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Wednesday, August 22, 2012

Pros and cons of economic value added

Effect of regulation on Economic Value Added
Economic value added is affected by economies of scale
Price equilibrium is reached when economic value is no longer added via cost cutting


Economic Value Added (EVA) is a term referring to financial gain in excess of profit expectations. In other words, EVA  measures the extra value profits yield for an organization after deducting cost of capital such as dividends to shareholders. Although EVA is an acronym used across multiple industries with different meanings, its significance in finance is specific. Moreover, the usage of EVA often refers to a proprietary version of the calculation claimed to have been created by the Business Advisory Firm Stern Stewart & Co in the late 1980s. The video below further illustrates the concept of economic value added:


Uses of the economic value added metric


The EVA metric is primarily used as a business valuation tool. Some proponents of EVA such as P.C. Narayan of the Indian Institute of Management at Bangalore advocate EVA over other profitability metrics because it demonstrates potential future earnings. This according to Narayan, is because measurements such as Earnings Per Share (EPS) only provide a snapshot of how well a company has met stock-holder's past financial expectations and does not reflect potential for capital reinvestment.

Calculation of economic value added


In terms of the Stern, Steward & Co. formula, EVA is the result of subtracting taxes and weighted average cost of debt and equity capital from net operating profit. This however, is not the only way to determine EVA because the cost of capital calculation varies between businesses. For example, the United States Postal Service version of EVA indexes its operating cost to inflation to more accurately reflect costs after rate increases. Other companies may not need to adjust costs to inflation based on corporate policies and accounting methods. The Stern Steward  & Co EVA formula is shown below:

EVA= (Net Operating Profit-Tax)-(Weighted Average Cost of Equity and Debt)

Advantages of economic value added


The advantages of EVA are it supplements financial data from other methods of business assessment and valuation. Moreover, it reflects businesses' cost management and demonstrates availability working capital after its original opportunity cost has been deducted. Another benefit of EVA is it can be used as a managerial incentive that helps assure the continued performance of a business. It also evades problems associated with percentage calculations by using specific values according to Aswath Damodaran, a Finance Professor at the New York Stern School of Business.

Disadvantages of economic value added


Economic value added cannot measure how well capital asset managers utilize retained earnings via project management and other business ventures. Moreover, capital asset managers may squander liquid reserves instead of effectively increasing the future return on capital by  reinvesting it with the aim of lowering operational costs via profitability instead of cost cutting. Economic value added also cannot valuate return on expenses such as research and development. Moreover, despite being an income statement operating expense, research and development actually has the potential to yield  future earnings not measured by EVA.

Image attribution: Mgmwki; CC BY-SA 3.0