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Economic Value Added: Much ado about nothing

N. Shanmuganathan

The proponents of the Economic Value Added tool argue that it is the only financial management system that provides a common language for employees across all operating and staff functions and allows all management decisions to be modelled, monitored, communicated and compensated in a consistent way — always in terms of the value added to shareholder investment. An apparently sensible approach, but there are fundamental flaws, as N. Shanmuganathan describes.

ECONOMIC Value Added (EVA) has received a good amount of interest in recent years. The main distinction between EVA and Net Profits, as reported in the P&L statement, is that "Net Profits" does not make an adjustment for the equity capital used. So a company, while making accounting profits, might still be destroying value from a shareholder perspective when the returns are lower in relation to the capital used. By incorporating the cost of equity, EVA claims to measure the amount by which profits exceed or fall short of the capital.

EVA is thus defined as net operating profit minus an appropriate charge for the opportunity cost of all capital invested.

Proponents claim that "EVA eliminates the confusion of having multiple goals by using a single financial measure that links all decision-making with a common focus: How do we improve EVA?" They also argue that "EVA is the only financial management system that provides a common language for employees across all operating and staff functions and allows all management decisions to be modelled, monitored, communicated and compensated in a single and consistent way — always in terms of the value added to shareholder investment."

An apparently sensible approach, but there are fundamental flaws, as described below.

Not complete

Given below are a couple of situations where the results of EVA analysis could be misleading.

How do we use EVA to decide if a firm should do a buyback?

By the very definition of EVA, a buyback doesn't add any value (refer 1999 Berkshire Annual Report to understand when a buy-back makes sense). In fact, according to EVA, a buy-back would reduce the worth of a company as there is a cash outflow without any associated inflows. While adjustments can be made to account for this outflow, EVA does not capture the benefits that accrue to the outstanding shareholders. Consider another example of two firms, A and B. They are identical in all respects — capital structure, business model, profits, etc. Firm A decides to acquire Firm B by issuing one stock of A for every stock of B. Now, after this acquisition, the EVA of the company A would have doubled, while stock owners of the company A will tell you that as far as they are concerned, no value has been added.Clearly, EVA is not complete, as claimed.

Not correct

For all practical purposes, proponents of EVA use CAPM for calculating the Cost of Equity. Notwithstanding the Nobel Prize to William Sharpe and the widespread acceptance among University Professors, knowledgeable investors will tell you that CAPM is, at best, an elegant equation. The not-so-reticent Charlie Munger, calls it a "Demented Theory".

Even from a common-sense perspective, why should the risk of a firm be reflected by Beta? After 30 years of arguments, even the most religious supporters of the Efficient Market Hypothesis acknowledge that decision-making among investors is hardly a rational process and that prices need not be reflective of the true value. Why, then, should numbers that are subject to movements on account of `irrational exuberance' or `maniacal depressions' be indicative of the risk of a firm or even that of the market?

Another mistake is the use of Capital Invested rather than the Market Value of Assets. When the Market Value of Assets is disproportionately high, using the Capital Invested on the books provides a erroneous picture of a company's performance.

Time-frames of investment projects are usually much longer than a year. To determine the success or failure of these projects, the returns over the entire period have to be taken into account.

Therefore, a project or, for that matter, even a company being EVA-negative in the early years is hardly indicative of the overall value.

Not even new

The present value of the EVA of a project over its life-time is exactly the same as the net present value (NPV) of the project. Thus, conceptually, EVA is no different from NPV — there is very little original other than it's "proprietary" nature. As long as assumptions made into the calculations are consistent, we would get exactly the same results for both EVA and NPV. EVA just happens to be a very special case of NPV and, as with all such definitions, a generalised methodology is better than a specific one.

Even if the NPV calculations prove difficult to do for an average investor, RoE always indicates the rate earned on its capital. Warren Buffett has been stressing for the last several decades on the importance of RoE, when he says "This hurdle rate is the RoE that must be achieved by a corporation in order to produce any real return for its individual owners".

Theoretical flaws

While EVA defines the goal of a company as Addition of Firm Value, the real goal ought to be "Addition of Firm Value on a Per-Share Basis".

Buffett emphasises the distinction when he says "We do not measure the economic significance or performance of Berkshire by its size; we measure by per-share progress". The distinction is explained in the "Owner's Manual" (downloadable from www.berkshirehathaway.com).

The above difference is usually the most important conflict between Management (which prefers bigger size of operations) and Share-owners (who seek growth on a per-share basis) and in not incorporating this distinction, EVA places Management interests ahead of that of the Share-owners.

Speculation time

So why did Stern Stewart (the global consulting firm that advises clients on the implementationof its proprietary Economic Value Added framework) get the definition wrong? Two scenarios:

— It did not really understand the difference.

— It knew the distinction, but still persisted with the faulty definition.

Our guess is that it is probably the latter — a case of "intentional ignorance". EVA, as it is defined today, is a mathematically elegant technique with little subjective interpretations. Incorporating the concept of a "per-share value" introduces many complications.

For one, CEOs need to make a reliable estimate of the intrinsic worth of a company; and the differences can be significant, even with two people with a similar background and valuation mindset. This would be true even of Buffett and Munger. Even more complex is the issue of making public this all-important number of per-share worth in the EVA calculations — we are not even sure if that's legally acceptable. So they chose the easier route, albeit a faulty one.

Limitations

We need to understand the limitations of accounting. Accounting is an abstraction that has been devised to compare performance of a diverse set of industries against a reasonably standard pattern. So, while the accounting laws might accurately capture the operating realities of one set of industries, it might do a terrible job of the others. Therefore, apart from the standard accounting numbers, managers also have to report numbers that they think truly captures the economic performance. Buffett emphasises this when he says "... because of the limitations of conventional accounting, consolidated reported earnings may reveal relatively little about our true economic performance. Charlie and I, both as owners and managers, virtually ignore such consolidated numbers. However, we will also report to you the earnings of each major business we control, numbers we consider of great importance... . We attempt to offset the shortcomings of conventional accounting by regularly reporting `look-through' earnings... We consequently regard look-through earnings as realistically portraying our yearly gain from operations." Even after determining what numbers are relevant, one has to be aware that a lot of these numbers cannot be accurately determined. For example, we all can guess at the useful life of items such as laptops, cars, etc. Just because companies express the depreciation of these items in neat percentages, it doesn't make those numbers any more real. And using these accounting approximations to calculate EPS up to the second decimal does not make it any more accurate.

Investors and companies should not be nave enough to believe that one magical number can capture the entirety of decision-making. Always look at multiple parameters — RoE, cash flows, RoCE, debt-equity and other parameters, as is appropriate.

Even more relevant is the fact that the most important of issues cannot be captured into immediate numbers, and these decisions reflect in the numbers over much longer time-frames. While using all of these numbers, companies should work towards adding to the Intrinsic Worth on a per-share basis.

Even so, EVA has some value in that it makes obvious the need to earn returns in relation to the capital employed. The concept that equity capital has a cost — an opportunity cost — and that the return on this is an important determinant of shareholder value — is sensible, though nothing new.

If Stern Stewart had stopped at this point, we would have had no major objections, the other mistakes notwithstanding. However, by adding a spin to make it an elixir of all management issues, ranging from incentive planning to acquisitions, it is really packaging old wine as a ten-course meal.

(The author is a Visiting Professor of Security Analysis at Great Lakes Institute of Management, Chennai.)

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