The EVA approach to investing

Abstract

[Chapter Introduction and Objectives]: That there is no profit unless the company earns the cost of capital is at the heart of some relatively new performance metrics like economic value added (EVA), which is defined as the difference between the net operating profit after taxes and the capital consumed. Many companies around the world have announced their commitment to improving their EVA. Analysts and fund managers who evaluate investment potential from the perspective investors are increasingly turning to EVA as an indicator of firm performance. This chapter discusses the EVA approach to investing. This chapter discusses the following objectives: • Discuss the calculation and characteristics of EVA • Highlight competitors to EVA • Provide evidence on EVA companies • Highlight how the implementation of EVA can lead to values enhancing strategies in a firm Since the objective of a firm is to maximize shareholders' wealth, a performance measure should have high correlation with changes in shareholders' wealth. Managers are commonly appraised on measures like return on assets, earnings per share, and return on equity that does not capture value. Managers focus on cash flows while evaluating capital investments; but when it comes to performance measurement, accounting measures take over. If a company changes its accounting method from first-in-first-out (FIFO) to last-in-first-out (LIFO) during a period of high inflation, cash flow increases but earnings fall. Similarly, when a company acquires another company, there may be special write-offs like amortization of good will that are noncash in nature. The earnings per share falls but cash flow is unaltered. Moreover, these measures can be easily manipulated due to 'denominator management'. One can increase the value of these ratios by simply cutting down whatever that appears in the denominator. Profit itself is not an appropriate measure of performance because it does not capture either the amount of capital used to generate those earnings or the required rate of return on capital. A good performance measure is one that incorporates all three. EVA is an accounting-based measure of operating performance. The period could be a month, quarter, half year, or a year. The entity whose performance is being measured could be a division or the firm itself. EVA is the difference between accounting earnings - with suitable adjustments for interest and some accounting methods - and the cost of capital used to generate these earnings.