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It is notable that many companies in India are focusing on value creation. The companies have adopted different
methods of measuring shareholder value. A number of them measure and report Economic Value Added (EVA),
Market Value Added (MVA) and shareholder return based on the market value of shares.
Several researchers and practitioners have claimed that Economic Value Added (EVA) is superior to traditional
accounting measures in driving shareholder value. EVA is one such innovation. Unlike conventional accounting
measures of performance, EVA attempts to measure the value that firms create or destroy by subtracting a capital
charge from the cash returns they generate on invested capital. The conventional measures are Return on Equity
(ROE), Return on Net worth (RONW), Return on Capital Employed (ROCE) and Earnings per Share (EPS).
EVA combines factors such as economy, accounting and market information in its assessment. This paper
describes and compares the EVA with other measures. This study is attempts to calculate the EVA and
conventional performance measures.
Apart from this, taking the real financial data of a company, the paper shows how EVA calculations can be done
to demonstrate whether the company is adding to shareholder value by generating profits over and above the
capital charge. From the analysis it can observed that EVA can be treated as one of the best measure for
measuring the value of shareholders.
Key Terms: Earnings per Share (EPS), Economic Value Added (EVA), Return on Capital Employed (ROCE) and
Return on Net worth (RONW).
(I)
Introduction
To create value for the entire company means to maximize the total value. A traditional measure reflects historical
performance, having a limited relevance for anticipate the future evolution of performance. Under conventional
accounting, most companies emerge profitable but many in fact are not. As Peter Drucker rightly remarked in a
Harvard Business Review article, Until a business returns a profit that is greater than its cost of capital. It
operates at a loss. Never mind that it pays taxes as if it had a genuine profit. The enterprise still returns less to the
economy than it devours in resources.. Until then it does not create wealth; it destroy it.
return on Investment, return on net assets, return on assets etc. The main shortcoming with all these rates of
return is that in all cases Maximizing rate of return does not necessarily maximize the return to shareholders.
Computation Includes
Measures
Returns
Cost of CE
NOPAT
Yes
No
No
ROCE
Yes
Yes
No
EPS
Yes
Yes
No
From the above table. It is clear that traditional measure of corporate performance does not consider cost
of capital in calculation of NOPAT whereas EVA includes the same.
(II)
Literature Review
A number of studies have been conducted to establish the relationship between EVA and traditional
accounting measures
r2
EVA
50%
ROE
25%
22%
EPS growth
18%
Asset growth
18%
Dividend growth
16%
Turnover growth
9%
Source: Adapted from Stern (1933:36)
Ashok Banerjee in his research titled as, Economic Value Added (EVA): a better performance measure
,has argued that for superiority of EVA over other traditional financial performance measures. Ten industries
have been chosen and each industry is represented by four/five companies. ROI and EVA have been
calculated for sample companies and a comparison of both has been undertaken, showing the superiority of
EVA over ROI. Indian companies are gradually recognizing the importance of EVA. Some of such companies
are Ranbaxy Laboratories, Samtel India Ltd and Infosys Technologies Ltd.
Pattanayak and Mukherjee3 (1998) in his research, found out that there are traditional methods to measure
corporate income or known as accounting concept and there is also a modern method to measure corporate
income or known as economic concept. EVA, which is based on economic concept, is professed to be a
superior technique to identify whether the organizations NOPAT (Net Operating Profit after Tax) during a
period is covering its WACC (Weighted Average Cost of Capital), thus generating value for its owners. But it is
very tricky to calculate EVA. Companies trying to implement EVA are asked to incorporate 164 amendments to
their financial accounts.
Uyemura et al.4 EVA and wealth creation Uyemura et al. (1996:98) In his research he used a sample of the
100 largest US banks for the ten-year period from 1986 to 1995 to calculate MVA and to test the correlation
with EVA, as well as four other accounting measures, namely net income (amount), EPS, ROE and ROA. The
results of their regression analysis are set out in Table 2.
Performance Measure
r2
EVA
40%
ROA
13%
ROE
10%
8%
EPS
6%
Source: Uyemura et al. (1996:98)
The analysis above clearly shows that EVA is the measure that correlates the best by far
with shareholder wealth creation. In an alternative approach where changes in the performance measures were
regressed against standardized MVA, the results were not very different. Standardised EVA (EVA divided by
capital) again had an r2 of 40%, while for ROA it was 25%, for ROE it was 21%, for net income it was 3% and for
EPS it was 6%.
Milunovich and Tsueis5 study on the use of EVA and MVA in the US computer industry
Milunovich and Tsuei (1996:111) investigated the correlation between frequently used financial measures
(including EVA) and the MVA of companies in the US computer technology industry (so-called server-vendors)
for the period from 1990 to 1995. The results of their study are set out in Table 3.
Performance Measure
r2
EVA
42%
EPS Growth
34%
ROE
29%
25%
FCF
18%
Clearly EVA demonstrated the best correlation and it would be fair to infer that a company that can consistently
improve its EVA should be able to boost its MVA and therefore its shareholder value. Milunovich and Tsuei
(1996:111) argue that the relatively weak correlation between MVA and FCF is due to the fact that FCF can be a
misleading indicator. They point out that a fast-growing technology start-up company with positive EVA investment
opportunities and a loss-making company on the verge of bankruptcy can have similar negative cash flows. They
concluded that growth in earnings is not enough to create value, unless returns are above the cost of capital. They
are of the opinion that EVA works best as a supplement to other measures when one is evaluating shares and that
EVA sometimes works when other measures fail.
Ghanbari and Sarlak6 (2006) studied economic value added in Indian automobile industry. The objectives of the
study are: to compute and analyze Economic Value Added (EVA) of firms in the automobile industry and to identify
the EVA trend of the industry the period of the study. The study found that the Economic Value Added (EVA) of
only 30 % of the selected companies is positive and 70 % of the selected companies have destroyed their
shareholders wealth by negative EVA. The study concluded that there has been a significant increasing trend in
EVA of the Automobile Industry firms which means that companies have a positive trend to improve their firm
values.
(III) Objectives:
1. To calculate the EVA and Traditional Performance measures like ROCE, EPS, RONW of ITC Ltd.
2. To compare EVA with the Traditional methods for evaluating a companys financial performance
S. NO.
Companies
1.
2.
3.
Nestl India
4.
GCMMF (AMUL)
5.
Dabur India
6.
7.
Cadbury India
8.
Britannia Industries
9.
10.
Marico Industries
Source: Naukrihub.com
W2 is weight of DEBT
Ke is cost of EQUITY
Kd is cost of DEBT
Where
Rf is Risk-Free Rate of Return.
Rm is Average Return from Sensex which is considered as proxy to Market.
is Beta.
Kd = Interest expences (1- Tax rate) / Amount of Debt
Sources of Data
Particulars
2007
2008
2009
2010
2011
200.88
208.86
214.43
165.92
177.55
2. Equity
10437.08
12057.67
13735.08
14064.38
15953.27
3.Capital Employed
10637.96
12266.53
13949.51
14230.30
16130.82
4. Cost of Debt%
4.29
8.27
13.24
44
32.85
5. Cost of Equity
17.50
17.50
17.50
17.50
17.50
17.25
17.34
17.34
17.81
17.67
7.COCE (3*6)
1835.11
2127.36
2432.02
2534.27
2850.14
2699.97
3120.10
3263.59
4061
4987.61
8.62
17.27
28.38
73
58.32
2708.59
3137.37
3291.97
4134
5045.93
1835.11
2127.36
2432.02
2534.27
2850.14
12. EVA(10-11)
873.48
1010.01
859.95
1599.73
2195.79
1.Debt
Capital % (WACC)
exceptional items
9. Add: Interest, After taxes
10. Net Operating profit After taxes
(NOPAT)
Interpretation
From the above table, it can be inferred that the company has been adding value to the shareholders
during the period of study (2007-2011). The calculation of EVA depends on the calculation of the
components of the EVA. The major components of EVA are NOPAT and COCE. The EVA of the
company has been increased from Rs.873.48 Crores for the year 2007 to Rs.2195.79 Crores for the
year 2011, indicating thereby a good economic earning capacity of the company. However, in the
year 2009 the EVA has indicated a significant decline it can be observed that the key reason behind
the same is sharp rise in cost of debt compared to last year. As mentioned in above table, in last two
years, the EVA has increased significantly.
EVA in
Crores
ROCE (%)
RONW
EPS
(%)
% of
Capital
Employed
EVA as a
% of Net
Worth
EVA as a %
of No. of
Shares
outstanding
2007
873.46
25.38
25.86
7.23
8.21
8.37
2.34
2008
1010.01
25.44
25.88
8.28
8.23
8.38
2.68
2009
859.95
23.40
23.76
8.64
6.16
6.26
2.28
2010
1599.73
28.54
28.74
10.64
11.24
11.24
4.19
2011
2195.78
30.92
31.26
6.45
13.61
13.61
2.84
Interpretation:
From the above table 2, it was observed that ITC Ltd. portrays a glowing picture in terms of Return on Capital
Employed, Return on Net worth and EPS. In the year 2007, ROCE is 25.8% i.e., for every Rs 100 investment the
return is Rs 25.38, where as EVA as a % of Capital Employed is only 8.21 i.e., for every Rs 100 investment, the
company has added value of Rs 8.21.On an average, the Return on Capital Employed during the study period is
26.74 % whereas average EVA as a % of Capital Employed is 9.6%. In the year 2007, RONW is 25.86 % i.e., for
every Rs 100 investment the return is Rs 25.86, whereas EVA as a % of Net Worth is only 8.37 i.e., for every Rs
100 investment, the company has added value of Rs 8.37. In the year 2007, EPS was 7.23% i.e., for every Rs
100 investment the return is Rs 7.23, whereas EVA as a % of Outstanding shares is only 2.34 i.e., for every
Rs100 investment, the company has added value of Rs 2.34. Thus the comparison shows that divergence exists
between the performance results given by traditional methods and EVA. The conventional measures do not
reflect the real value addition to shareholders wealth.
(VI) Conclusion
From the analysis, it is clearly observed that EVA, when compared with traditional measures, it gives exact figures
how much really the shareholder is going to get at the end of the accounting year by considering cost of capital
like cost of equity, cost of debt. Hence I conclude that EVA is the best appropriate measure for measuring the
value of shareholders.
References
1. [1] Stern, J, The EVA Challenges, New York: John Willey & Sons, 1993, pp. 25-35.
2. Banerjee, Ashok (1997), Economic Value Added (EVA): a better performance
measure, The Management Accountant, December 1997, pp. 886 888.
3. Pattanayak, J.K., Mukherjee, K. (1998), Adding Value to Money, The Chartered
Accountant, February 1998, pp. 812.
4. Uyemura, D. G., C. C. Kantor and J. M. Petit, EVA for Banks: Value Creation, Risk
Management and Profitability Measurement, Journal of Applied Corporate Finance,
9(2), 1996, pp. 94-111.
5. Milunovich, S. and A. Tsuei, EVA in the Computer Industry, Journal of Applied
Corporate Finance, 9(2), 1996 pp. 104-115.
6. Ghanbari, M. Ali and Sarlak, Narges (2006), Economic Value Added: An Appropriate
Performance Measure in the Indian Automobile Industry, The Icfain Journal of
Management Research, Vol. V, No. 8, March 2006, pp. 45-57.
7. Chen, S. and J. L. Dodd, Economic Value Added: An Empirical Examination of a New
Corporate Performance Measure, Journal of Managerial Issues, 9(3), 1996, pp. 318333.