The one-dimensional aim that the Stern Stewart consulting organisation intended for there system of Economic Value Added was to deliver a measure which would give shareholders a generously proportioned return on there investment. Essentially this is done by dispersal of the cost of the asset over the period of asset productivity, instead of spreading the cost of the asset over one financial period. The formula used to calculate EVA is;
Conventional divisional profit based on GAAP (generally accepted accounting practices) + accounting adjustments – cost of capital charge on divisional assets.
The key elements within EVA lie in the accounting adjustments made to the conventional divisional profit measure. Stern Stewart consulting organisation identified 160 accounting adjustments that may be required in order to convert a firma historic accounting data in order for it to express an EVA value. Most firms only need ten or so accounting adjustments though. The most common reason as to the adoption of the EVA measurement system is that it is the most directly linked system measuring the creation of shareholder opulence over time. As the primary function of a firm is to create a return on investment greater than that of its competitors, EVA gives investors a useful tool for measuring current performance. EVA gives managers superior information that aids motivation of staff and others involved in the strategic setting and execution levels of a firm. This system allows management to see clearly how they are performing and, theoretically, it should motivate them to work harder and thus achieve greater shareholder wealth in any publicly traded company. Put in simpler terms it is an estimate of the “ECONOMIC” profit not of the “ACCOUNTING” profit in comparison to the required minimum rate of return, which the shareholders could get when, comparing them to other investments that would have comparable statistically calculated risk values.
Thus, it can be seen that EVA is a powerful and useful tool for shareholders, and potential investors. EVA helps establish the differences between those businesses that seem to make conventional accounting profit from those that seem to make an accounting profit. Ray Kroc eloquently illustrated this point in his book Grinding It Out. The founder of McDonalds said, “Until the business returns an income greater than the capital outlay, we are running at a loss. It is irrelevant if we pay taxes. The aim of the expansion is to strategically deploy the capital in creating an infrastructure that when all the expansion plans are met, we deliver stable profitability to other investors”
EVA is recognised as substantially outperforming its competing performance related measures. As the measure of EVA indicates and highlights to managers any potential under performing assets, in which the firma capital may be uneconomically distributed. This obviously makes it a good measure.
There have been a great many advantages both to the managers and investors since the development of EVA as firm’s economic positions have improved dramatically consequently meaning that the shareholder’s wealth has also increased. EVA has two main features in its underlying principles these are: “The primary financial objective of any company should be to maximise its wealth of its shareholders,” and “The value of the company depends on the extent to which investors expect future profits to exceed or fall short of the cost of capital.” (Taken from ) If a firm can achieve these two principles then the firm’s market value will increase as a result. If the EVA value stops increasing then the market value as a follow on would also remain constant, all other factors remaining constant.
The EVA measure is a very simple concept to understand as it incorporates both the operating profits and the capital investment charge, providing one explanation for its high success rate with managers. As the calculations are simplistic any confusion between individuals within a company are minimised. This makes it more likely that the manager will execute the calculations in the first place and increase the firm’s income. The idea of issuing shares for the employees in that particular firm also acts as a greater incentive to work well and produce a better organised and highly successful firm as they are personally concerned and would benefit from its success.
However, there are also a few downfalls to a firm relying on the use of EVA as its only measurement system. Namely, any future cash flows cannot be predicted as only the current cash flow is taken into consideration, these means that certain types of managers may be at risk. The system is only really useful for quick pay back projects so people wanting to take on a more long-term one would be at a disadvantage, as they would in effect be working blindly.
The EVA measurement system acts as a good way for prospective shareholders to assess whether it is worth investing in a particular company or not. For example, GlaxoSmithKline PLC has an EVA value of 5,061,506,912 whilst the EVA value for Vodafone Airtouch PLC is merely -13,371,636,840 (figures taken from ). If you were to compare these two figures as a reflection upon the companies Vodafone would be a bad company to invest in. As Howard Shultz the CEO of Starbucks said “The aim of a good CEO is to always deliver more than you promise, otherwise they kick you out”
In conclusion, EVA is a very useful “TOOL” for both investors and management alike, but it is only a tool and for maximum results it must be used in conjunction with other methods and systems to create the most valid long-term and short term delivery of value to stock holders/investors. It is no good to implement a system to meshed performance or ROI ext if the fundamentals of the firm are unstable. As Warren Buffet famously says “I only invest in a company if its fundamentals are sound, I always said thoughts dot com firms would go belly up, they invented loads of different performance meshed for investors but in the end there were no fundamentals”
Bibliography
1: Ray Krock, Girding it out, p167
2: Brealey Myers, McGraw Hill, 7th edition, p322, p325, p323
3:
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5: Howard Shultz, Building Starbucks one cup at a time, p254
6: Warren Buffet, Financial Times, 2000, p4
