Economic Value Added

You may recall seeing Economic Value Added Statements in many annual reports - Infosys (for that matter in those of most software companies), Hindustan Lever and even Balrampur Chini to name a few.

EVA as a tool for spotting value has assumed a lot of importance these days. But what exactly is this new thing, EVA? And is it important for you as a shareholder?

Very simply, EVA is a measure of value that a company has added as a result of its operations during a period of time. And it has its genesis in the same timeless concepts of RoCE and Cost of Equity.

 

Return on Capital Employed, we saw, is smart in showing the operational competence (or lack of it) for a company. But it still does not indicate the "take home" that you get by investing in the business. This is because something very crucial is still to be accounted for and that is the Cost of Capital.

Cost of Capital?

A business makes use of capital for its operations.

 

And capital - debt or equity - entails certain costs. For a company, the overall cost of capital is the sum of cost of debt and cost of equity weighted by their proportion in the total capital. This is called the Weighted Average Cost of Capital (WACC).

Now, Cost of Capital sets an important benchmark for the company. This is the least return that it should earn on its capital for its operations to make sense in the first place.

 

If the RoCE is equal to the WACC, then it effectively means that the company is worth the initial investment, since it has earned exactly what it has paid for its capital. It's a 'nothing lost, nothing gained' scenario - that is, it's a kind of break-even for the shareholders.

Anything that the firm earns over and above its cost of capital is what has been added by way of value from its operations. This simple concept is called Economic Value Added. Thus,

 

Economic Value Added	= Return on Capital Employed
	- Weighted Average Cost of Capital

 

 

Ultimately, this spread between the RoCE and the WACC is what the market seeks and values in a company. This is the very source of capital appreciation. In fact, this is what you are betting on when you are taking a risk on an equity.

 

The concept of EVA is not new

Needless to say, EVA has its relevance in any and every business. And that's the reason for its universal popularity. But while EVA has become a much talked about parameter, it is not as if it is a novel concept hit upon only in recent times.

This concept of a business's ability to earn something over and above what it pays for its capital has been in existence for a long time. Way back in 1890, Sir Alfred Marshall, while defining the concept of economic profit, had said, "What remains of his (owner's or manager's) profit, after deducting interest on his capital at the current rate, may be called the earnings of his undertaking."

 

The EVA way of determining value

EVA is just another way of determining value rather than a new concept in itself. To get a perspective on the EVA way of calculating value, take the example of Hindustan Lever.

1. The first step is to calculate the Return on Capital Employed, tax adjusted. Net operating profit less adjusted taxes divided by the average Capital Employed gives the Return on Capital Employed.

Aside: Why deduct taxes?
This is because, as a shareholder, you are entitled to what is ultimately due to you after paying all possible expenses. And tax is a statutory payment that needs to be paid anyway. Thus for the calculation of RoCE for EVA, we take the operating profit less tax.

Calculation of ROCE	1999	1998	1997	1996
Operation Profit	1,206	956	711	464
- Less Depreciation	129	101	58	55
- Less Tax Paid	318	286	281	173
- Less Tax shield on interest	5	8	11	17
Net Optg Profit less adj Taxes (NOPLAT)	754	562	361	219
Average Capital Employed	2,118	1,703	1,412	688
RoCE(%)	36	33	26	32

(Wondering what Interest Tax Shield is? Take a look here.)

2. The next step is the computation of the Weighted Average Cost of Capital. Well, its name is self-explanatory.

All we do is calculate the cost of debt (using interest), cost of equity (using CAPM), and the proportion of debt and equity in the total capital employed. And, finally, compute their weighted average cost.

Calculation of WACC	1999	1998	1997	1996
Cost of debt(adjust for tax) (%)	8	10	10	31
Weight of debt in total capital (%)	8	14	13	19
Beta	0.8	0.8	0.8	0.8
Cost of equity (%)	20	20	20	20
Weight of equity in total capital (%)	92	86	87	81
WACC (%)	19	18	19	22

3. Finally, tax adjusted RoCE minus WACC gives EVA.

Calculation of EVA	1999	1998	1997	1996
RoCE (%)	36	33	26	32
WACC (%)	19	18	19	22
EVA (%)	17	15	7	10

Voila! - we have EVA!

As is evident, the primary strength of EVA is that it helps to track the value added by a company year after year.

If you just ponder about EVA, you would realise that it is no different from discounted cash flows so far its principle goes.

EVA and DCF - siblings

EVA does something similar to what discounted cash flow (DCF) does. It takes the returns from operations and deducts all charges of operations, including depreciation, and then finally deducts the cost of capital. And that is what the company has earned for the year.

And what does a DCF do? It finds the free cash flows of the firm over its life after deducting all charges towards operations and financing.

Isn't then EVA akin to free cash flow? It is!

Now the Net Present Value of these free cash flows (in DCF) give the fair value of the company today. Similarly, can we compute the fair value of a company using EVA?

Hmmm... true that EVA is often expressed as a percentage, since both RoCE and WACC are computed as percentage of capital employed. But instead of taking EVA as a percentage, if we just take the operating profit minus taxes and deduct the capital charges, then the resultant is the amount of value added in absolute terms (in crores in this instance).

When the stream of EVA over all future years in the life of a company is discounted to the present, then the cumulative EVA will be nothing but equal to the Net Present Value.

But what has spurred the popularity of EVA over DCF is that it is a more practical version. It can be calculated for every period and hence is the more handy tool to track the performance of a company.

But while it serves its purpose of revealing the final return to shareholders, it might miss slip-ups in operations. For instance the benefits of a better capital structure of a company might hide its slackening operations.

And this is where Return on Capital Employed (RoCE) comes in handy. Supremely indifferent to the source of capital, it examines the efficiency in the use of total capital.

But both these ratios content themselves with the balance sheet value of the capital used in the business. EV/EBIDTA brings in the opinion of the market. It reflects the market's point of view in valuing the operating efficiency of a company.

And hence it serves as an important tool in valuing equities.