33

Vikalpa

firms drawn from diverse industries. Estimating

future EVAs for these firms, then, would require
some generalization of assumptions. Such an effort

might have been counter-productive. Therefore, the

above results could be considered keeping in mind
these limitations.

Appendix 1: Computed Values ofIndependent and Dependent Variables

Company Name

COV
(1994)

FGV

Company Name

MV
(1994)

Ceat Ltd.
Century Textiles & Inds. Ltd.
Cheminor Drugs Ltd.
Cimmco Birla Ltd.
Cipla Ltd.
Clutch Auto Ltd.
Colgate-Palmolive (India) Ltd.
D C W Ltd.
Dalmia Cement (Bharat) Ltd.
Deccan Cements Ltd.
Denso India Ltd.
Dewan Rubber Inds. Ltd.
Dr. Reddy'S Laboratories Ltd.
Duphar-Interfran Ltd.
E I D-Parry (India) Ltd.
E Merck (India) Ltd.
East Coast Steel Ltd.
Elgitread (India) Ltd.
Escorts Ltd.
Essar Steel Ltd.
Eurotex Industries &
Exports Ltd.
Falcon Tyres Ltd.
Finolex Cables Ltd.
Forbes Gokak Ltd.
Fulford (India) Ltd.
G K N Invel Transmissions
Ltd.
G S L (India) Ltd.
Gabriel India Ltd.
Gajra Bevel Gears Ltd.
German Remedies Ltd.
Godfrey Phillips India Ltd.
Goetze (India) Ltd.
Gontermann-Peipers (India)
Ltd.
Goodricke Group Ltd.
Goodyear India Ltd.
Govind Rubber Ltd.
Grasim Industries Ltd.
Greaves Ltd.
Gujarat Ambuja Cements Ltd.
Gujarat Lyka Organics Ltd.
Hardcastle & Waud Mfg.
Co. Ltd.

AFT Industries Ltd.

85.43
27.63
75.70
Abbott Laboratories (India) Ltd. 22.37
4.15 60.18
Advani-Oerlikon Ltd.
51.36 22.86 76.29
Albert David Ltd.
22.16 -15.94 38.40
Alfa Laval (India) Ltd.
126.10 -96.46 874.97
Amtek Auto Ltd.
20.53
17.74
9.86
Andhra Pradesh Paper Mills Ltd. 65.64 -20.51 102.88
Apollo Tyres Ltd.
233.35 147.39 637.31
Arvind Mills Ltd.
1262.52 -847.74 2054.38
Asea Brown Boveri Ltd.
277.95 -66.08 637.52
Ashok Leyland Ltd.
788.27 -598.65 2282.15
Asian Coffee Ltd.
33.81 -10.02
77.05
Asian Paints (India) Ltd.
288.42 160.10 528.20
Associated Cement Cos. Ltd.
895.76 -645.90 824.83
Astra-Idl Ltd.
24.06 30.48 33.89
Autolite (India) Ltd.
36.66 -46.43 51.12
Automobile Corpn. Of Goa Ltd. 31.74
51.31
5.27
BASF India Ltd.
104.77 -28.21 284.83
Bajaj Auto Ltd.
1200.29 617.92 1660.82
Banco Products (India) Ltd.
32.67
20.64
9.33
Baroda Rayon Corpn. Ltd.
231.68 -235.60 123.13
Bayer (India) Ltd.
203.63 -45.28 711.27
Berger Paints India Ltd.
44.21 20.88 33.54
Bharat Bijlee Ltd.
26.48 -0.28
47.13
Bharat Forge Ltd.
323.57 -148.08 695.31
Bharat Gears Ltd.
24.06 29.59 43.62
Bharat Seats Ltd.
14.70 -1.33
15.26
Bimetal Bearings Ltd.
44.88 -14.03 137.86
Birla Corporation Ltd.
284.85 -255.33 919.1
Birla Yamaha Ltd.
24.63
1.75 5
Blow Plast Ltd.
46.63 -33.53 47.24
Blue Star Ltd.
64.10 15.44 50.26
Bombay Burmah Trdg.
Corpn. Ltd.
60.09 -43.07
44.46
Bombay Dyeing & Mfg.
Co. Ltd.
710.94-490.02 1649.74
Britannia Industries Ltd.
102.94 49.16 511.03
Burroughs Wellcome (India) Ltd. 71.91
193.40
8.98
Cadbury India Ltd.
42.67 59.52 233.36
Camlin Ltd.
21.22 16.42
29.61
Caprihans India Ltd.
76.03 -118.79
88.51
Carrier Aircon Ltd.
33.55 66.91
146.74
Castrol India Ltd.
325.54 279.35 453.63

COV
(1994)
534.13
1582.42
112.07
174.50
281.45
28.30
409.41
175.33
120.25
29.41
23.29
124.55
330.07
31.11
192.51
385.12
34.67
38.86
267.25
4095.27

FGV

MV
(1994)

54.65 854.13
1594.72 1140.23
-37.38 170.26
-84.20 138.06
545.43
91.03
-3.45 32.91
-2.08 6416.90
-108.60 263.03
-46.91 296.33
10.05 42.16
10.06 105.68
-74.42 121.58
81.64 291.15
-14.66 59.28
-186.60 370.14
207.11 297.95
-24.22
32.44
18.24 36.20
-113.41 514.15
3449.07 4075.24

35.62
26.95
269.29
139.64
13.80
34.89
94.06
72.65
11.10
129.11
107.29
87.40
25.75
88.65
77.05
69.30
2398.06
230.28
914.55
79.60

-1.30 5.41 273.62

-27.77
11.49 4.21 63.38 26.61 0.61
160.55
116.67 10.43 108.27
-17.60 19.37 8.41 838.57
-44.93 231.79
-96.92

11.33

-5.41

72.97
13.67
254.20
427.87
35.98
97.35
89.26
104.10
22.49

263.15
349.13
127.99
20.62
438.41
107.10
111.66
5573.31
365.35
991.73
26.39

15.99

(Appendix 1 Contd.)
Vol. 25, No. 3, July-September 2000

34

Vikalpa

Company Name

COV
(1994)

FGV

MV
(1994)

Company Name

COV
(1994)

T I L Ltd.

54. 94

28 .21

74.14

VST Industries Ltd.

T T K Pharma Ltd.
TVS Srichakra Ltd.
Talbros Automotive
Components Ltd.
Tata Chemicals Ltd.
Tata Engineering &
Locomotive Co. Ltd.
Tata Infotech Ltd.
Tata Iron & Steel Co. Ltd.
Tata Tea Ltd.
Tata-Yodogawa Ltd.

66.67
15. 34

1 .36
9 .31

65.06
17.48

Vardhman Spinning &

General Mills Ltd.
Videocon Appliances Ltd.
Vikrant Tyres Ltd.
Voltas Ltd.
Warren Tea Ltd.

265 .16
497.87
86. ,56
361. 08
51. 95

West Coast Paper Mills Ltd.

Wimco Ltd.
Wipro Ltd.
Z F Steering Gear (India) Ltd.

46.
75.
112.
8.

Zuari Industries Ltd.

Ambalal Sarabhai
Dee Pharma
Gujarat Themis

254. 44
103. ,56
41.57
-6. ,82

Ucal Fuel Systems Ltd.

Uttam Steel Ltd.
V D O India Ltd.
VIP Industries Ltd.

10, ,7
5 .36
12.90
2204 .1 851 .43 4277.06
1774.
80.
3866.
552.
32

63 -100 .01 5261.92

55 59 .54 103.26
62
- .2410296.28
24 14 .58 1777.20
.1 -2 .87
62.94

32. ,0 23 .37
194 .1 -161 .11
46. 44
-21.51
97.43 9 .76

50.24
198.44
33.08

126.14

FGV

MV
(1994)

160.72 -88. 65

752.41

-30. 98 224.47
-114.68 669.74
51. 03 160.15
-194.52 729.51
28.15 327.02

29 19. 39
25 -55. 22
22 218. 68
39
-9.37

13.11
181.29
82.46
18.44

168.14 328.22
- 55 176.72
- 52 26.24
3. 34 96.03

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