Economic value added or EVA ®

Economic value added or EVA® is a measure of the true economic profit of a company. Although in a sense it is nothing more than the traditional, commonsense idea of “profit”, it makes a clear separation from dubious accounting adjustments that may occur (remember ENRON, which for a long period of time was reporting profits, while in fact was in the final approach to becoming insolvent).

EVA® is calculated as the difference between the Net Operating Profit After Tax and the opportunity cost of invested Capital. This opportunity cost is determined by the weighted average cost of Debt and Equity Capital (“WACC”) and the amount of Capital employed.

The term EVA® is a registered trademark by its developer, the consulting firm Stem Stewart & Company, since 1994. Still, another much older term for economic value added, the Residual Cash Flow, has been also used by companies for years. These measures have their foundation in the residual income and internal rate of return, concepts developed in the 1950s and 1960s. Residual income was originally developed and used by General Electric (GE) to measure performance, and was popularized by McKinsey & Company as economic profit (Carton, Hofer, 2006).

Unlike other measures, EVA® can be calculated at divisional level (i.e. Strategic Business Units), can be used for performance evaluation over time, as it is a flow, and it captures the period-by-period value creation or destruction of a given firm or investment and thus makes it easy to audit performance against management projections.

EVA® can also be used for corporate valuation and equity analysis, motivating the managers and setting organizational goals.

Even though it is a much appreciated indicator, it also has some limitations. EVA® overemphasizes the need to generate immediate results and therefore it doesn’t stimulate investments in innovative products or process technologies. Also, when calculated at the divisional level of a company, it does not control for size differences, and a larger plant or division will tend to have a higher value than its smaller counterparts.

Taking into consideration the usefulness of EVA® , many companies have adopted it as part of a comprehensive management and incentive system, which leads their decision processes.

Changing our economic base – a long, slow process

Changing and expanding the Territory's economic base is a challenge. Canberra as the national capital was designed to have federal government business as its economic base. However, self-government in March 1989 brought with it an onus on the ACT Government to create and manage its own economy.

In terms of gross value added by various industry sectors, government administration and defence continue to be the largest industries in the ACT (contributing 31% of current price Gross State Product, above its long-term average of around 28%), followed by property and business services, ownership of dwellings and construction. Figure 1 demonstrates the relative contributions over a 10-year period.

Figure 1: ACT industry value added contribution to current price Gross State Product, 2006–07

Note: includes Agriculture, forestry and fishing, Mining, Manufacturing, Wholesale trade and Taxes less subsidies on products; Source: Australian Bureau of Statistics 2007c

The major non-government industries are all strongly related to property, construction and land development.

The 2005–06 review of the ACT public sector and services also acknowledged that continued above average public spending on the back of, among other things, proceeds of land sales, is not sustainable. The government's intention with the review was to achieve structural reform to reduce expenditure, accompanied by revenue measures, so that land-based revenues would be a decreasing proportion of the overall revenues in the future (ACT Government 2007a:17).

Land-related economic activity has consequences outside of economic growth, leading to loss of significant biodiversity (see Conserving biodiversity issue).  However, Commonwealth and ACT legislation are in place to protect biodiversity.

A recent example is the proposed residential development in the Molonglo Valley. The Spatial Plan, adopted as part of the Canberra Plan in March 2004, identified land for future residential development in the short-, medium- and long-term. Propelled by demand, particularly in the latter part of the reporting period, the ACT Government made a concerted effort to release land for housing. As part of this program, development of the Molonglo Valley, identified initially in the Spatial Plan as a possible future urban area over the next 30 years, has been brought forward. While some of that proposed development will involve conversion to residential land of pine forest that had been burned in the January 2003 bushfire, other parts of it may affect threatened wildlife habitat unless a satisfactory resolution can be achieved. This reinforces the need for planning to be strategic, regionally focused and based on sustainability principles.

The ACT private sector is characterised by large numbers of small and micro business (Small Business Commissioner 2006, see About the data). The Australian Bureau of Statistics estimates at the time suggested small and micro-sized firms in Canberra accounted for around one-third of the Territory's total workforce, and represented over 96% of all private sector firms.

The Chief Minister's annual Export Awards highlight successful business ventures in the ACT (see www.business.act.gov.au). In January 2007 the ACT Government released a new business prospectus, Investing in Australia's Capital, designed to assist business development and investment in the ACT.

Actions to support private business, such as the Canberra Commercialisation Council, the ACT Exporters' Network and the 'Live in Canberra' campaign, have received strong support from the Canberra Business Council. In its annual report for 2005–06, the council acknowledged the benefits of the ACT Exporters' Network in establishing links with other strategic groups such as Austrade, the Australian Institute of Export and Australian Business Limited to harness opportunities to grow the Territory's export community.

The Canberra Business Council also strongly promotes the interdependence between the Territory and its neighbours in the Australian Capital Region as a way forward.

EVA, SVA, and the Economy

While at Accenture, one of our analytical tools was Shareholder Value Analysis (SVA) – a tool based on Economic Value Added.  The premise is that by looking at a company’s financials, we can determine where to best target our innovation efforts.  The analysis can show us, for example, if reducing SG&A will have a greater impact on EVA than, let’s say, COGS.  It will tell us the impact on EVA if we increase sales by a certain amount.   It is a very powerful tool.  You can see the general model by clicking the image on the right.  The analysis is obviously a lot more complex.

This model works nicely in good times.  But does it work today?  What is it telling us?

I asked two of my ex-Accenture colleagues who are experts on SVA the following question:

Cost of Capital is part of the EVA equation. Given the credit crisis, how has this impacted EVA? Is cost of capital going up? If so, what does that mean in terms of where companies should invest then efforts? Or is it going down because the prime rate is so low? What does this mean that from a targeting perspective?

Here are the two responses:

Response #1: On the EVA question, theoretically the Cost of Capital is down given the prime.  But actually it’s up given the credit markets — the Libor is a good proxy (the rate at which banks lend to each other). The B2B rates are even worse, hence all the talk about the credit markets freezing up. In terms of targeting Cost of Capital, that’s a tougher question. Most of the action in EVA around the Weighted Average Cost of Capital (WACC) is related to more or less leverage. So targeting it would mean more leverage and there’s not too many companies that want to go in this direction now. In fact, we may have determined a “ceiling” on how far you can push on that lever.

Response #2: From a mathematical perspective, marginal cost of capital is fairly low these days. The availability of capital, however, is the real issue. In the current market it is difficult to raise capital. Therefore if an enterprise can generate excess cash and can identify opportunities with good returns they should certainly invest. It is no different for an individual. Assuming that a major catastrophe is not looming on the horizon and assuming that one has available cash, this is the time to invest. I should hasten to add that the “classical” capital market theories upon which WACC and EVA are based are NOT, in my opinion, quite valid in a tumultuous market where risk free rates are almost zero and people are simply keeping cash “under the mattress.”

Interesting thoughts.

My follow up question is, “Assumiung WACC is up, what is the relative impact of cost reduction versus revenue growth on EVA?”

What do you think?  I’d love to get many different perspectives on this topic.

The Relationship Economy: Value Creation Factors

Most intangible asset measurements have been top-down: Investors theorize a contributing factor and then try to figure out how to measure it. Studies have been performed using different approaches to determine such value.

What has been developed  is now known as EVA, or economic value added.

Some perceived value drivers translate into market value; others do not.

It suggests that in the connected economy, connections matter. Alliances are incredibly, even decisively, important.

HERE’S WHAT DRIVES VALUE (IN RANK ORDER):

Studies have shown a set of value drivers for Internet companies, because in no other industry are accounting values less relevant in explaining market capitalization. These drivers were culled from a stand-alone studies Forbes did on e-commerce firms. Here’s their list, in order of importance:

(1) alliances, (2) innovation, (3) eyeballs (usage traffic), (4) brand investment, (5) stickiness (minutes spent on Web pages).

Three categories had substantial effects on e-commerce market values. The most important was the number of alliances and alliance partners. Investments in innovation (captured by research and development and capital expenditures) ranked close behind. Perhaps the most widely discussed driver of e-commerce value—the number of “eyeballs” viewing a Web site—was measured by using data on a site’s visitors, reach, or market share, and the number of hyperlinks to other sites.

Forbes found that a high visitor count also was strongly associated with market values, supporting the push by e-commerce companies to drive traffic through their sites at almost any cost. Taken together, these three category relations indicate that the strength of an e-commerce company’s network—both in connections to its customers and alliances within its economic web of suppliers and other partners—has a profound effect on a firm’s value.

By contrast, investment in building brand awareness has no statistical association with market values. So much for those millions spent on Super Bowl ads. Big marketing campaigns may boost the egos of company executives, but the research suggests they do little to raise a firm’s value. Equally surprising, “stickiness”—vaunted as the next competitive step after eyeballs—proved only a minor contributor to value. This analysis was completed in the year 2000[i]

So what does this all mean to us as individuals?  For individuals involved in the networked economy, it provides a set of levers that, if effectively applied, can prepare you for individual performance and increase in market value.Consider what we do with the medium of social networking and the related emergence of adoption.  What are the attributes of participation within adult and business communities leveraging social networks as the medium? It appears obvious that the attributes closely match the drivers of value defined in the older study by Forbes.  These include: 

    alliances with others for both personal and professional gains

    innovation, our collective communities repeatedly fine news ways to leverage the medium

    eyeballs, Have you noticed the craze for expanding ones quantity and quality of connections and viewers to your blog post?
    brand investment, whether our businesses or us as individuals we investing time to build our brand for future opportunities
    stickiness- time spent on our profiles and in our communities reviewing our content

 As time goes by, a model will evolve to identify new value-creation drivers, while maintaining enough flexibility to adapt to the constantly changing nature of the companies and individuals that are producing value in the connected economy, The Relationship Economy.  Our individual strategies should be aimed at thinking through what value we can create and exchange with other individuals and communities as a whole.

The definition of ones value is the critical answer which facilitates the five drivers of value previously mentioned. When you define your value offering and how it can be leveraged through the medium of social networks you have defined a new means for wealth creation.

Today developers and networking platform operators are capturing the economic values. Tomorrow, when individuals define their value and unite with a purpose, the economic gains will be afforded to the users who leverage the five drivers of value creation.  The shift will create The Relationship Economy and it will disrupt markets globally.

Economic Value Added: The Practitioner’s Guide to a Measurement and Management Framework: Craig Savarese

The shareholder value creation philosophy is a central element in many companies’ financial management practices. A widely adopted approach to measuring financial performance and managing for value creation is economic profit (economic value added). A deceptively simple concept, companies often are not prepared for the challenges and issues they need to consider when measuring economic profit, nor for how to incorporate it into financial management practices. This book addresses these challenges by: developing a framework for linking economic profit to shareholder value; explaining the issues relevant to developing a company-specific economic profit measure; and demonstrating how to incorporate economic profit into financial management practices. The book is about practical application - designed as a user’s guide - so that you can apply shareholder value principles and understand the implications for your business. It shows how economic profit links to shareholder value, and dispels commonly cited myths about adopting a shareholder value framework to drive a company’s financial management practices. It is aimed at financial managers and accounting professionals, managers, consultants and equity analysts who want to understand the application of shareholder value.