FREE online courses on Financial Management and Creating Value - Chapter 3 -
Using EVA
Once calculated, EVA (Economic Value Added) is an indicator
of how much value was created or destroyed by management. If EVA is positive,
value was added, if EVA was negative, value was destroyed. EVA is also used in
conjunction with MVA (Market Value Added). Since EVA is a period to period
measurement, we need to compliment EVA with a cumulative long-term measurement
like MVA. We can view MVA as the present value of all future EVA's. Stern
Stewart, a major advocate of EVA, considers EVA to be the true economic profits
of the business and the best guide to MVA is EVA. In order to increase EVA,
management has three options:
- Growth: Invest capital in projects that earn a
return higher than the cost of capital.
- Process Improvement: Increase returns (NOPAT)
through better efficiencies, cost control, higher productivity, etc.
- Asset Management: Improve the management of assets
by selling-off non-performing assets and increasing asset efficiency. For
example, reducing the amount of time cash is tied up in receivables and
inventory would be a basic approach to increasing EVA.
Stern Stewart considers EVA to be at the center of Value
Based Management with numerous applications, such as:
- Evaluating the true performance of business units
and the overall organization.
- Establishing budgeted EVA levels for strategic
areas of the business.
- Evaluating capital projects by using EVA as
opposed to cash flows.
- Compensating executives based on levels of EVA and
not earnings.
The main benefit of EVA like other value-based metrics is
that management now views performance differently. For example, Company A and
Company B (both in the same industry) have the same level of earnings per share.
However, Company A requires twice the capital of Company B to generate these
same earnings. Under Value Based Management, Company B is much more profitable
than Company A. If we follow the traditional accounting model, there would no
difference in how we look at performance.
