Economic value added: applications and analysis

Economic Value Added (EVA)

An Examination of the Efficacy of Economic Value Can Improve a Company's Profitability

The need for improved transparency and improved corporate governance is greater than ever, and many companies are faced with increasing competition by virtue of a globalized marketplace. In this environment, some experts suggest that a company's economic value added function represents the best and most reliable method for measuring the profitability or value of the company and for maximizing shareholders' wealth today. Some analysts, though, have soundly criticized the economic value added technique as providing misleading results of financial performance. To determine the validity of these assertions, this study provides a discussion concerning how economic value added is in fact the most accurate tool for measuring profitability of a company and how various economic value added functions can be implemented to maximize the profitability of a company and therefore the organizational goal of maximizing shareholders wealth, followed by a summary of the research in the conclusion.

Review and Discussion

Background and Overview.

Economic value added (EVA) is shareholder value measurement technique that was originally developed by the New York firm of management consultants Stern Stewart Management Services (Mcmenamin, 1999). The original definition of EVA provided by Stern Stewart of New York City states that "EVA is the difference between a company's net operating income after taxes and its cost of capital of both equity and debt" (Stern Stewart, 1993, p. 37). Although the term EVA had appeared in the literature as early as 1989 (Finegan, 1989; Walter, 1992), it did not receive much attention until a September 20, 1993, article in Fortune magazine (Tully, 1993). Following the article's strong praise of EVA as the most recent and exciting innovation in measuring corporate success, a flurry of papers have been published telling successful EVA stories and promoting EVA adoption Today, the EVA approach is being touted as a useful technique for measuring the real economic value created for shareholders by a firm's management for a given year (Mcmenamin, 1999). According to Brewer, Chandra, and Hock (1999), "EVA is a financial performance measure based on operating income after taxes, the investment in assets required to generate that income, and the cost of the investment in assets (or, weighted average cost of capital). The three elements used in calculating EVA are operating income after tax, investment in assets, and the cost of capital" (p. 4). The primary formula for measuring EVA is:

EVA = After tax operating income - (investment in assets x weighted average cost of capital). EVA is a dollar amount. If the dollar amount is positive, the company has earned more after-tax operating income than the cost of the assets employed to generate that income. In other words, the company has created wealth. If the EVA dollar amount is negative, the company is consuming capital, rather than generating wealth. A company's goal is to have positive and increasing EVA. (Brewer et al., 1999, p. 4)

Because the EVA seeks to realistically measure a company's economic profit for a given year by making adjustments to the traditional accounting profit reported in the profit and loss account, profits, for example, will be adjusted to take into account any non-cash items such as depreciation; in this regard, yet another method of calculating EVA is as follows:

EVA = Operating profit cost of capital where,

Operating profit = Total revenues operating costs taxes

Cost of capital = Total capital supplied X cost of capital (Mcmenamin, 1999, p. 280).

In the formula above, the cost of capital is equal to the total value of all the capital supplied, debt and equity, multiplied by the weighted average cost of capital (WACC) (Mcmenamin, 1999). Further, the weighted average cost of capital is typically expressed as a single composite percentage figure that is determined by multiplying the cost of each individual source of capital -- ordinary shares, preference shares, bonds and loans, all valued at their market, not book, values -- by the respective proportion or percentage that each individual source forms of the total capital structure (Mcmenamin, 1999). According to this author, "The weighted average cost of capital (WACC) thus reflects the relative importance of each individual source of long-term finance in the firm's overall capital structure" (Mcmenamin, 1999, p. 280). Not surprisingly, not everyone is in agreement that the EVA approach provides managers with a meaningful and realistic picture of a company's financial performance during a given period of time, and these issues are discussed further below.

Efficacy of Economic Value Added as a Measure of Profitability.

According to Ray (2001), there is mixed evidence concerning the efficacy of economic value added as a financial-management tool. "In recent years," he advises, "Economic Value Added has been touted by the popular press as the financial savior of the corporate world. Indeed, Fortune magazine described EVA as 'today's hottest financial idea and getting hotter'" (p. 66). Financial-management initiatives such as identifying effective measures of a company's performance have been largely in response to a new emphasis on the financial aspects of organizational performance (Neely, 2002). While empirical observations suggest that value is what someone is willing to pay for something, the formal definition indicates that in this context, "Value is simply the quality/price which is perceived/paid by the customer. The quality component of value includes the inherent quality of the particular product or service, as well as all of its auxiliary features (follow-up service, complaint resolution, etc.)" (Ray, 2001, p. 66). If companies compete in free markets, then they are going to be faced with some tough decisions about what products and services they should provide their customers based on frequently changing wants and needs - and if they do not get it, they will quickly move on to a competitor that will. In this regard, Ray (2001) suggests that there must be a reasonable return on the customer's investment in terms of satisfaction for the price paid if there is any competition in a given industry. From the consumers' perspective, the price of the product or service must be on a par commensurate with, or, ideally commensurately lower than, the consumers' perceived value of the product or service received (Ray, 2001). Absent this, consumers will feel that they have not received real value from the transaction, and the bottom-line for the companies involved with be severe: "In the long run, if a firm's customers perceive that they're not receiving value, then the firm will almost certainly become just another corporate fatality (assuming free markets, of course)" (Ray, 2001, p. 66).

Many observers may suggest that the foregoing factors are intuitive and well-known in the business world, but Fletcher and Smith (2004) emphasize that the numerous financial metrics that are used otherwise to track financial performance may satisfy "spreadsheet junkies" by providing them with snippets of timely data, but these metrics fail to provide analysts with the "big picture" involved that takes into account all of the exchanges that are required to produce a company's return on shareholders' investment. For instance, Fletcher and Smith (2004) report that, "According to economic theory, a firm is creating value if the net present value of all its investments is positive. Quite simply, EVA is a measure that enables managers to see whether they are earning an appropriate return on the capital under their control. It is a measure of profit less the cost of capital employed and is the one measure that properly accounts for all the complex trade-offs, often between the income statement and balance sheet, in creating value" (Fletcher & Smith, 2004, p. 2). Even though the EVA represents a potentially valuable resource in the financial analysis toolbox, there are some constraints to its implementation and management that have caused some observers to suggest that it the approach is not all that it is cracked up to be, and these issues are discussed further below.

Implementing Economic Value Added Initiatives to Maximize Organizational Profitability.

The increasing popularity of the economic value added approach to measuring a company's financial performance has been accompanied by a number of scholarly studies that have determined that while the EVA formula itself might be straightforward, implementing these processes that support the approach are not as easy. For example, according to their recent study, "Managing for Value," Fletcher and Smith (2004) report that, "Economic value added (EVA) systems have generated a tremendous interest in corporate America recently as approaches to performance management. Implementation of these methodologies has not proven to be easy" (emphasis added) (p. 1). Likewise, Mcmenamin (1999) points out that, "The fact that new techniques or approaches to value measurement are continually being developed and promoted is testimony to the importance of the value concept in business and finance and also of the inherent complexity in its measurement" (p. 279). Given these inherent constraints on implementation and administration, it is not surprising that there have been some mixed results using the economic value added approach.

Based on the results of their comprehensive analysis of how EVA has played out in numerous real-world settings, Chen and Dodd (1997) report that: "Our primary finding is that EVA is a useful measure of corporate performance. However, EVA is neither as perfect as claimed by its advocates, nor is it the only performance measure that suggests a path to a superior stock return" (emphasis added) (p. 319).

More importantly, though, while the economic value added measurement approach to financial performance may not be without its detractors, the scholarly literature is consistent in emphasizing the need for such initiatives for companies to remain competitive in an increasingly globalized marketplace today. For instance, in his recent essay, "Profit-Increasing Strategies," Tracy (2006) reports that there are a number of ways for most companies to add value to their product or service. "There are many strategies for generating sales, profitability and wealth in every industry," he advises. "Your ability as an entrepreneur to create a profitable business where no business existed before is the key to your success. In every market, it's usually true that 20% of the businesses earn 80% of the profits in their industry" (Tracy, 2006, p. 2).

The studies of companies to date concerning their ability to capture market share suggest that these companies have the following in features common: