corporate performance measurement through eva

8/12/2019 Corporate Performance Measurement Through Eva

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CORPORATE PERFORMANCE MEASUREMENTTHROUGH EVA

Dr. Vishal KumarAssistant Professor in Commerce

Dev Samaj College for WomenFerozepur City (PB)

Abstract: Economic alue A!!e! (EA) is a value "ase! performancemeasure t#at gives importance on value creation "y t#e management fort#e o$ners% Pro&t ma'imization as a concept is ageol! $ealt# ma'imizationis mature! an! value ma'imization is to!ay*s $is!om% Stern Ste$art*s EAraises storm in corporate $orl! an! gives a ne$ $ay to t#in+ a"outre$ar!ing management% ,sa"ility of EA largely !epen!s on t#e -uality of

accounting information system as tra!itional information system $ill notprovi!e su.cient information to compute true EA% /#us EA is re-uire! to"e tailore! in line $it# accounting system management p#ilosop#y an! t#e!egree of !eman! of suc# a system% 0n t#is paper an earnest e1ort #as "eenma!e to e'plain t#eoretical foun!ation of EA $it# its origination !e&nition$ays to ma+e it tailore! a!justments re-uire! scope an! some ot#errelate! issues% /#e met#o!ology use! is a type of t#eoretical mining oflogics resulting a step"ystep process re-uire! for EA implementation% Ascorporate #ouse plans to move from tra!itional to value "ase! performancemeasures EA $oul! yiel! goo! result%

Key Words:Economic Value Added, Market Value Added, Net Present Value, Weighted Average

Cost of Capital

INTRODUCTION

Performance Measurement systems was developed as a means of monitoring and maintaining

organisational control, which is the process of ensuring that an organisation pursues strategies

that lead to the achievement of overall goals and o!ectives" Performance Measurement plays a

vital role in every organisation as it is often viewed as a forward#looking system of

measurements that assist managers to predict the company$s economic performance and spot the

need for changes in operations" %n addition, PM can provide managers, supervisors and operators

with information re&uired for making daily !udgments and decisions" PM is increasingly used yorganisations, as it enales them to ensure that they are achieving continuous improvements in

their operations in order to sustain a competitive edge, increase market share and increase profits"

'easons for adapting performance measurements(#

1. )o evaluate the performance of firm*department*individual"

2. )o control different activities so that it leads to achieve organi+ational goal"


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3. )o udget according to the future re&uirement"

4. )o motivate y giving people significant goals to achieve and then use performance

measures to provide periodic sense of accomplishment"

TRADITIONAL MEASURES

)raditional PM has mainly een financial measuring ratios such as '% -'eturn on %nvestment.,

'% -'esidual %ncome., and EP/ -Earnings per share." )hese metrics accounts for the costs

associated with capital and help firms spot areas in which capital is eing invested unprofitaly"

Although these financial data have the advantage of eing precise and o!ective, the limitations

are far greater, making them less applicale in today$s competitive market" rganisations, that

have adopted the traditional PM, have e0perienced great difficulty in trying to fit the measures

with increasing new usiness environment and current competitive realities"

While the traditional financial metrics are value#ased, they are nonetheless lagging indicators")hey offer little help for forward#looking investments, where future earnings and capital

re&uirements are largely unknown investments such as new product introductions and capital or

new market entry"

1ail to measure and monitor multiple dimensions of performance, y concentrating

almost e0clusively on financial measure"

)hey solely concentrate on minimising costs and increasing laour efficiency while

neglecting other operational performance measures such as &uality, responsiveness and

fle0iility"

Allowing managers to use slow#reacting and tactical management control system such as$udgets$" )hese udgeting measures mainly focus on short#term value creation as it only

attempts to control and improve e0isting operations"

Moreover, most companies motivate their worker through reward system" )raditionally,

employees are rewarded with onuses at the end of the year once a specific target has

een achieved" 2owever, this reward system causes short#termism as employees are seen

to narrow down their focus y !ust targeting the $rewarded$ goal"

)hus, ma0imi+ing shareholders value is ecoming the new corporate standard in the world"

/hareholder3s wealth is measured in term of the returns they receive on their investment" )he

returns can either e in the form of dividends or in the form of capital appreciation or

oth" Capital appreciation depends on the suse&uent changes in the market value of the

shares" )his market value of shares is influenced y a numer of factors, which can e company

specific, industry specific and macro#economic in nature" )o help corporate to generate

value for shareholders, value#ased management systems have een developed" %ndeed, value#

ased management, which seeks to integrate finance hypothesis with strategic economic


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philosophy, is considered as one of the most significant contriutions to corporate financial

planning in the last two decade or so"

Many of the traditional corporate performance measures have een found to poorly correlate,

or even conflict, with management$s primary o!ective which is ma0imi+ing the market value

of a firm$s stock" Now, there are several new measures in the financial world that attempt toalign the ehaviors of an organi+ation with its stockholders$ interests" ne measure that has

received a great deal of notice and acceptance is Economic Value Added -EVA. which developed

y 4oel M" /tern and 5" 6ennett /tewart 7 Co" %mplementation of one of these measures,

such as EVA, can fundamentally change the ehavior of an entire organi+ation" )he new

measure focuses the ehavior of individuals throughout all parts of the organi+ation in a way

that is etter aligned with creating stockholder wealth" 6ecause performance compensation

incentives are ased upon the new measure, employees and stockholders mutually enefit"

)he EVA frame work, which is ecoming more and more desirale tool for measuring the

financial performance of corporates, offers a consistent approach to set goals and measureperformance, communicate with investors, evaluate strategies, allocate capital valuing

ac&uisitions and determine incentive onuses" 2owever, the EVA implementing and

improvement process is one of the several ongoing initiatives for a new corporate"

Economic Value Added -EVA. is a value ased performance measure that gives importance on

value creation y the management for the owners" Profit ma0imi+ation as a concept is age#old,

wealth ma0imi+ation is matured and value ma0imi+ation is today3s wisdom" /tern /tewart3s EVA

raises storm in corporate world and gives a new way to think aout rewarding management"

8saility of EVA largely depends on the &uality of accounting information system, as traditional

information system will not provide sufficient information to compute true EVA" )hus, EVA isre&uired to e tailored in line with accounting system, management philosophy and the degree of

demand of such a system" %n this paper, an earnest effort has een made to e0plain theoretical

foundation of EVA with its origination, definition, ways to make it tailored, ad!ustments

re&uired, scope and some other related issues" )he methodology used is a type of theoretical

mining of logics resulting a step#y#step process re&uired for EVA implementation" As corporate

house plans to move from traditional to value ased performance measures, EVA would yield

good result"

EVA: EVOLUTION AND GROWTH

/tern /tewart defines EVA as the difference etween a company$s net operating income after

ta0es and its cost of capital -/tern /tewart, 9::;." )he idea is that the value -positive or negative.

a company creates over a period of time is determined y its actual financial performance minus

the cost of capital re&uired to fund the performance" %n essence, /tern /tewart took

an accounting#ased metric, residual income -'%. that has e0isted for several decades and

reathed new life into it y manufacturing a very attractive acronym, EVA"


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At first glance this appears almost identical to the definition of EVA and raises the &uestion as to

whether EVA is simply another name for '%" )here are, however, some important differences" %n

general, '% does not ad!ust accounting earnings or accounting assets in calculating the level

of '% generated y an organi+ation during a given time span" %n essence, '% is a simplified form

of EVA" %t means EVA is not a newer innovation" 'esidual income is defined as operating profit

sutracted with capital charges" EVA is thus, one variation of residual income with ad!ustments

to how one works out income and capital" According to Wallace, one of the earliest to point out

the residual income concept was Alfred Marshall in 9


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of relatively high '7@, 5AAP statements will understate income statement earnings and

alance sheet accounts" )o correct for such distortions, /tern /tewart suggests a list of

specific ad!ustments that add e&uity e&uivalent reserves to capital and periodic changes in

the reserves to after#ta0 operating profits -/tewart, 9::9 /tern /tewart, 9::;." E0amples of

the e&uivalent reserves include items such as( deferred %ncome ta0 reserves, F%1

reserves, cumulative goodwill amorti+ation, unrecorded goodwill, intangiles not

capitali+ed, allowance for doutful accounts, and other reserves"

EVA is a powerful tool for several reasons( %t aligns employee ehavior with stockholder value

generation, separates employee incentive compensation from the traditional performance

measurement that compares actual to udgeted results, and it is relatively easy to communicate

and understand" EVA can ring great value to a company y focusing the entire organi+ation on

activities that produce results valued y shareholders" With a well#grounded

understanding of EVA, the financial organi+ation is uni&uely capale of providing counsel that

will ensure successful implementation of this new measure"

WHAT IS ECONOMIC VALUE ADDED (EVA)?

Economic Value Added -EVA. is the financial performance measure that comes closer than any

other to capturing the true economic profit of an enterprise" )hus, in modern economics and

finance area, EVA holds an important part that has less deate among practitioners" %t is the

performance measure most directly linked to the creation of shareholders wealth over time"

/hareholders are very much choosy for their interest into the usiness and they like management

to come up with very specific solution" 6y the time, it is estalished that the very logic of using

EVA is to ma0imi+e the value for the shareholders" More e0plicitly, EVA measure gives

importance on how much economic value is added for the shareholders y the management forwhich they have een entrusted with" EVA is e0ceptional from other traditional tools in the sense

that all other tools mostly depend on information generated y accounting" And we know

accounting more often produces historical data or distorted data that may have no relation with

the real status of the company" 6ut, EVA goes for ad!ustments to accounting data to make it

economically viale"

8nder conventional accounting, most companies appear profitale ut many in fact are not" As

Peter @rucker put the matter in a 2arvard 6usiness 'eview article, 8ntil a usiness returns a

profit that is greater than its cost of capital, it operates at a loss" Never mind that it pays ta0es as

if it had a genuine profit" )he enterprise still returns less to the economy than it devours in

resourcesDuntil then it does not create wealth it destroys it" Company may intentionally

pay ta0 to prove that they have made profit for their shareholders and thus a falsification is done

with owners that is not a rare corporate practice" EVA corrects this error y e0plicitly recogni+ing

that when managers employ capital they must pay for it, as if it were a wage" %t also ad!usts all

distortions that are very much prevalent in the information generated y

conventional accounting" )hus, it is the most demanded tool for the owners in every situation" %t

has een implemented in numerous large companies to motivate managers to create shareholder


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value -@odd and Chen, 9::?." )he decision role is very simple if the EVA is positive, the

company creates shareholder wealth" Negative EVA indicates that shareholder wealth is

destroyed -/tewart, 9::9." @e facto, EVA is the same as residual income -'%. that has een in

e0istence for several decades" )he only significant difference etween the two lies in the

handling of accounting distortions -@odd and Chen, 9::." EVA removes e0isting distortions y

using up to 9?G ad!ustments to traditional accounting data -/tewart, 9::9 6lair, 9::." )hese

distortions are disregarded in the '% calculation" %n this chapter, an earnest effort has made to

introduce EVA as a value ased performance measurement tool"

EVA-Economic Value Added. was developed y a New Hork Consulting firm, /tern /teward 7

Co in 9:


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Mathematically, the EVA can e calculated as(

COMPONENTS OF EVA

Cal!la"#$% $& N'" O'a"#%* P$" a&"' Ta+', (NOPAT)

NPA) is easy to calculate" 1rom the income statement we take the operating income and

sutract ta0es" perating income is sales less cost of sales and less selling, general and

administrative e0penses" )he following e0ample from KHL Company illustrates the NPA)

calculation(

KHL Co" -.

/ales BG,;?,===

Cost of goods /old 9,==,===

##############

5ross Profit ,;?,===

Fess(

Administrative, 5eneral

7 /elling E0penses G,==,===

##############

perating Profit ;,;?,===Fess(

)a0es >= 9,?


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component of risk is referred to as non#systematic risk" )he second component of risk is non#

diversifiale and is called the systematic risk" %t stems from general market fluctuations which

reflect the relationship of the company to other companies in the market" )he non#diversifiale

risk creates the risk premium re&uired y the investor" %n the security markets the non#

diversifiale risk is measured y a firm3s eta"

)he higher a company3s non#diversifiale risk, the larger is their eta" As the eta increases the

investor3s e0pected rate of return also increases" Current estimates of eta for a wide variety of

companies are availale from Value Fine and 6loomerg" /hareholders usually e0pect to earn

aout si0 percent more on stocks than government onds" With long term government onds

earning ">, a good estimate for the cost of e&uity capital would e aout 9;"> " )he true cost

of capital would e the weighted average cost of det and e&uity"

MEASURING CAPITAL EMPLOED

)he ne0t step is to calculate the capital that is eing used y the usiness, from the economistpoint of view" Accounting profits differ from economic profits" 8nder generally accepted

accounting principles, most companies appear to e profitale" 2owever, many actually destroy

shareholder wealth ecause they earn less than the full cost of capital" EVA overcomes this

prolem y e0plicitly recogni+ing that when capital is employed it must e paid for"

%n financial statements, created using generally accepted accounting principles, companies pay

nothing for e&uity capital" As discussed earlier, e&uity capital is very e0pensive" Economic

profits are defined as total revenues less total costs, where costs include the full opportunity cost

of the factors of production" )he opportunity cost of capital invested in a usiness is not included

when calculating accounting profits"

Capital would include all short and long term assets" %n addition, other investments that has eene0pensed using accrual accounting methods are now included as capital" 1or e0ample, research

and development, leases, and training, which are investments in the future, that 5AAP re&uires

to e e0pensed in the year they occur, would e treated as a capital investment and assigned a

useful life" %f the usiness invest in developing new products this year, that amount would e

added ack to operating profits and to the capital ase" %f the product has a five#year life, deduct

9*> of the investment would e deducted each year from operating profits and from the capital

ase in each of the ne0t five years"

FUNDAMENTAL CONCEPT OF EVAEVA is the amount of economic value added for the owners y management" )he thrust area fortoday3s management is to find means to create value for the owners" %t is now estalished that the

accounting profit in no cases represents the real value created for the owners" 6ut, it may

originate the calculation" %n other words, accounting profit is re&uired to

e converted into economic profit" 8nder EVA, all distortions in conventional accounting are

identified and accounting profit is ad!usted to make it distortion free and finally we get the


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amount of EVA" /tewart defined EVA -9::=, p"9;. as Net operating profit after ta0es -NPA).

sutracted with a capital charge" Algeraically, it can e stated as follows(

EVA O NPA)2Capital Cost

NP -9#). 2 Capital Emploed 3 Cost of Capital

Ad!usted NP -9#). 2 Capital Emploed 3 ACC

Ad!usted NP -9#).

'eturn 2 Capital Emploed 3 ACC

-'ate of '% 2 ACC5 Capital Emploed

66666666666666666666667 eq. 1)

1rom the aove derivation it is clear that EVA computation re&uires a lot of hurdles to e passed"

Net operating profit is ad!usted for accounting distortions and a charge on capital employed atthe rate of weighted average cost of capital -WACC. is sutracted from NPA) to reach to the

amount of EVA" %t aims to tell aout what happens to the wealth of shareholders" As per e&uation

9, earning a return greater than the cost of capital increases value for the owners and vice versa"

1or listed companies /tewart defined another measure that assesses if the company has created

shareholder value" %f the total market value of a company is more than the amount of capital

invested in it, the company has managed to create shareholder value" %f the case is opposite, i"e",

the market value is less than the amount of capital invested the company has destroyed

shareholder value" /tewart -9::=, p"9>;. calls it as Market Value Added -MVA. and can e

e&uated as follows(

MVA O Market Value of the Company 2Capital %nvested

Market Value of E&uity 2 6ook Value of E&uity -assuming Capital invested O 6V of E&uity.

-MV 6V. Numer of /hares utstanding

Present Value of All 1uture EVA ('. 2)

%n other words,

Market Value of E&uity O 6ook Value of E&uity Present Value of All 1uture EVA""""""""""

('. 3)

MVA is identical y meaning with the market#to#ook ratio" )he difference is only that MVA is

an asolute measure and market#to#ook ratio is a relative measure" %f MVA is positive that

means that market#to#ook ratio is more than one" Negative MVA means market#to#ook ratio

less than one" %f a company3s rate of return e0ceeds its cost of capital, the company will sell on

the stock markets with premium compared to the original capital -has positive MVA." n the

other hand, companies that have rate of return smaller than their cost of capital sell with discount


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I" a% al,$ ;'


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)he MVA rate of return concept is similar to that of the yield on a ond" When a ond is issued

with a yield greater than the current market rate then the ond will sell at a premium -there is

positive EVA and so the ond will sell at positive MVA." %f the yield of a ond is lower than the

current market rate then the ond will sell at a discount -there is negative EVA and so the ond

will sell at negative MVA." /ince the valuation formula given aove is always e&ual to @C1 and

NPV, then the right estimate of value is always otained regardless of what the original ook

value of e&uity is"

)he implementation process of EVA parallels the successful implementation of /tern /tewart

GMs, e"g", measurement, management system, motivation and mindset" EVA at the very

eginning looks for a measurement ase for converting accounting profits into economic reality"

Without commitment from management, the implementation of EVA is impossile" Managementsystem should e streamlined with the asic EVA philosophy" %t should e guaranteed that the

application of EVA is well accepted y all" And finally, mindset should e cultivated into the

corporate culture to make it the focal point for reporting, planning and decision#making"

4 M6S OF EVA

/tern /tewart descries four main applications of EVA with four words eginning with the letter

M"(#

1. M'a,!'/'%"

EVA is the most accurate measure of corporate performance over any given period" 1ortune

maga+ine has called it today$s hottest financial idea, and Peter @rucker rightly oserved inthe 2arvard 6usiness 'eview that EVA is a measure of total factor productivity whose

growing popularity reflects the new demands of the information age" %t rings goal

congruence or matching of employees and shareholders" %t provides significant information

eyond traditional accounting measures like '%, 'CE, EP/, etc

2. Ma%a*'/'%" S0,"'/

While simply measuring EVA can give companies a etter focus on how they are performing,

its true value comes in using it as the foundation for a comprehensive financial management

system that encompasses all the policies, procedures, methods and measures that guide

operations and strategy" )he EVA system covers the full range of managerial decisions,including strategic planning, allocating capital, pricing ac&uisitions or divestitures, setting

annual goals#even day#to#day operating decisions" )he management can use the EVA for

accessing the performance of the usiness units or segments within the company" %f the

segment is making surplus after achieving the cost of capital then it makes sense to invest

into it"


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3. M$"#8a"#$%

)o instill oth the sense of urgency and the long#term perspective of an owner, /tern /tewart

designed cash onus plans that cause managers to think like and act like owners ecause they

are paid like owners" %ndeed, asing incentive compensation on improvements in EVA is the

source of the greatest power in the EVA system" 8nder an EVA onus plan, the only way

managers can make more money for themselves is y creating even greater value for

shareholders" )his makes it possile to have onus plans with no upside limits" %n fact, under

EVA the greater the onus for managers, the happier shareholders will e"

4. M#%,'"

When implemented in its totality, the EVA financial management and incentive compensation

system transforms a corporate culture" 6y putting all financial and operating functions on the

same asis, the EVA system effectively provides a common language for employees across

all corporate functions" EVA facilitates communication and cooperation among divisions and

departments, it links strategic planning with the operating divisions, and it eliminates much

of the mistrust that typically e0ists etween operations and finance" )he EVA framework is,

in effect, a system of internal corporate governance that automatically guides all managers

and employees and propels them to work for the est interests of the owners" )he EVA

system also facilitates decentrali+ed decision making ecause it holds managers responsile

for#and rewards them for#delivering value"

EVA: AS A TOOL OF FINANCIAL MANAGEMENT MEASUREMENT

)he important goal of financial management is to create highest capital employees -owners 7

lenders. wealth and conse&uently enhancing the value of the firm" /hareholder wealth is

traditionally reflected y either standard accounting magnitudes -such as profits, earnings and

cash flow from operations. or financial statement ratios -including earnings per share and the

returns on assets, investment and e&uity." )his financial statement information is then used

y managers, shareholders and other interested parties to assess current firm performance, and

is also used y these same stakeholders to predict future performance" )he &uestion then

arises is whether these measures of corporate performance are linked to the

e0pectation of the shareholders"

)he prolem with these performance measures is that they lack a proper enchmark for

comparison" )he shareholders re&uire at least a minimum rate of return that the

aove mentioned performance measures ignore" Most of the time the enchmark used is the

industry average or the nearest competitor performance" 6ut the fact the industry

average or competitors performance may e elow what is re&uired y the investors is ignored"

/o a company may e earning returns etter than others in the industry ut it might not meet

the capital employee3s minimum e0pectations"


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An appropriate performance measure should assess how managerial actions affect the

firm value" 1or this to e happen, the performance measure must incorporate at least three things"

a" the amount of capital invested" the return earned on the capital and

c" the cost of capital -WACC.

)ale presents a comparison of profit, EP/, 'CE, 'E across the aove three parameters" %t

shows that those criteria have failed to capture the capital employees3 value

creation*destruction as a result of management actions" )here was a &uestion which indicators

can measure relialy the change in the value of the firmQ

A C$/a#,$% $& #&&''%" "a#"#$%al '&$/a%' /'a,!',

P'&$/a%'

M'a,!'

C$/!"a"#$% I%l!',

R'"!% Ca#"al E/l$0' C$," $& Ca#"alE/l$0'

P$"

EPS

ROCE

ROE

',

',

',

',

N$

',

',

',

N$

N$

N$

N$

ver the past several years, an alternative performance measure called Economic Value Added

-EVA. has een gaining acceptance in 8nited /tates" %t is acknowledged y institutional firms asa credile performance measure" %n order to overcome the limitations of accounting

ased measures of financial performance, 4oel /tern postulated a modified concept of

economic profit in 9::= in the name of Economic Value Added -EVA. as a measure of usiness

performance"

/tern has claimed that EVA as a tool of financial management was neither !ust a phenomenon

not it is limited to Ifor profit3 organi+ations" Economic Value Added has een put to use

for management performance evaluation and much more than !ust a measure of performance, it

is the framework for a complete financial management -for improving scarce capital

allocation and for valuation of a target company at the time of ac&uisition." Economic ValueAdded, through the implementation of a complete EVA#ased financial management

and incentive compensation system, gives managers superior information and superior

motivation to make decisions that will create the greatest shareholder wealth in any pulicly

owned or private enterprise" %t can improve the working lives of everyone in an organi+ation y

making them more successful and can help them produce greater wealth for shareholders,

customers, creditors and themselves"


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EVA as a tool of financial measurement enlightens us whether the operating profit is enough

to cover the cost of capital" /hareholders must earn sufficient return for the risk they have

taken in investing their funds in company3s capital" )he return generated y the company for

shareholders has to e more than the overall cost of capital to !ustify risk taken y shareholders"

%f a company3s EVA is negative, the firm is destroying shareholders wealth even though it may

e reporting a positive and growing earning per share and return on capital employed Economic

Value Added simply alances a company$s profitaility against the capital it employs to generate

this profitaility" %f a company$s earnings, after ta0, e0ceed the cost of the capital

employed in the usiness, EVA is positive" Market studies have indicated that a company

that continually generates an increasingly positive EVA will e rewarded y a higher stock

price" f course, if a company$s long#term prospects are impaired, due to market conditions,

litigation, management change or some other reason, then its stock price will not necessarily

increase"

/everal evidences e0ist to support the relationship etween EVA and firm performance"

/pecifically, the advantage of EVA is that it tends to identify specific idle assets or, from a

portfolio of assets, identify those that provide the lowest economic return" Conse&uently, EVA

can e raised and y(

i" Earning more profit without using more capital,ii" 8sing less capital, and*oriii" %nvesting capital in high return pro!ects"

)he 1igure shows the relation among Cash from operations, accounting earnings, 'esidual

%ncome and Economic Value Added" %t summari+ed the steps that transform underlying cash flow

from operation -C1. into economic value added -EVA."

EVA - CFO @ A!al, @ AT I%" Ca. C>* @ A. A

N'" I%$/' (NI)

N'" O'a"#%* P$" A&"' Ta+ (NOPAT

R',#!al I%$/' (RI)

E$%$/# Val!' A' (EVA)


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C1 O Cash flow from operations Accruals O Accrual introduced y the financial accounting process

N% O Net income efore e0traordinary items

A) %nt O After#ta0 interest -added ack to produce an operating performance numer that

is efore the cost of financing. NPA) O Net operating profit after ta0

Cap Chg O Charge for the estimated current cost of det and e&uity capital

Acc Ad! O /tern /tewart3s ad!ustments to NPA) and Capital for alleged accounting

distortions EVA O Economic value added -registered trade name of /tern /tewart 7 Company.

OTHER APPLICATIONS OF EVA

Val!'&$!,' D'#,#$% Ma7#%*

)o ma0imi+e shareholder wealth, decision makers at all levels must e value#focused" )he

market value of any firm is a function of its e0pected future performance, which in turn is a

function of the effectiveness of management" 1or Eg( # /tern /tewart 7 Co" helped clients

improve performance y etter understanding the value inherent in their strategy and operations"

)o assess the value of an ac&uisition target, analy+e the economics of a product portfolio,

formulating the structure of a compensation plan, or introducing a new financial management

framework, the approach for all pro!ects can e done from one vantage point #the strategy estma0imi+es the value creation of the usiness over time i"e" EVA"

Ma%a*', W>$ T>#%7 a% A" l#7' O


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falls, their incentive compensation should e at risk" %t helps in designing compensation system

for managers ased on EVA" )his approach effectively makes a manager think like an owner, and

provides strong motivation to make decisions that focus on the continuous improvement in EVA

decisions that the market will reward"

A C$//#"/'%" "$ C$%"#%!$!, I/$8'/'%"

A final condition for ma0imi+ing wealth is to focus on continuous improvement rather than

short#term goals" %nvestors don$t reward companies ecause managers have met their annual

udget they reward companies when managers regularly seek out and undertake initiatives that

improve long#term performance" /tern /tewart encourages clients to stay focused on continuous

improvement"

Val!' a,' S"a"'*0 a% Ma%a*'/'%"

/tern /tewart$s mission is to help clients estalish clear, accountale links etween management

action and the creation of shareholder wealth" %n his view, the most effective way to alignmanagement initiatives with shareholder interests is to implement a framework for decision#

making that is ased on the proprietary EVA measure" EVA has gained road acceptance in the

usiness community for its aility to help managers increase the value of their companies" More

than G== ma!or corporations, gloally, have adopted our EVA framework and een rewarded with

significant improvements in corporate performance and share price"

EVA V,. TRADITIONAL PERFORMANCE MEASURES

Conceptually, EVA is superior to accounting profits as a measure of value creation ecause it

recogni+es the cost of capital and, hence, the riskiness of a firm3s operations" 1urthermore EVA isconstructed so that ma0imi+ing it can e set as a target" )raditional measures do not work that

way" Ma0imi+ing any accounting profit or accounting rate of return leads to an undesired

outcome" 1ollowing paragraphs seek to clarify the enefits of EVA compared to conventional

performance measures"

EVA9 NPV 8,. IRR9 ROI

'eturn on capital is very common and relatively good performance measure" @ifferent

companies calculate this return with different formulas and call it also with different names like

'eturn on investment -'%., 'eturn on invested capital -'%C., 'eturn on capital employed

-'CE., 'eturn on net assets -'NA., 'eturn on assets -'A. etc" )he main shortcoming with

all these rates of return is in all cases that ma0imi+ing rate of return does not necessarily

ma0imi+e the return to shareholders" 1ollowing simple e0ample will clarify this statement( #

/uppose a group with two susidiaries" 1or oth susidiaries and so for the whole group the cost

of capital is 9=" )he group names ma0imi+ing '% as target" )he other susidiary has '% of

9> and the other '% of


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to ma0imi+e their own '%" )he etter daughter company re!ects all the pro!ects that produce a

return elow their current 9> although there would e some pro!ects with return -%''. 9B #

9;" )he other affiliate, in turn, accepts all the pro!ects with return aove to 9? and with the not#so#good susidiary '% increases from


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good and e0clusive investment pro!ects, Pro!ect 9 and Pro!ect B" Pro!ect 9 has lower %'' ut is

much igger in scope -igger initial investment and igger cash flows and igger NPV." Pro!ect

9 -the pro!ect offering lower %''. is etter for shareholders even though it has lower %''" )hat is

ecause it provides igger asolute return than Pro!ect B" )he reason is e0actly same as with

'%( ma0imi+ing rate of return percentage does not matter" What matters is the asolute amount

of shareholders3 wealth added"

%n the corporate control it is worth rememering that EVA and NPV go hand in hand as also '%

and %''" )he formers tell us the impacts to shareholders wealth and the latter tell us the rate of

return" )here is no reason to aandon '% and %''" )hey are very good and illustrative measures

that tell us aout the rate of returns" %'' can always e used along with NPV in investment

calculations and '% can always e used along with EVA in company performance" 2owever,

we should never aim to ma0imi+e %'' and '% and we should never ase decisions on these two

metrics" %'' and '% provide us additional information, although all decisions could e done

without them" Ma0imi+ing rate of returns -%'', '%. does not matter, when the goal is toma0imi+e the returns to shareholders" EVA and NPV should e in the commanding role in

corporate control and '% 7 %'' should have the role of giving additional information"

R'"!% $% '!#"0 (ROE)

'E suffers from the same shortcomings as '%" 'isk component is not included and hence

there is no comparison" )he level of 'E does not tell the owners if company is creating

shareholders wealth or destroying it" With 'E this shortcoming is however much more severe

than with '%, ecause simply increasing leverage can increase 'E" As we all know,

decreasing solvency does not always make shareholders3 position etter ecause of the increased

-financial. risk" As '% and %'', return on e&uity -'E. is also an informative measure ut itshould not guide the operations"

Ea%#%*, a% 'a%#%*, ' ,>a' (EPS)

EP/ is raised simply y investing more capital in usiness" %f the additional capital is e&uity

-cash flow. then the EP/ will rise if the rate of return of the invested capital is !ust positive" %f the

additional capital is det then the EP/ will rise if the rate of return of the invested capital is !ust

aove the cost of det" %n reality the invested capital is a mi0 of det and e&uity and the EP/ will

rise if the rate of return of that additional capital invested is somewhere etween cost of det and

+ero" )herefore EP/ is completely inappropriate measure of corporate performance and still it is

very common yardstick and even a common onus ase" EP/ and earnings can e increased

simply y pouring more money into usiness even though the return on that money would e

entirely unacceptale from the viewpoint of owners" EP/, earnings and earnings*EP/ growth

should therefore e aandoned as performance measures"

ADVANTAGES AND DISADVANTAGES OF EVA


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A8a%"a*', $& EVAEVA is more than !ust performance measurement system and it is also marketed as a

motivational, compensation#ased management system that facilitates economic activity and

accountaility at all levels in the firm"

/tern /tewart reports that companies that have adopted EVA have outperformed their

competitors when compared on the asis of comparale market capitali+ation"

/everal advantages claimed for EVA are(

EVA eliminates economic distortions of 5AAP to focus decisions on real economic

results

EVA provides for etter assessment of decisions that affect alance sheet and income

statement or tradeoffs etween each through the use of the capital charge against NPA)

EVA decouples onus plans from udgetary targets

EVA covers all aspects of the usiness cycle

EVA aligns and speeds decision making, and enhances communication and teamwork

Academic researchers have argued for the following additional enefits( 5oal congruence of managerial and shareholder goals achieved y tying compensation of

managers and other employees to EVA measures

6etter goal congruence than '%

Annual performance measured tied to e0ecutive compensation

Provision of correct incentives for capital allocations

Fong#term performance that is not compromised in favor of short#term results

Provision of significant information value eyond traditional accounting measures of

EP/, 'A and 'E

L#/#"a"#$%, $& EVA

EVA also has its critics" )he iggest limitation is that the only ma!or pulicly#availale sample

evidence on the evidence of EVA adoption on firm performance is an in#house study conducted

y /tern /tewart and e0cept that there are only a numer of single#firm or industry field studies"

EVA does not control for si+e differences across plants or divisions

EVA is ased on financial accounting methods that can e manipulated y managers

EVA may focus on immediate results which diminishes innovation

EVA provides information that is ovious ut offers no solutions in much the same way

as historical financial statement do"

5iven the emphasis of EVA on improving usiness#unit performance, it does notencourage collaorative relationship etween usiness unit managers

EVA although a etter measure than EP/, PA) and 'NW is still not a perfect measure

EVA IN INDIAN CORPORATES


21/26

)he corporate procedures have undergone through a deep#seated change in the modern time and

the use of traditional financial variales to e0plain the ehaviour of the present capital market is

not an appropriate move toward" 1urther, in the changing corporate environment, the

time has come to ga+e at association etween financial variales and stock prices or market

risk in different way"

ne outcome of the economic reforms implemented in 9::=3s in most of the countries around

the gloe is that the whole world is ecoming a universal economy and the si+e of usiness

entities has een increasing" )his has een happening ecause, in order to compete in the world

market, an organi+ation needs to have si+ale resources and the capaility to e the est

performer of these resources"

A &uestion that arises, as organi+ations grow in si+e, get decentrali+ed and are put

into units, is that of financial performance evaluation" )he financial performance

evaluation measure used needs to e accurate, consistent, and gloally analogous and should

lead to goal similitude etween the owners and managers" When all is said and is done, leadingmultinational companies, worldwide have already adopted EVA#ased system financial

management that out the system ahead of its competitors" %n such circumstances, the

%ndian corporates simply may not stay ehind for understanding and implementing the

concept" )he corporates in %ndia need to e fully e&uipped with Iifs3 along with Iuts3 of EVA

!ust not for the reason of gloal competition ut for their long#standing persistent

survival"

utstanding and competent management or good corporate governance or a system for

shareholders3 value conception, these are popular terms" Everyody speaks on the su!ect within

and outside the corporate organi+ation, ut not many are aware of as what to do and what not todo with reference to this concept" n the other hand, the concept of good corporate governance is

here to stay in this country and shareholders and financial institutions turn more down to

usiness, feels )e!pavan 5andhok, country Manager, %ndia for /tern /tewart 7 Company"

According to him,R %ndia companies on the whole have a poor average in wealth

creation"R ver G== companies3 worldwide implement the economic value added -EVA.

program, ut it is still relatively a new#metric and &uite emerging techni&ue for corporate

performance measurement in %ndia"

)he EVA analysis, un&uestionaly, has attracted much attention in the Western countries oth as

a management innovation as well as stock market analysis" )he recognition of such a techni&uein %ndian conte0t, nevertheless, shows to some e0tent diverse trends" Ma!ority of

companies are still not prepared to put in the EVA techni&ue for evaluating their financial

performance ecause of certain inherent difficulties associated with the computation" 6ut in a

country like %ndia where capital is still costly, one would have thought, corporate managements

would e trying to get a igger return for every rupees invested in the usiness" )his will

e happened y utili+ing the new performance measure, EVA" %t is emerging out from the


22/26

discussion made aove that the gloal market place is asking for some change in the role of

policy#makers and managers in corporate sector" As information systems get more refined,

managers will have the task of providing top management with information that is gloally

competitive for corporate decision#making" EVA is a measure that should e used y top

management to evaluate investment centre managers ecause it considers goal picture

etween shareholders and corporate managers"

'ecently a lot of emphasis is eing positioned on EVA rather than '%, as a measure of

corporate performance in the %ndian financial literature" 2owever, using the concept may not e

suitale since it is not without deficiencies and pitfalls" Certain disputes regarding EVA

calculation and implementation have een highlighted y /ateesh Sumar -B===." /ome of

the important pitfalls in the use of EVA revealed y them are as follows(

Most of %ndian companies suffer from over#capacity situations, which distort the EVA

results"

EVA analysis does not give any idea aout the financial performance ofcompanies that are affected y usiness cycle variations"

Possiility of error in calculating NPA) and also estimating WACC is another gray area"

When EVA is used as a measure to evaluate the performance of managers and their units,

they feel reluctant to ac&uire new fi0ed assets even if the circumstances demand so"

@espite all these arguale issues, EVA has made a position for itself not only in the Western

usiness community ut also in the %ndian corporate sector" 2owever, the recognition of this

concept in %ndia is gradually picking up and it is e0pected that in the coming years, more and

more %ndian companies will start relying upon this new measure of financial performance"

)his would, possily, catch the attention of policy#makers at 5overnment level,corporate level, and N53s engaged in investors3 protection to press the corporate managers

to come up to the e0pectation of shareholders in the country" With the appearance of EVA,

the managers may e &uite aware aout the e0pected return y shareholders which is

invarialy higher than return e0pected y the det holders" )hat is why, now a days, the

corporate superiors are eing re&uired to work on the model of trading on e&uity that would

design some surplus for e&uity shareholders" )his surplus, if placed under technical terminology,

may lead to positive EVA for the organi+ation"

%n view of the aove fact, the competent authorities in %ndia like %CA%, /E6% and Company Faw

6oard should issue wide#ranging guiding principles for the computation of EVA and its practicesin financial reporting and accounting disclosures y the corporate world" %t further e0pected

from %CA% to issue necessary guidelines to the appropriate odies in the country so that it may

ecome oligatory for %ndian companies to disclose their EVA in the financial statements"

A CASE STUD OF HINDUSTAN UNILEVER LIMITED


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O;'"#8', $& ">' S"!0)his study has the following o!ectives(

9" )o e0amine whether 2industan 8nilever Fimited -28F. has een ale to generate valuefor its shareholders"

B" )o compute the performance of the company y applying traditional performance

indicator like '% and the new corporate performance measure EVA"

1ollowing is the performance measurement of 28F for > years from B==B to B==? ased oninformation given"

-All 1igures in 's" Crore.

PARTICULARS 2 2 24 23 22

1. D';" 9?; ;?= 9>?= ;=G ;J.C$," $& E!#"0 9?";< 9>"> 9G" 9B":? 9G"G.W'#*>"' A8'a*' C$," $& Ca#"al

(WACC)

9>"G 9;"< 9="?? 99"= 9G";

K.C$," O& Ca#"al E/l$0' (3) 421.2 33.2 3K4. 41.4 4.3

ECONOMIC VALUE ADDED(EVA)

1.P$" a&"' "a+ (PAT) 9>G= 9;>> 99:: 9G 9;? 9B G9< G


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24 J 3J4 23.K 32.3J

2 114 2 3K. 2.K3

2 112 2JJ 42. J.1

RETURN ON INVESTMENT (ROI) FOR HUL

ECONOMIC VALUE ADDED (R,. C$') OF HUL


25/26

)he aove tale shows that divergence e0ists etween the performance results given ytraditional measure -ased on '%. and percentage of EVA on Capital Employed" )he 'eturn on%nvestment -'%. does not reflect the real value addition to shareholders3 wealth and it is notpossile to !udge the efficiency of any decision, value creation or value addition aspect is ofutmost importance in the present ackdrop of corporate governance ut EVA ased performancemeasurement system give an idea clearly aout the shareholders value addition or valuedestruction" )he company has een successfully ale to create value for its shareholders during

the study period"

)his clearly shows that 28F is creating value for its shareholders ased on EVA calculated overa period of > years" )hus Economic value Added -EVA. is increasingly eing applied tounderstand and evaluate financial performance of an organi+ation"

CONCLUSION

Economic profit # otherwise known as Economic Value Added -EVAT. is ased on classic

financial theory, and, for this reason, is not entirely different from traditional free cash flow

measures" )hree conceptual pillars support economic profit( firstly, Cash flows are more reliale

than accruals"/econd is that some period e0penses are # in economic reality # actually long#term

investments" Fastly, the company does not create value until a threshold level of return is

generated for shareholders"

2owever, economic profit is an appropriate performance metric for the company to e evaluated

and one can identify the many pros and cons in the process of its application" With only one

single performance numer, economic profit is proaly the est ecause it contains so much

information -mathematicians would call it elegant.( economic profit incorporates alance sheet
http://www.investopedia.com/terms/e/eva.asphttp://www.investopedia.com/terms/f/freecashflow.asphttp://www.investopedia.com/terms/a/accrualaccounting.asphttp://www.investopedia.com/terms/e/eva.asphttp://www.investopedia.com/terms/f/freecashflow.asphttp://www.investopedia.com/terms/a/accrualaccounting.asp


26/26

data into an ad!usted income statement metric" Economic profit works est for companies

whose tangile assets-assets on the alance sheet. correlate with the market value of assets # as

is often the case with mature industrial companies" %n contrary, some proponents argue

economic profit is all you need, it is very risky to depend on an single metric" )he companies

least suited for economic profit are high growth, new economy and high#technology companies,

for whom assets are $off alance sheet$or intangile"

6ut in overall, we can definitely say that EVAT has emerged as a powerful conceptual

framework and is practically implemented in most of successful corporations across gloe" %t3s

likely to stay as widely accepted concept ecause of its practical application and in depth insights

it throws on performance, efficiency and most importantly how much value has een created to

the shareholders )hus, EVA is oth a measure of value and also a measure of performance" )he

value of a usiness depends on investor3s e0pectations aout the future profits of the enterprise"

/tock prices track EVA far more closely than they track earnings per share or return on e&uity" Asustained increase in EVA will ring an increase in the market value of the company" As a

performance measure, Economic Value Added forces the organi+ation to make the creation of

shareholder value the numer one priority" 8nder the EVA approach stiff charges are incurred for

the use of capital" EVA focused companies concentrate on improving the net cash return on

invested capital"

'eferences(

9" U1inancial ManagementR %ndian Edition y Eugene 6righam and Micheal Ehrhardt

9=G#99B

B" Pandey % M U1inancial ManagementR Vikas Pulishing 2ouse,PP ;;#Gth /ept B==:

" http(**www"investopedia"com*ask*answers*=?*economicvsmarketv alueadded"asp # 9Gth

/ept B==:

corporate performance measurement through eva

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