The Hindu Business Line : The call of EVA

THE traditional yardstick, such as earnings per share (EPS), price-earnings (P/E) ratio, return on capital employed (ROCE), and so on, for measuring company performance are now increasingly becoming irrelevant as they often portray misleading information. Investors are more interested in knowing whether the company recorded positive cash flows during the year and whether it was able to add to the wealth of its owners. Roberto Goizueta, the late CEO of Coca-Cola, had observed: "I get paid to make the owners of the company increasingly wealthy with each passing day. Everything else is just fluff".

While the traditional measurements took into account only loan interest as cost of capital even though the total capital employed had a fair mix of both debt and equity, the modern approach includes a charge for interest, being the cost of the shareholders' funds, as a notional cost of capital. The idea is that the residual profit, after this notional charge for cost of capital, should represent economic value added, which the shareholders could have achieved had they been in possession of their capital and had had the freedom to deploy it elsewhere for market-related returns.

The cost of equity is the rate of return required by shareholders to compensate them for the risk inherent in the investment. It is thus an opportunity cost and not an actual cash cost. Thus, the profit remaining after charging the cost of equity is what is now widely recognised as economic value added (EVA), a concept developed by Stern Stewart & Co., which is also the owner of the registered trademark EVA. Many companies are now incorporating an EVA value in their annual reports by way of investor information.

EVA is now becoming increasingly important for New Economy companies whose capital consists largely of intangible assets funded predominantly by shareholders' equity. With the global slowdown in the IT sector, these assets could possibly be generating sub-optimal revenues resulting even in a negative economic value addition during the year. Unless there is a method for measuring economic value addition, apart from arriving at the traditional profits, it is well nigh impossible to know whether all the equity has been profitably employed and are generating revenues in excess of the cost of the equity. EVA is a measurement which fulfils this need adequately as will be seen from the following illustration:

Two companies, A Ltd and B Ltd, have businesses similar to each other but B Ltd, in addition, has diversified into a couple of other industries that are currently on the downturn and the results of their operation for the latest financial year 2001 are as follows:

It will be seen that B Ltd has shown a better performance than A Ltd by every traditional parameter, namely, better ROCE, EPS and better return on the turnover but, when a notional charge is made for the cost of utilisation of shareholders' equity, the economic value addition in B Ltd is negative while it is positive in A Ltd. This means that the shareholders of B Ltd have had a lower return on their equity in terms of economic value addition, if the company considers a charge for the cost of utilisation of those funds.

The management of B Ltd has not delivered on shareholder value as profits alone are not, any longer, sufficient for ensuring shareholder satisfaction and the problem would appear to stem, at least in part, from its diversification into unrelated businesses that are pulling down its profitability.

Does a negative EVA mean any loss of confidence in the company? No. What it means is that EVA matters more with where the company is heading than with where it presently is. This is borne out by the correlation of EVA with share prices. Any efforts to increase EVA will be rewarded by the stock market and such recognition will be in the form of increased market capitalisation.

Indeed, the additional value created for a company is represented by the difference between amounts invested by lenders and shareholders and the value of the market capitalisation. Companies with market values of their shares quoting well below their face values are those which have destroyed shareholder value consistently over a period of time.

EVA could be improved over a period of time by focussing on areas where it is being created, such as product categories, geographic areas, customer segments, distribution channels and business processes. Special attention should be bestowed on the processes and activities which contribute to increased productivity and profitability and, as a result, to increased EVA. A framework for product pricing should also be established so as to ensure that there is no erosion in margins arising from faulty pricing policies.

In conclusion, we may say that EVA is fast gaining ground as a system of measurement supplementing the traditional measures of performance.

It provides management with an insight into areas of business highlighting factors that affect the company's performance. Indeed, some companies are now linking their managers' compensation to performance measured against EVA parameters, thus fully aligning reward programmes with the interests of the shareholders.

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