EVAECONOMIC VALUE ADDED

Stern Stewart & Co.A global consulting firm established in 1982 by Joel M. Stern and Bennett StewartPioneered the EVA concept in 1989A financial performance measure that captures the true economic profit of an enterprise is neededEVA is used by over 300 successful companies

EVA Defined...EVA is a financial measurement tool that determines if a business is earning more than its true cost of capital.

EVA is the net operating profit minus an appropriate charge for the opportunity cost of all capital invested in an enterprise or project, or net income minus dollar cost of equity capital.

EVA is ...An estimate of true economic profit.A tool that focuses on maximizing shareholder wealth. A fundamental measure of Return on Capital.

EVA is True Economic ProfitUntil a business returns a profit that is greater than its cost of capital, it operates at a loss. -Harvard Business Review

History of EVAEVA is not a new concept: Alfred Marshall mentioned the concept of Residual Income in 1890. Adam Smith Maximize wealth of ownersModigliani & Miller Net Present Value (long term tool) Established by Stern Stewart in 1989

Why use EVA? The Four MsManagement SystemMotivationMindsetMeasurement

Management SystemSimply measuring EVA can give managers a better focus on performance.Provides a foundation for a comprehensive financial management system

MotivationIncentive plans to make managers think like owners because they are paid like owners. EVA Bonus Plan

MindsetChanges corporate cultureEVA system provides a common language for employees across all corporate functions. Facilitates decentralized decision making

MeasurementMost accurate measure of corporate performance over any given period.Translates accounting profits into economic reality.

Prime Directive: Maximize Shareholder WealthPrimary Goal: Maximize Shareholder Wealth

Maximizing Shareholder Wealth Maximizing Market Value, or Total Value

Maximizing Shareholder Wealth and Market Value AddedMaximize shareholder wealth only if the companys managers are able to add value to the Total Equity Capital

This added value is what we call, Market Value Added, or MVA

Market Value AddedMVA is the difference between a companys Total Value and its Total Equity Capital.

MVA = Total Value Total Equity Capital

MVA Component: Total Value Total Value = Market Value of Equity = Market Capitalization = Current Market Share Price x (No. of Shares Outstanding)

MVA Component: Total Equity CapitalTotal Equity Capital = Book Value of Equity = Common Stock + Capital Surplus + Retained Earnings Treasury Stock

Importance between Market Value and MVA: GM ExampleIn 1988, General Motors:

Market Value = $25 billion Total Equity Capital = $45 billion

MVAGM = $25 billion - $45 billion = - $20 billion

Importance between Market Value and MVA: Merck Example In 1988, Merck:

Market Value = $25 billionTotal Equity Capital = $5 billion MVAMERCK = $25 billion - $5 billion = + $20 billion

MVA: GM and Merck Same Market Values at the end of 1988.However, Merck created $20 billion while GM destroyed roughly the same amount.

MVAGM = - $20 billionMVAMERCK = + $20 billion

Shareholder Wealth and MVAMaximize not only Total Market ValueBut the difference of Total Market Value and Total Equity Capital

In short, Maximize Shareholder Wealth = Maximizing MVA

How does MVA relate to EVA?To increase MVA => increase Economic Value Added, or EVAMVA is a premium based on market expectations of future EVAs

Shareholders Wealth = MVA = PV of Future EVAs

Calculating EVAEstimate based on revised reported earnings:

EVA = Sales Operating Expenses - Depreciation - Interest Expenses (includingTaxes) Equity Financing Expenses ( or, Cost of Equity x Total Equity Capital = Net Income - Keq x Total Equity Capital = Net Income - $ Cost of Equity Capital

The Coca-Cola Company ExampleEVA = Net Income Keq x Total Equity Capital = $3,533 million 12% x $7,700 million = $3,533 million $924 million = $2,609 million

The $2.6 billion is an estimate of the companys true economic profit for 1998.

Residual Income & EVABangalore City Subduction Plant (Rs. mil)Given COC = 10%

Residual Income & EVAIncomeSales550COGS275Selling, G&A 75200taxes @ 35% 70Net Income$130

AssetsNet W.C. 80Property, plant and equipment1170less depr.360Net Invest..810Other assets110Total Assets$1,000Bangalore City Subduction Plant (Rs. mil)

Residual Income & EVAResidual Income or EVA = Net Rupee return after deducting the cost of capital EVA is copyrighted by Stern-Stewart Consulting Firm and used with permission.

Residual Income & EVABangalore City Subduction Plant (Rs. mil)Given COC = 10%

EVA of Indian firms - 2005(Rs. in Crores)

Why should you implement EVA?A consistent way of improving firmAllows Managers to make better decisionsAligns interests of Managers and investorsImproves communication Used to Evaluate Corporate ManagementBest measurement of shareholder wealth

EVA is ConsistentFinancial Management System or FrameworkGoal is continuous improvement of EVA to increase stock priceEnds confusion of multiple goals

Managers behave like ownersIncentive package offers rewards based on EVA improvementCash bonuses have no limitPlan is Long-term

Improves CommunicationDecentralizes authorityMotivates management and workers to cooperateInvestors understand goals

Evaluating ManagersMeasures true profitabilityHigher correlation with Stock PriceKeq gives investors opportunity costEvaluate divisions of company

Why should you implement EVA?Best measurement of shareholder wealthA consistent way of improving wealthAllows Managers to make better decisionsAligns interests of Managers and investorsImproves communication

AdvantagesEVA can be calculated for divisions and even projects.EVA is a measure that gauges performance over a period of time rather than at a point of time. EVA is a flow variable and depends on the ongoing and future operations of the firm or divisions. MVA, on the other hand, is a stock variable.EVA is not bound by the Generally Accepted Accounting Principles (GAAP). As we discuss below, appropriate adjustment are made to calculate EVA. This removes arbitrariness and scope for manipulations that is quite common in the accounting-based measures.EVA is a measure of the firms economic profit. Hence, it influences and is related to the firms value.

Message of EVA+Managers are motivated to only invest in projects that earn more than they cost.+EVA makes cost of capital visible to managers.+Leads to a reduction in assets employed.-EVA does not measure present value-Rewards quick paybacks and ignores time value of money

SUMMARYEVA is a financial measurement tool that determines if a business is earning more than its true cost of capital

Most accurate in measuring true profitability; motivates managers to think like owners; and provides a common language within the corporate culture.

Shareholder Wealth = MVA = PV of future EVAs

THE END

First, Id like to tell you a little about Stern Stewart & Co.We were established in 1982 by Joel Stern and Bennett Stewart. We are a modern global consulting firm specializing in helping companies in the measurement and creation of shareholder wealth through the application of tools based on modern financial theory. We are the company who pioneered the concept of Economic Value Added and today, over 300 companies use EVA.

EVA is defined as the net operating profit (NOPAT) minus an appropriate charge for the cost of capital. Alone, EVA is the an estimate of the true economic profit of a firm, or the amount by which earnings exceed the amount invested in the company.Only when earnings surpass all that was invested in the firm, is there a profit and shareholder wealth is created. NOPAT is the profits derived from a companys operations after taxes, but before financing costs and noncash-bookkepping entries. The capital charge is the product of the cost of capital times capital tied up in investment. In other words it is the cash flow required to compensate investors for the riskiness of the business given the amount of capital invested. Carlos will go into the details of calculating EVA in a moment. Like I said earlier, EVA is an estimate of true economic profit. By looking at how profitable a company is through other financial measurement tools, a shareholder may be fooled by the companys true wealth because of accounting tricks (write offs, etc). EVA focuses on shareholder wealththe EVA formula takes into account a companys earnings and what a shareholders return should be. If a company has an EVA above 0, the shareholder is actually earning more than enough to compensate them for their invested capital. EVA is simply another measurement of a companys return on capital. EVA is not a new discovery. EVA is a spin off of the concept residual income. Residual income was actually thought of as early as 1890 by Alfred Marshall. It never really caught on until the last decade or so, probably in a time when investors demand a focus on shareholder wealth most. Once Stern Stewart introduced the concept, it took off. There are 4 main reasons why you should implement EVA into your company. When implemented, EVA fundamentally affects the Management System, Motivation, Mindset, and Measurement aspects of your company.

Measuring EVA can give companies a better focus on how they are performingAnd its true value comes in using it as the foundation for a comprehensive financial management systemThe EVA system covers the full range of managerial decisions, including strategic planning, allocating capital, acquisitions, and setting annual goalsWith EVA in place, managers realize that there are only 3 ways to increase shareholder value: Increase returns from capital already invested in the company by using it more efficiently, invest new capital and earn more than the cost of capital, or release capital from existing operations that would earn you a higher return elsewhere.

Under an EVA bonus plan, managers think and act like owners because they are paid like owners. They are paid bonuses with no upside limits when they improve EVAthe only way they can make more money for themselves is to create more value for shareholders.

When implemented in its totality, the EVA financial management and incentive compensation system transforms corporate culture. By putting all financial and operating functions on the same basis, the EVA system effectively provides a common language for employees across all corporate functions. The EVA framework is a system of internal corporate governance that automatically guides all managers and employees to work for the best interests of the owners

In calculating EVA, we first make a number of adjustments to conventional earnings in order to eliminate accounting inconsistencies and bring them closer to true economic results. For example, GAAP requires companies to expense R&D outlays even though the expenditures are investments in future products or processes. EVA capitalizes R&D and amortizes it over an appropriate period.

The primary objective is to maximize the wealth of its shareholders, and that the value of a company depends on the extent to which investors expect future profits to exceed or fall short of the cost of capital.