What is EVA or Economic value added?

Well, first, it is a measure of profitability. As a measure of profitability, it is just another way to calculate profits. And so, this is not really the accounting profits that you find in any income statement as we will talk a little bit about that in, in just a minute, but it’s just another way of calculating profit. And, and as we’ll clarify it a couple minutes from now there, there’s a very important distinction between economic profits and accounting profits, and the profits that you probably hear all the time are actually accounting profits. All those that you have to file on a quarterly basis because the regulations say so. All those are accounting profits, they are based on accounting standards, and that gives, gives you an accounting number. What we are going to do today, is focus on the economic number. And, and that is what we call economic profit, and we’ll define that in just a second. But, point number one, EVA is just another way of calculating profits. We are not going to go back to the history of EVA. Strictly speaking, a company called Stern Stewart introduced it, and they did so in the early 80’s. Whether they actually introduced something that is completely new, or they sort of piggybacked on an older idea that some people call residual income, that some people call economic profit. We are not going to go there either. I guess that people at Stern Stewart, they would tell you we created something very original. Some people say, well, this is just a rehash of an old idea; it does not really matter for us. What really matters for us is that there’s this valuable called economic value added. That it is true that it is related to an older idea that some people have been calling for many years, either economic profit or residual income. So, you know, you can give to Stern Stewart all the credit or little credit that that is actually your, your decision. But what is important is that really the name EVA is a trademarked concept that was actually pioneered by Stern and Stewart in the ear, the early 80’s. What is the idea behind EVA? The idea behind EVA is exactly the same idea behind the id, the concept of economic profit or residual income. And that is the very a basic notion of charging managers, let me say that again, charging managers for the capital that they use. In other words, this is nothing that is going to be shown in an accounting income statement but what we want to do is to force managers to recognize that the using capital, that the capital providers want a return. They demand a return to the capital provider provided. And that you cannot really say that you have created value if you have not first compensated the capital providers with the return that they expect. So that is a very simple idea. What we are going to do is we are going to charge managers for the use of capital. If there’s any cash left after that, then we are creating value. But if we fall short of compensating capital providers, then we will not be creating value. So EVA economic profit residual income, all of them are just a slight variations of the idea that we need to make managers recognize built into their decisions, that they’re using capital and that there’s a return required on that capital. So at the end of the day when we say, well, you know, we go by our accounting standards in whatever country you are. There must be accounting standards that companies actually need to follow. Then you get to the bottom line, which some people call the the the profit or the net income of, of, of the company. That is basically the bottom line result. That is what we call an accounting profit. But that accounting profit may actually be, however large that number may happen to be, may be hiding a process of value destruction. That is, it is perfectly possible for a company to have positive accounting profits, and at the same time, destroying economic value. That is why the number that we are going to calculate, we are going to call it economic profit. So again, EVA residual income economic profit, for our purposes, all these terms are going to be interchangeable. Because of they all point in the same direction, which is forcing managers to admit that there is a cost to the capital they are using and that, when they say we are creating or destroying value, they are considering that cost.

So let us go with the expressions. There is two ways of writing EVA, and mathematically they are identical. Some people like one better, some people like the other better, it does not really matter. I am going to present both of them to you and you are going to decide whether you like one better than the other. They are both equally intuitive, although they, they reflect a slightly different ways of thinking about the process of value creation. The first expression that you’re seeing thereof EVA, economic value added, basically starts with a NOPAT and then you subtracts the Capital that we’re using in the corporation, multiply by the weighted average cost of capital or the capital as we define the, the cost of capital as we define it before. Now, the NOPAT there’s going to be a, a neater and, and more precise definition of the reading that goes with this session, but for our purposes now, just think of a quick and dirty cash flow. This is the cash flow generated by the company. And what comes after that, capital multiplies by the cost of capital is what some people would call the capital chart. That is, there is a capital being invested in this company. There is a return required on that capital and when you multiply one times the other, it gives you in dollars and cents what is the return that you need to deliver to the capital providers. We will be looking at a couple of examples in couple of minutes from now when it is going to be clearer. But notice what we’re saying, is that we are making money. But before we say that we’re creating or destroying value, we need to take into account that we’re using capital, and that that capital has a cost. After taking into account that capital charge, if there is something left, we are creating value. In other words, if EVA is positive, we are creating value. If EVA is negative, that means that we have actually produced some cash, but it is not enough to compensate the capital providers, given the required return on that capital. So, a positive EVA in this framework says that you’re creating value, and a negative EVA says that you’re not creating value. Now, as you see there is the both, the NOPAT and the capital that they are sub-subject to some proprietary adjustments. And that basically is a fancy way of saying that, when a company provides this service to you. They will tell you something like look, for the reason of being this particular company in this particular sector and the type of company that you are. Then we need to calculate the NOPAT in this specific way, and we need to calculate the capital in this specific way. So there is a lot of adjustments that need to be made in the calculations of this we’re going to try to understand the measure, not getting into the nitty gritty of the calculation. We will get into a little bit, just a little bit of nitty gritty, in the reading that goes with this session, but we are not going to get into that nitty gritty now. I do want to give you one example though. And the example is a very simple that, again, sort of reflects the difference between accounting profits and economic profits and, and thinking properly or improperly about the process of value creation. That is, suppose that as a company, you invest $1 billion in R&D, big amount of money in, in R&D. From an accounting point of view, $1 billion dollars in R&D is a cost. All right, so you take out $1 billion out of your profits and then, you keep going the income statement. Now if you really think about it, no company would invest $1 billion today, if they did not expect to get something in the future. So, $1 billion investment in R&D is just that, it’s an investment. So you expect to get a return in the future. So, if you are actually using the idea of EVA residual income, economic profit. What you would probably do is the following. You would say look, I’m going to build this $1 billion of R&D into my capital. Because that is what it really is, I am making an investment here, and I’m going to be depreciating this capital over time. And that depreciation is what I’m going to be charging, so earnings, period after period after period. So there’s a fundamental difference there in the way you think about R&D. One way is to say R&D is an expense today, I charge it to earnings today, end of the story. But that’s not really what R&D is from an economic point of view. We are making a capital investment. That capital investment is going to be depreciating over time. And that depreciation is what we would charge to earnings. So this is just to clarify some of the many adjustments that you could actually do to the NOPAT, to the capital, and to the traditional accounting in order to go from the accounting profit into the economic profit, right. So that’s enough for definition number one. Let us bring now definition number two. And let me hasten to add once again, these two definitions are identical. If you define the Return on Capital as the NOPAT divided by Capital, you can algebraically go between one definition and the other back and forth. But notice what that second definition says. And a lot of people that like that because it takes us back to some of the issues we were discussing before. It says something that is very simple. If you create a positive spread between the Return on Capital and the cost of Capital, you are going to be creating value. And if you find activities, you find investments, you find things that you can do in which you can create a positive spread between the Return and the Cost of Capital, then put Capital into those activities. And if you do that, then you’re going to be creating value. So in the same way as we, we said before, positive EVA indicates value creation and negative EVA indicates value destruction. Here we actually have exactly the same thing. Now, let us put these two expressions together. And in order to, to, to do that then we’re going to focus how do we create value at the end of the day? Well, you know, if you put the two expressions together, it is pretty much in front of your eyes. One is you can increase the company’s profitability, and that basically means to create more NOPAT. So, if you create more cash, if your investment activities, if your operations, if the product and services that you sell create more cash, then you are going to be increasing the process of value creation. Now, let us go to the second expression. You can create more value by investing more capital in activities in which you have a positive spread. Because if you have a positive spread if you’re beating the cost of Capital, more Capital is going to increase the process of value creations, so that’s possibility number two. Possibility number three, very often overlooked. If you are investing in activities in which you have a negative spread, that is in which the return of cap, on Capital is lower than the cost of Capital, take Capital out of those activities. That is very important, and that is sometimes again overlooked. If we are doing things in which we are destroying value, take the Capital out and put it somewhere else. You will be creating value. You will be enhancing value creation by doing that. And the fourth, which sometimes is, is, is overlooked when we’re discussing these issues but, but only because of that. Because we know that this is an important thing to do is to optimize the Capital structure. And that, remember that although with this is not one of those topics that we’re going to be addressing specifically. Minimum of the optimal Capital structure is the one that minimizes the cost of Capital. And so you can look at expression one, or you can look at expression two. But everything else equal the lower cost of Capital, the higher is going to be the, the EVA. So the four ways in which you can create value in this framework is, increase the profitability of the company, increase the NOPAT, put more Capital into activities in which you have a positive spread, return on Capital higher than the cost of Capital. Take out Capital from activities in which the return of cap, on Capital is lower than the cost of Capital, and minimize your Capital structure so as though you minimize the cost of Capital. If you do those four things, if you improve in the direction of doing those four things, you are going to be creating more value according to this framework that we’re discussing here.

 

AdminCapital Budgeting TechniquesWhat is EVA or Economic value added? Well, first, it is a measure of profitability. As a measure of profitability, it is just another way to calculate profits. And so, this is not really the accounting profits that you find in any income statement as we will talk a little bit about that...Investment analysis basics