EVA Example

But very simple example just to round up the idea of the, you know, whether a company’s creating or destroying value. Let us consider a company that is generating a NOPAT of $9 million. So from an accounting point of view, this company is making money. It is investing $100 million of capital. That capital was raised from capital providers, and these capital providers actually require the return of ten percent. So the cost of capital of the company is ten percent. So we’re dealing with a company that makes, in any given period, $9 million with $100 million of capital invested and the capital providers require a return of 10%. Did this company create value or not? Well, I am sure you can guess now what the answer is going to be. We can calculate EVA with the first definition. A NOPAT of 9 million minus $100 million of capital multiplied by the 10% cost of capital, that gives me minus $1 million. Why minus $1 million? Well, remember what the product of capital multiplied by the cost of capital is. It is basically what we call the capital charge. So, the managers of this company need to be delivering at least $10 million to properly compensate the capital providers, but they have delivered only $9 million. So they have been $1 million short, and that is the negative EVA that you have here. So, they generated $9 million. There was a minimum expectation of generating $10 million, the minus one million is the shortage of that provision of profits, provision of cash to the capital providers. We can use the second formula. The second formula will be remembered, capital multiplied by the return on capital minus the cost of capital. And the return on capital was the NOPAT, in our case nine million divided by the capital, in our case 100 million. So that gives you 9%. Now, 9% is the return on capital, 10% is the cost of capital, so we have a negative spread. And that negative spread, you know, if we put any amount of capital at any negative spread, then we’re going to be destroying value. And in this case, because we’re putting $100 million in an activity that generates a return on capital is 1% that’s the point lower than the cost of capital will destroying 1 million of value. So as we said before, you can use formula number one or formula number two. You are going to get numerically exactly the same number, and in this very simple company, in both cases, we are destroying $1 million of value. Another way of saying that is that this company actually generated an accounting profit of $9 million, but generating an economic loss, a negative economic profit of $1 million. It fell short of compensated capital providers, and therefore, this company had a positive accounting profit but a negative economic profit.

Now, we are going to go with a more interesting example. And we are going to compare Apple and Yahoo, and we’re going to do this in May of 2014.

And before we actually look into these numbers, let me say that I made a few assumptions just to simplify the example a little bit. But the numbers are fairly accurate, and they actually, you’ll see that they go where they want to go and we’re going to try to get a company that is clearly creating value and one that may be destroying value and so that’s basically what we going to try to put together with this example. So let us start with Apple. Apple in May 2014, at that point in time, the company was generating a NOPAT of almost $40 billion. Now Apple, as you know, in terms of market value is the largest company in the world. In terms of revenue, it generated $176 billion back in the year 2013. And out of that, 40 billion of that, almost 40 billion were profit. So we’re going to start from a note about a 39.8, almost 40 billion dollars. Now, they did so with a lot of capital. They have a lot of capital invested over $120 billion, so almost $121 billion of capital invested, and if you calculate the cost of capital, we’re not going to go into the nitty gritty now, its about 7%. A little bit lower than 7%, 6.8%. Now, knowing the NOPAT, the capital, and the WACC, we know that we can actually calculate everything else. But before we do it, because we’re going to calculate the EVA with both expressions, let us calculate the return on capital. And as you remember, that is simply, in this framework, the NOPAT divided by the capital, so the $39.8 billion divided by the $120.8 billion, and that gives you a round number of 33%. Now, we could stop the calculations here. We are dealing with a company that has a return on capital of 33% and a cost of capital of 7%. They are creating huge value. And now we can still run the EVA numbers, but we could stop here whether we’re asking the question of they’re creating value or not. Of course, they are. They are beating the cost of capital by a huge margin. They are creating a big gap of over, well over 20 percentage points. Now, if we still want to calculate the numbers, expression number one. NOPAT $39.8 billion minus the $120.8 billion of capital invested multiplied by the 6.8 cost of capital. That gives me, remember, that second part, the capital of 100 and almost $121 billion multiplied by the cost of capital of almost seven percent gives me the capital charge. And so, the minimum amount of money that the capital providers actually would expect would be $8.2 billion. But, guess what? Apple is generating $39.8 billion. So, it is got to compensate the capital providers and then some. And the excess of how much more money they have is the $31.65 billion that you’re seeing there. In other words, they need to deliver at least $8.2 billion in terms of cash. They deliver almost $40 billion of cash; therefore, they produce $31, almost $32, billion dollars more than they should from the point of view of value creation. The second expression highlights what we were saying before. And what we were saying before is that when you look at the spread between the return on capital of 33% and the cost of capital of almost 7%, well you have 26 percentage points, a gap between one and the other. And if you actually apply $121 billion of capital to that spread, you go back to the same number we calculated before, Apple is generating $31.65 billion of economic profit. That is profit beyond what capital providers were requiring for providing that capital in the first place. So in this framework, if you believe this whole idea of residual income, economic profit, EVA, we can clearly say that last year Apple create, clearly, Apple created value. Now, let us compare that to Yahoo. The situation of Yahoo is a little bit different. Yahoo, first, is a much smaller company. They have actually $4.7 billion of revenue, out of which they actually created about $180 million in profits, about 179 million dollars in profits. Now, in order to create $179 million in profits, they used capital, and they used $12.8 billion in capital. Far less than Apple, about one-tenth the amount of capital that Apple actually used, but the problem is that they have a higher require return, which is actually pushing at 9%. And before we actually keep on with the calculations, remember that we can calculate one more thing, and that is what we call the Return Capital, the NOPAT divided by the capital. So if we divide the 879 million by the $12.8 billion in capital, we get a return on capital of 6.8%. And we’re going to keep going, but we could stop right there. And the reason that we could stop right there is that if you have a company that has a return on capital of less than 7% but it has a cost of capital of almost 9%, well, you know, you’re investing resources but you’re not creating enough return to satisfy the capital providers. Be that as it may, we can calculate the EVA with expression one, and creating that the EVA with an expression one would be the NOPAT, $879 million minus the capital invested which is $12.8 billion, multiplied by the cost of capital of 8.9%. And if we multiply that $12.8 billion by 8.9%, we get a $1.1 billion capital charge. Now, where is the problem? Those capital providers are requiring at least $1.1 billion, but Yahoo provided them with less than $880 million. So there was a shortage of $260 million, and that is what, in this framework, we would create value destruction. The capital providers were expecting $1.1 billion, Yahoo provided them with 180 billion, so there was a shortage thereof $260 million. Or we can look at this with a second expression. And the second expression, as we clarified before, says that we look at the spread, which is 6.8 and with respect to 8.9. That means that there is a negative spread of over two percentage points. And if we apply capital to any activities in which we have a negative spread, we’re going to destroy value, and that value destruction is going to be, obviously, the same number as before, and that is going to be $260 million. In other words, in this framework, we would say that Yahoo destroyed value. So we looked at two companies, Apple and Yahoo, at the same point in time based on figures for 2013. And we’re saying, well at this particular point in time, Apple was creating value because it had a positive and huge EVA, and Yahoo was destroying value because it did have a negative EVA.

All right. So, as you see that the idea of EVA is very simple. It basically tells you that you need to compare the return on capital with the cost of capital. And as long as the former is higher than the later, then you’re creating value, otherwise, you’re not. So whether you’re focusing on EVA, or residual income, or economic profit, and all the maybe little differences between them, they all take you to a very basic and elementary and important idea which is managers are using capital, someone has to provide that capital. Those capital providers require a return. That return is related to the risk that you perceive in the corporation, and when you bring everything together, if you actually delivered a return that is higher than the return required by the capital providers, then you are going to be delivering, that value that shareholders actually expect. Or you can think of this from the point in dollars and cents rather than in percent, that would be the first. A formulation of EVA where you say that one can calculate, given the capital that I am using and the cost of capital, what is the minimum amount of cash that I need to produce. If I produce more than that, I will be creating value. If I produce less than that, I will be destroying value. One way or the other all these ideas of EVA residual income or economic profit. Again, they point in the same direction and that is a very important direction. Managers need to use capital. That capital is not free. That capital is going to be requiring a return related to the risk of putting this capital in this company, and when I bring everything together, I need to compare the return that I provide with the cost of raising that capital in the first place. Now, that is the very simple idea of EVA. And as we said before, it is not the only way to think about the process of value creation. Some other consulting companies might actually tell you, I have a better variable to measure whether you are creating or destroying value. And now we go back to an example that at this point is very familiar to you, which is the CAPM. Again, the CAPM is not the only way to calculate the cost of capital, but it’s very intuitive, it’s very widely used, and there are many alternatives, but it’s kind of the beacon, you know, it’s kind of the benchmark against all the other models is measured against. Well, EVA is a little bit of that, in this whole business of value creation. It is very intuitive, it is easy to understand, and it is very widely used. That does not mean that it is the only one or that it is the best one. There are other competing measures of value creation, and we are discussing one that is actually popular, again intuitive and it has an economic rationale. As we have been saying before, it compares the two basic variables of return and cost of capital and what you need to do in order to create value for the shareholders.

AdminCapital Budgeting TechniquesCorporate FinanceEVA Example But very simple example just to round up the idea of the, you know, whether a company's creating or destroying value. Let us consider a company that is generating a NOPAT of $9 million. So from an accounting point of view, this company is making money. It is investing $100 million of...Investment analysis basics