EVA or Economic profitis a measure of company’s financial performance based on the difference between return on

invested capital and appropriate charge for the cost of capital invested in an enterprise or firm.

EVA = net operating profit after taxes [capital * cost of capital (WACC))]

EVA is an estimate of true “economic” profit, or the amount by which earnings exceed or fall short of the required minimum rate of return that shareholder and lenders could get by investing in other avenues of comparable risk.

To inflate the earnings and to show the rosy picture companies often break the accounting rules and try to bend the rules to smoothed their earnings. In this way the ethics becomes backend. So, to find out the reliable intrinsic value of all companies in all time EVA is of great significance.

EVA eliminates confusion by using a single financial measure that links all decision-making with a common focus. EVA provides a common language for the users and allows all management decisions to be modeled, monitored, communicated and compensated in a single and consistent way – always in terms of the value added to shareholder investment.

A sustained increase in EVA will bring an increase in the market value of a company. This approach has proved effective in virtually all types of organizations, from emerging growth companies to turnarounds. It is the continuous improvement in EVA that brings continuous increases in shareholder wealth.

The focus is on how to improve EVA:

EVA provides a common language for the users and allows all management decisions to be modeled, monitored, communicated and compensated in a single and consistent way

– always in terms of the value added to shareholder investment.

Two basic principles:

  • Maximization of shareholders wealth – The value of a company depends on  the extent to which investors expect future profits to exceed or fall short of the cost of capital.
  • Earnings per share (EPS), and return on equity (ROE), does not reflect `economic reality’.

Advantages of EVA:

  •  Simple and easy to explain
  •  Help managers to assess tradeoffs between charge for using capital and managing assets
  •  Improvement in the quality of decision-making by the management.
  •  Goldman Sachs and Credit Suisse First Boston uses EVA as equity valuation.
  •  Improve company’s chances of success in Mergers & Acquisitions (M&A) and other major investments.
  • EVA is based on a simple premise that true economic profits must account for the cost of capital and investments made in areas like R&D and employee training
  •  Helps to prioritize investments.
  • Provides a framework for an intensive compensation system.

If the revenues are in excess of costs including operating expenses, costs of developing and investing in people, products and business it will create value.

Facts Regarding EVA:

  •  TCS and Lafarge use EVA as a measure of CEO performance.
  •  ONGC is the only PSU which has both MVA and EVA positive.
  • Godrej Industries has adopted the (EVA) model to reinforce its commitment to the creation of shareholder value.
  •  Business  groups  like  GODREJ  and TATA are  evaluating  their  economic  profit through evaluation of EVA.
  • HLL and NIIT are also using the system.
  •   TATA group  use  EVA for  evaluation  of  economic  profit  and      its  major  12-13 companies are having positive EVA

 

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