Financial management seeks to create wealth or value for shareholders since shareholders are interested in knowing what return they will receive on their investment. Thus, value creation for shareholders is undoubtedly a corporate objective for any company.
What is Economic Value Added & Market Value Added?
The ability of firms to manage, utilize, and allocate funds efficiently by generating surpluses beyond what shareholders expect measures manager efficiency. Several corporate behemoths, including Coca-Cola, Infosys, and HUL, have taken steps to move in this direction. This article will describe the two most widely used solutions in this direction, EVA (Economic Value Added) and MVA (Market Value Added).
Economic Value Added
Economic Value Added is the abbreviation for EVA. In addition to being referred to as the Stern Stewart Approach, it was first proposed by that firm to measure earnings efficiency. It demonstrates the surplus economic profits generated to investors by the firm after capital costs are met, which is written as follow:
EVA = PAT – (COC * CAPITAL)
EVA = Economic Value Added, excess returns over capital charges are quantified
PAT = Profit After Taxes of the firm, it is nothing but EBIT plus tax expense, the excess returns the firm would generate after meeting tax expenses.
COC = Cost of Capital incurred by a firm to raise funds from various sources. It is the aggregate or Cost of debt and equity. The cost involved in raising funds from various sources.
Capital = Implies total capital invested or capital employed in the business, it is important to be noted that non-cash items, like depreciation that do not lead to provisions that do not leads to cash outflows, are required to be adjusted, as these resources can be further utilized in the business.
- EVA (Economic Value Added) is the incremental difference in the rate of return (RoR) over a company’s cost of capital. As EVA calculates the surplus left after meeting all capital charges, it is also called the residual approach. It makes the management more accountable for their decisions.
- Essentially, we’re trying to determine what cash flows that would exist after taxes were paid by business operations. The depreciation has been left untouched in this case, as it is an operational expense for the limited purposes of EVA. To arrive at the actual cash earnings, we need to identify the non-cash expenses and adjust them. A common non-cash adjustment would be the provision for bad and doubtful debts, which is a book entry rather than an actual cash outflow.
Also Read, What Is Cost of Capital?
Uses of Economic Value Added in analysis
(1) The role of EVA is to assist managers in focusing their attention on how their decisions impact the profit of shareholders and select and allocate funds strategically on the projects.
(2) EVA is a good performance indicator; based on the EVA, investors can determine if they should invest money in a particular company. Companies generating higher EVA would be lucrative to them.
(3) The EVA can be used to value goodwill and shares. Higher EVA indicates higher efficiency in funds allocation and, leading to higher shareholder value and goodwill.
(4) For efficient operations in a decentralized enterprise, EVA is a good controlling device. Management can adapt EVA to find out the contribution of each decentralized unit or segment of the company. Research results show a higher level of efficiency than before the adaptation of EVA.
(5) EVA associated compensation schemes can be implemented for employees and managers to protect shareholders’ funds.
Issues with EVA
As it uses historical data and is based on past performance, it cannot make predictions of value-added, It may not be adaptable to cyclical industries with high fixed assets and long returns on investment.
The measure is based on value, but it contains only accounting information, such as discounted cash flows, which is not enough for investment decision-making.
Market Value Added
As the expression goes, “Everything is discounted on the stock market”, so share prices are a standard by which to measure efficiency.
Considering the share price, Market Value added is another way to gauge the value generated by a company. A business’ wealth is calculated in terms of the income generated by its investors, which is calculated according to the following formula:
Market Value Added = Market Capitalization – Book Value
Market Capitalization = Market Price per Share * No of shares outstanding
Book Value = The price at which shares were issued to the investors (Sometimes the value of an investment is also considered)
The difference between the Book Value and Market Value indicates how much value the firm generates or destroys for its shareholders. It is an indication that a firm has generated some value for its investors if its MVA is higher than its book value or capital invested.
If the Book value or investment value is higher than the Market value, it implies that the investment value is being destroyed. There is a loss of money for investors.
Even though both EVA and MVA measures value generation, there are slight differences between them.
Difference between EVA & MVA
EVA measures excess economic profits generated after meeting a firm’s operating and financial charges, whereas MVA suggested the wealth generated to the shareholders on their investment.
Details required to arrive at the EVA are extracted from Profit or loss A/C, balance sheet, and accounting statements. Whereas, MVA required a Balance sheet as well as stock prices data.
The company’s survival chances are boosted by higher economic profits, while MVA raises investors’ confidence and leads the share price up.
Issues with MVA
More often than not, the market price doesn’t represent the true value a business generates as market fluctuations and cyclical changes as the economy influences it.
EVA can be used to evaluate the performance of the department or division managers, but not market value-added as it changes according to investors’ thoughts and confidence and external to the company.
The MVA has very sensitive pricing and is subject to larger fluctuations than the EVA, which may cause investors to become confused.
Firms listed on a stock exchange can only be subject to it, and private companies cannot. Private company shares are not traded on the exchange, so this cannot be used.
- Methods for Business Valuation – Cost Method, Market Value & Discounted Cash-Flow Method
- What is Liquidity Ratio? How to Analyze a Business Using It
The linkage between EVA and MVA, we examine how these two tools work and are correlated with each other in this section. EVA is positive only if the return on capital exceeds the cost of capital. This means that investors are earning more than they would have earned if they had invested elsewhere.
The rise in hope and confidence propels the bull run in the share prices. Also, expected discounted EVA is considered by managers when computing the NPV (Net Present Value) of future MVA, reflecting investor expectations. There is evidence that both of these are correlated and provide valuable information about the company’s performance and value generation.