Description
Economic value is a measure of the benefit that an economic actor can gain from either a good or service.
Economic Value Added
EVA® of Stern Stewart & Co
Peter Drucker put the matter in a Harvard Business Review article, "Until a business returns a profit that is greater than its cost of capital, it operates at a loss. Never mind that it pays taxes as if it had a genuine profit. The enterprise still returns less to the economy than it devours in resources…Until then it does not create wealth; it destroys it." EVA corrects this error by explicitly recognizing that when managers employ capital they must pay for it, just as if it were a wage
How Value is Created
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Management makes decisions, hopefully, with benefits exceeding costs
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Benefits may be near or distant future Costs should include direct investment costs + cost of capital True source of value-enhancing projects
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Firm’s comparative or competitive advantage.
EVA-© Baba
Slide 2
Comparative Advantage
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Advantage one firm has over another in terms of ? Cost of producing or ? Distributing goods/services ? Example: ? Wal-Mart invested in regional warehouses and distribution system ? Reduces the need for retail inventory ? Replenish store inventory quickly. Advantage one firm has over another because of structure of the markets in which they operate ? Barriers to entry ? Patents ? Capital requirements ? Regulation ? Influence over suppliers ? Influence over buyers
EVA-© Baba Slide 3
Traditional Measures
MEASURES OF CORPORATE PERFORMANCE
•Return on Sales (ROS)
•Return on Investment (ROI) •Residual Income (RI)
•Economic Value Added (EVA)
•Market Value Added (MVA) •Balanced Score Card
EVA-© Baba
Slide 5
Performance vs. Valuation
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Performance measurement
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Relies on actual results
? ?
Historical GAAP
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Valuation
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Relies on forecasts Stock price relies on investors’ expectations, not historical performance.
Slide 6
EVA-© Baba
Reconciling Value Drivers Avoid Mixed Signals
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The Traditional Financial Management System
Corporate Office
Investor Relations
EPS
Treasury Management Cost Accounting Capital Budgeting
Discounted Cash Flow Cash Flow
Strategic Planning Human Resources
Market Share, Earnings Growth
Asset Turns
ROE and Net Income
? ?
?
No common denominator of value. Heavily dependent on corporate synthesis and reconciliation of departmental figures. Information transfers slow and EVA-© Baba inefficient.
Slide 7
Reconciling Value Drivers Avoid Mixed Signals
?
The Traditional Financial Management System
?
The Ideal Financial Management System
Valuation Strategic Planning Annual Budgeting
Investor Relations
Treasury Management
Capital Budgeting Human Resources
Cost Accounting
? ?
?
No common denominator of value. Heavily dependent on corporate synthesis and reconciliation of departmental figures. Information transfers slow and inefficient.
EVA-© Baba
?
?
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Common language for allocating resources, conducting valuations, measuring performance, and communicating with investors. Minimal corporate synthesis and reconciliation. Information transfers real-time and Slide 8
Reconciling Value Drivers Avoid Mixed Signals
?
The Traditional Financial Management System
?
The Ideal Financial Management System
Valuation Strategic Planning Annual Budgeting
Investor Relations
Treasury Management
Capital Budgeting Human Resources
Cost Accounting
? ?
?
No common denominator of value. Heavily dependent on corporate synthesis and reconciliation of departmental figures. Information transfers slow and inefficient.
EVA-© Baba
?
?
?
Common language for allocating resources, conducting valuations, measuring performance, and communicating with investors. Minimal corporate synthesis and reconciliation. Information transfers real-time and Slide 9
Return on Investment
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Compare benefits (numerator) with resources (denominator) affecting that benefit
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Basic earning power ratio
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EBIT / Total assets Net income / Total assets Net income / Book value of equity
Slide 10
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Return on assets
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Measured relative to what?
?
Return on equity
?
EVA-© Baba
Pro’s & Con’s
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Benefits of these ratios
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Ease of calculation & interpretation Decompose to reveal sources of changes
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Downside of these ratios
?
?
? ?
Sensitive to choice of accounting method Accumulation of monetary values from different periods Backward looking Fail to consider risk.
Slide 11
EVA-© Baba
EPS
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EPS is such an unreliable measure of value that managers often make “dumb” decisions to increase it Prompts managers to misallocate capital – Treats retained earnings as a free source of capital – Promotes retaining capital and using it wastefully. Accounting rules discourage EPS-manic mangers from spending capital on value enhancing investments in intangibles like brands, research and training Why? – GAAP requires outlays to be written off immediately against earnings EPS focus may cause management to refrain from issuing equity at times when the company really needs it Fabricate EPS gains by using more debt than prudent Both on and off the balance sheet Accept weak projects that happen to be financed with debt.
EVA-© Baba Slide 12
EPS…
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Earnings manipulation often used
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?
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Establish reserves Invest pension funds in equities Extreme cases, make up numbers as you go
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Worldcom and HealthSouth.
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Today’s market perception:
“Management that aims to boost earnings at the expense of quality will be more certainly penalized then ever before with a lower stock price and a sullied reputation
EVA-© Baba Slide 13
Cash Flows
Statement of Cash Flows (SFC)
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SCF combines balance sheet and income info
? Eliminates
the “sins of accrual accounting”
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SCF consists of:
? Operating
cash flows ? Investing cash flows ? Financing cash flows.
EVA-© Baba
Free cash flow
Slide 15
Cash Flow Not the Answer
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Cash flow has problems as a valid performance measure
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So long as investments in projects earn a return higher than shareholders could earn by investing on their own, then the more investment a company makes and the more negative its cash flow becomes, the higher its share price will be.
Slide 16
EVA-© Baba
Better Than Some Alternatives
?
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Accounting profits versus cash operating profits Cash flow frequently defined as:
Net income + depreciation or as EBITDA
?
3000 2500 2000 1500 1000 500 0 -500 '97 '98 '99 '00 '01 '02 NI + depr. NI CFFO
Poor definition
?
Quality of earnings ...
EVA-© Baba
Slide 17
Free Cash Flows
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Definition:
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After-tax operating earnings + non-cash charges - investments in operating working capital, PP&E (Property,Plant & Equipment) and other assets It doesn’t incorporate financing related cash flows
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Represents cash flow available to service debt and equity.
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When used in capital budgeting proposals
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Based on expectations.
Slide 18
EVA-© Baba
FCF & Capital Budgeting
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FCF is the method of choice of most firms for evaluating capital budgets Identify incremental
? ? ?
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Investment in PP&E + working capital Revenues Costs (excluding financing) Depreciation tax shields.
Slide 19
EVA-© Baba
Common Techniques
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Evaluation techniques:
? ? ?
Payback Accounting rate of return DCF analysis
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Consists of NPV and IRR DCF analysis is not a problem in theory
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Only in practice.
EVA-© Baba
Slide 20
NPV Methodology
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Net present value (NPV)
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Estimate of change in the value of equity if the firm invests in the project Forward looking
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If NPV>0
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Investment is expected to add value Investment is expected to erode value
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If NPV<0
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Decision rule
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Invest in projects expected to enhance value.
Slide 21
EVA-© Baba
Internal Rate of Return
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Practice is to compare IRR with weighted average cost of capital Problem:
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IRR fails to measure scale or growth It sees no difference between earning a 20% return on a Rs. 1 million investment or a Rs. 1 billion investment
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These two projects are very different with distinctly different NPVs.
Slide 22
EVA-© Baba
Conflicts: NPV & IRR
Which to Choose? NPV Marketing Campaign IRR = 16.35% Discount rate
10% 10.7%
Product development IRR = 13.24%
Select project with higher NPV (product development project)
EVA-© Baba Slide 23
Value Enhanced?
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Once a project is applied, the investment becomes buried in the balance sheet
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How is its contribution measured?
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No idea whether project generates value
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Accounting measure relied upon
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EBITDA and EPS generally increase Means? Bonuses probably will be paid
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Motivation:
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Get your hands on as much capital as possible.
Slide 24
EVA-© Baba
Focused Finance & EVA
Interpreting EVA
? ?
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Calculation reflects the idea that firm must earn enough to cover the cost of debt and the opportunity cost of equity before it even begins to create value. Representing real profit versus paper profit, EVA underlies shareholder value, increasingly the main target of leading companies' strategies. A positive EVA means the firm generated a return to invested capital that exceeds the opportunity cost of capital
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The “value” of the firm should increase
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A negative EVA means the firm did not generate sufficient return to cover it’s cost of capital
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The “value” of the firm should decline
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The absolute value of EVA is less important than the trend in EVA
EVA-© Baba
Slide 26
EVA & Wealth Creation
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Warren Buffet:
We feel noble intentions should be checked periodically against results. We test the wisdom of retaining earnings by assessing whether retention, over time, delivers shareholders at least Rs. 1 of market value for each Rs. 1 retained.
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Translation:
Ultimate litmus test of any company’s success lies in increasing its market value by more than it increases its capital.
EVA-© Baba
Slide 27
View of the Firm
Market Valued Balance Sheet Assets Debt Equity
?
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Value of firm = Value of debt + value of stock Market value of a company reflects: ? Earning power of invested assets
? Present
value of current operations ? Present value of expected improvement in operating performance.
EVA-© Baba Slide 28
What is Required to Focus?
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Tie performance methods to capital budgeting techniques:
? ?
Economic value added (EVA) Market value added (MVA)
Links to NPV
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Want to gauge management’s performance
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Focus on:
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Decisions made in the past to help project the future.
Slide 29
EVA-© Baba
What is EVA?
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EVA = Economic profit
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Not the same as accounting profit
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Difference between revenues and costs
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Costs include not only expenses but also cost of capital
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Economic profit adjusts for distortions caused by accounting methods
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Doesn’t have to follow GAAP
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R&D, advertising, restructuring costs, ...
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Cost of capital accounted for explicitly
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Rate of return required by suppliers of a firm’s debt and equity capital Represents minimum acceptable return.
Slide 30
EVA-© Baba
Components of EVA
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NOPLAT
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Operating capital
Net operating profit after tax Net operating working capital, net PP&E (Plant, Property & Equipment) goodwill, and other operating assets Weighted average cost of capital % Cost of capital % * operating capital NOPLAT less the capital charge.
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Cost of capital
? ?
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Capital charge
?
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Economic value added
EVA-© Baba
Slide 31
What is NOPAT?
Net sales Cost of sales Depreciation SG&A Net Operating profit Taxes @ 40% NOPAT 150,000 135,000 2,000 7,000 6,000 2,400 3,600
Excludes financing charges
EVA-© Baba Slide 32
What is Operating Capital?
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Capital: Net operating assets adjusted for certain accounting distortions
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Asset write-downs, restructuring charges, …
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Net operating assets:
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Cash, receivables, inventory, prepaids Trade payable, accruals, deferred taxes Net property, plant, and equipment
Marketable securities, investments,...
Slide 33
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Exclude non-operating assets:
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EVA-© Baba
What is Cost of Capital?
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Weighted average cost of capital consists of:
Cost of debt after taxes = Market interest rate x (1 – tax rate) Cost of equity = Risk-free rate + beta x (market risk premium) WACC = Cost of debt after taxes x % debt + cost of equity x % equity where % debt + % equity = 100%.
EVA-© Baba Slide 34
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? ?
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Risk Premium used in the CAPM (Capital Asset Pricing Model) is the excess average return on select stocks over average return on risk free securities over the measurement period. Damodaran has suggested use of lone run average taking the measurement period of at least ten years. There is also disagreement as regards type of mean to be used . Arithmetic mean is justified as it is more consistent with the mean – variance framework of the CAPM . Whereas the geometric mean is justified on the grounds that it takes compounding into account and that is a better predictor of the average premium in the long term. There can be significant difference in premiums depending upon the choice of average. For computing risk premium , it is possible to take return on broad based market index over risk free rate.
EVA-© Baba Slide 35
Risk Premium
Risk Free Rate
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Variants on the risk free rate - Damodaran explained
use of three variants of risk free rate for computing cost of equity : Short term government security rate : This may be justified in the CAPM framework which is considered as a one – period model; Short term forward rate : This is based on superiority of the forward rate in forecasting future short term rate; and Current long term government bond rate : This takes a strict view of matching the duration of the risk free security with the duration of assets being nalyzed. Damodaran has finally used long term rate for computing risk free rate.
Slide 36
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EVA-© Baba
Risk Free Rate
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As per Indian Fixed Income Securities Market , National Stock Exchange , April 2002 issue Yield on Government Securities of maturity range over 10 years was 8.05% in February 2002 , 8.06% in March 2002 and 7.79% in April 2002. So for illustrative purpose 8.06% can be taken as risk free rate, which is maximum of the latest yield.
EVA-© Baba
Slide 37
What is the Capital Charge?
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Represents a rental charge for the use of the operating capital Minimum rate of return the operating capital should earn Calculated as the firm’s weighted average cost of capital % x invested capital.
EVA-© Baba
Slide 38
Calculating EVA
NOPAT/Average capital = Return on invested operating capital (ROIC) - Weight average cost of capital (WACC) = Spread (= ROIC - WACC) X Operating capital = Economic value added (EVA) Net operating profit after tax (NOPAT) - Capital charge (= WACC * Capital) = Economic value added (EVA)
EVA-© Baba
Slide 39
Calculating EVA
1] NOPAT (Net Operating Profits After Tax) PPBT (Profits Before Tax) Add back interest Add/Deduct Adjustments for non operating income & expenses) = OPERATING PBT Less Taxes =NOPAT (Net Operating Profits After Tax) 2]EVA= NOPAT/Average capital = Return on invested operating capital (ROIC) - Weight average cost of capital (WACC) = Spread(= ROIC - WACC) X Operating capital = Economic value added (EVA) 3] Net operating profit after tax (NOPAT) - Less Capital charge (= WACC * Capital) = Economic value added (EVA)
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Relationship to Market Value Added The firm's market value added, or MVA, is the discounted sum of all future expected economic value added: ? Note that MVA = NPV of company. EVA-© Baba Slide 40
What’s Affecting EVA?
Sales - Operating expenses - Taxes = NOPAT
Market potential COGS, SG&A + other Potential gov’t actions Net working capital PP&E WACC
- Capital charge
= EVA
Evaluate the many assumptions!
EVA-© Baba Slide 41
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Stern Stewart developed EVA to help managers incorporate two basic principles of finance into their decision making. The first is that the primary financial objective of any company should be to maximize the wealth of its shareholders. The second is that the value of a company n depends on the extent to which investors expect future profits to exceed or fall short of the cost of capital. By definition, a sustained increase in EVA will bring an increase in the market value of a company the level of EVA isn't what really matters. Current performance already is reflected in share prices. It is the continuous improvement in EVA that brings continuous increases in shareholder wealth.
EVA-© Baba Slide 42
Forward Looking Relationship for EVA & MVA
EVA Year 1 EVA Year 2 EVA EVA Year 3 .... Year n
Market Value Market value
MVA
EVA + EVA + 1+r (1 + r)2 EVA + ... + EVA (1 + r)3 (1 + r)n
=
Book value capital
Market value is based on establishing the economic investment made in the company (capital), making a best guess about what economic profits (EVA) will happen in the future, and discounting those EVAs to the present to get market value added.
Slide 43
EVA-© Baba
EVA Drives MVA
Companies that consistently earn profits in excess of their required return ...
NOPAT EVA
Charge
… are typically valued at premiums to book value.
Market Value
Capital
EVA-© Baba Slide 44
MVA
Fundamental Strategies
? NOPAT ? EVA ? ? ? Cost of capital ? * Capital ? Capital ?
Operate: Improve the return on existing operating capital Decrease: WACC Build: Invest as long as returns exceed the cost of capital Harvest: Re-deploy capital when returns fail to achieve the cost of capital.
EVA-© Baba Slide 45
An Example of Drivers
EVA-© Baba
Slide 46
Focus on EVA Improvement
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A positive change in EVA is better than a positive yet unchanging base level of EVA
? Why?
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Positive changes in EVA are consistent with “shareholder value added” -- whether from a positive or negative base Positive changes in EVA are consistent with the managerial notion of continuous improvement in performance.
Slide 47
EVA-© Baba
Why Use EVA & Not NPV?
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? ? ?
Present value of EVA = Present value of NPV Provides insight into each period Is a direct link to performance More useful for future project audits.
EVA-© Baba
Slide 48
An Example Revisited
(See Slides 27 & 28)
Asset's Balance 200 190 180 170 160 150 140 130 120 110 100 90 80 70 60 50 40 30 20 10 0 Period 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 NPV IRR WACC NOPAT 115 110 90 70 60 40 30 20 15 15 15 15 15 15 15 15 15 15 15 15 Deprec 10 10 10 10 10 10 10 10 10 10 10 10 10 10 10 10 10 10 10 10 FCF -200 125 120 100 80 70 50 40 30 25 25 25 25 25 25 25 25 25 25 25 25 $125.86 50.4% 25% CapChg 50.0 47.5 45.0 42.5 40.0 37.5 35.0 32.5 30.0 27.5 25.0 22.5 20.0 17.5 15.0 12.5 10.0 7.5 5.0 2.5 EVA 65.0 62.5 45.0 27.5 20.0 2.5 -5.0 -12.5 -15.0 -12.5 -10.0 -7.5 -5.0 -2.5 0.0 2.5 5.0 7.5 10.0 12.5 $125.86
EVA = NOPAT – WACC * Beginning Balance = 110 – 25% * 190 = 110 = 47.5 = 62.5
EVA-© Baba
Slide 49
Measure Earnings with EVA
? ?
Simple to explain and understand EPS (and NI) ignore cost of equity capital
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EVA doesn’t
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Retained earnings no longer considered free
?
Benefits:
? ? ? ?
Reduce cost of capital Improve operational efficiency Better management of assets Profitable growth.
Slide 50
EVA-© Baba
EVA-incentives
EVA introduces four powerful incentives: Improve efficiency, and thus returns. ? Grow, but only if new investments can earn the cost of capital. ? Redeploy capital from underperforming operations. ? Manage risk, and therefore the cost of capital.
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EVA-© Baba Slide 51
Measurement Challenges:
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Differentiate substantive performance from bookkeeping:
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Acquisition accounting Write-offs and restructuring charges Off balance-sheet financing Expensing of long-term investments Capture the real cost of money: Cash-basis versus accrual accounting
Slide 52
EVA-© Baba
Why are incentives so important?
Pressure on Performance
Tremendous opportunities ? Fewer competitive barriers ? Accelerating change ? Rapid competitive response ? Investor pressure
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Executive Talent
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Decisive edge in value creation ? Highly sought
Strategy: Use performance-based pay to attract top talent and and encourage value creation
EVA-© Baba Slide 53
The Reality: Most incentive plans aren’t designed to drive value creation
Stock and Options
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Cash Incentives
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Linked to stock price ? Competitive Line of sight often poor ? No focus on goals
Mainly annual EPS, ROE goals, capped ? Weak link to value ? Battles over fairness
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Value-based plans, in contrast, clearly link decisions, results and shareholder value.
EVA-© Baba Slide 54
The traditional annual incentive plan
Rs. Bonus
Target
Operating Profit 80%
EVA-© Baba
Budget
120%
Slide 55
The EVA-based incentive plan
Rs. Bonus
Key Features:
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No caps (or floors) A bonus “bank”
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Greater leverage
Target
Self-adjusting Deferred “at risk” targets
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portion of award
EVA Performance Target
EVA-© Baba Slide 56
The EVA-based incentive plan: Target-Setting
Targets can reflect:
Rs. Bonus ? Uniform improvement level ? Peer performance ? Market expectations Target
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Key Features:
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No caps (or floors) A bonus “bank”
?
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Greater leverage
Self-adjusting targets EVA
Performance Target
EVA-© Baba Slide 57
Measure Earnings with EVA
? ?
Simple to explain and understand EPS (and NI) ignore cost of equity capital
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EVA doesn’t
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Retained earnings no longer considered free
?
Benefits:
? ? ? ?
Reduce cost of capital Improve operational efficiency Better management of assets Profitable growth.
Slide 58
EVA-© Baba
Improvement in EVA
Sales
Customer Satisfaction Volume Product Pricing New Products Marketing Growth
Operating Expenses
Overhead Account Management Manufacturing Costs Compensation Training & Development
Capital Charge
Acquisitions & Divestitures Alliances R&D Decisions Working Capital Management Accounts Receivable Inventory Management
Manufacturing EVA Drivers
Reduce inventory Reduce cycle time Improve yields Reduce scrap/waste Maximize labor efficiencies Improve vendor efficiencies Process improvements
Research & Development EVA Drivers
Improve “to-market” process Reduce R&D expenses as % of new product sales Strategic partners for R&D Stronger links to product marketing New products via: - Research - Formulation - Development -Acquisition
Staff EVA Drivers
Work group/process simplification Consistency “monitors” – audit Centralizing resources/synergies Best practices benchmarking Insourcing/outsourcing decisions Simplify EVA measurements/reporting Ensure compliance with legislation
Marketing EVA Drivers
Increase market share / revenue New markets More focused channel programs Voice of customer / consumer Leverage advertising / promotion Build brand awareness Slide 59
EVA-© Baba
COMPANIES REPORTING EVA The concept of EVA is well established in financial theory, but only recently has the term moved into the mainstream of corporate finance, as more and more firms adopt it as the base for business planning and performance monitoring. There is growing evidence that EVA, not earnings, determines the value of a firm. •HUL
•Godrej Consumer Products Limited
•Infosys Technologies Ltd •Satyam Computer Services Ltd •Dr Reddy’s Lab •Tata Steels
EVA-© Baba Slide 60
IMPLEMENTATION OF EVA IN GODREJ
GROUP OF COMPANIES “EVA will be the main financial parameter by which we measure our performance. It will also be used in all capital expenditure decisions including acquisitions. We have just completed an exhaustive modular training on EVA and its application for all employees. The objective is to make all employees think like owners. This should be supported by an open-ended variable remuneration scheme.” C K Vaidya Executive Director EVA-© Baba Slide 61 (Corporate Personnel)
BOOH Factor in the implementation of EVA at Godrej
Build --- Invest as long as returns exceed the cost of capital
Optimise---Reduce cost of capital by optimising capital structure Operate---Improve the return on existing capital Harvest---Divest capital when the returns fail to achieve the cost of capital
EVA-© Baba Slide 62
Market Value Added
Total market value
Premium
Market value added
Book value debt + equity
Investment
EVA-© Baba
Slide 63
Also, Market Value Added
MVA = Present value of all future EVA
Expected improvement in EVA
Total market value
MVA
Book value debt + equity
Current level of EVA
EVA-© Baba
Slide 64
How do you drive MVA?
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MVA comes from operations, not finance. MVA depends on the future, not the past.
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EVA-© Baba
Slide 65
How do you drive MVA?
The Performance Measurement Challenge
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Reconcile the discrete and often conflicting value drivers of a business. ? Differentiate substantive economic performance from bookkeeping entries. ? Capture the real time cost of money.
EVA-© Baba
Slide 66
The End
EVA-© Baba
Slide 67
doc_359081736.pptx
Economic value is a measure of the benefit that an economic actor can gain from either a good or service.
Economic Value Added
EVA® of Stern Stewart & Co
Peter Drucker put the matter in a Harvard Business Review article, "Until a business returns a profit that is greater than its cost of capital, it operates at a loss. Never mind that it pays taxes as if it had a genuine profit. The enterprise still returns less to the economy than it devours in resources…Until then it does not create wealth; it destroys it." EVA corrects this error by explicitly recognizing that when managers employ capital they must pay for it, just as if it were a wage
How Value is Created
?
Management makes decisions, hopefully, with benefits exceeding costs
? ?
?
Benefits may be near or distant future Costs should include direct investment costs + cost of capital True source of value-enhancing projects
?
Firm’s comparative or competitive advantage.
EVA-© Baba
Slide 2
Comparative Advantage
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Advantage one firm has over another in terms of ? Cost of producing or ? Distributing goods/services ? Example: ? Wal-Mart invested in regional warehouses and distribution system ? Reduces the need for retail inventory ? Replenish store inventory quickly. Advantage one firm has over another because of structure of the markets in which they operate ? Barriers to entry ? Patents ? Capital requirements ? Regulation ? Influence over suppliers ? Influence over buyers
EVA-© Baba Slide 3
Traditional Measures
MEASURES OF CORPORATE PERFORMANCE
•Return on Sales (ROS)
•Return on Investment (ROI) •Residual Income (RI)
•Economic Value Added (EVA)
•Market Value Added (MVA) •Balanced Score Card
EVA-© Baba
Slide 5
Performance vs. Valuation
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Performance measurement
?
Relies on actual results
? ?
Historical GAAP
?
Valuation
? ?
Relies on forecasts Stock price relies on investors’ expectations, not historical performance.
Slide 6
EVA-© Baba
Reconciling Value Drivers Avoid Mixed Signals
?
The Traditional Financial Management System
Corporate Office
Investor Relations
EPS
Treasury Management Cost Accounting Capital Budgeting
Discounted Cash Flow Cash Flow
Strategic Planning Human Resources
Market Share, Earnings Growth
Asset Turns
ROE and Net Income
? ?
?
No common denominator of value. Heavily dependent on corporate synthesis and reconciliation of departmental figures. Information transfers slow and EVA-© Baba inefficient.
Slide 7
Reconciling Value Drivers Avoid Mixed Signals
?
The Traditional Financial Management System
?
The Ideal Financial Management System
Valuation Strategic Planning Annual Budgeting
Investor Relations
Treasury Management
Capital Budgeting Human Resources
Cost Accounting
? ?
?
No common denominator of value. Heavily dependent on corporate synthesis and reconciliation of departmental figures. Information transfers slow and inefficient.
EVA-© Baba
?
?
?
Common language for allocating resources, conducting valuations, measuring performance, and communicating with investors. Minimal corporate synthesis and reconciliation. Information transfers real-time and Slide 8
Reconciling Value Drivers Avoid Mixed Signals
?
The Traditional Financial Management System
?
The Ideal Financial Management System
Valuation Strategic Planning Annual Budgeting
Investor Relations
Treasury Management
Capital Budgeting Human Resources
Cost Accounting
? ?
?
No common denominator of value. Heavily dependent on corporate synthesis and reconciliation of departmental figures. Information transfers slow and inefficient.
EVA-© Baba
?
?
?
Common language for allocating resources, conducting valuations, measuring performance, and communicating with investors. Minimal corporate synthesis and reconciliation. Information transfers real-time and Slide 9
Return on Investment
?
Compare benefits (numerator) with resources (denominator) affecting that benefit
?
Basic earning power ratio
?
EBIT / Total assets Net income / Total assets Net income / Book value of equity
Slide 10
?
Return on assets
?
Measured relative to what?
?
Return on equity
?
EVA-© Baba
Pro’s & Con’s
?
Benefits of these ratios
? ?
Ease of calculation & interpretation Decompose to reveal sources of changes
?
Downside of these ratios
?
?
? ?
Sensitive to choice of accounting method Accumulation of monetary values from different periods Backward looking Fail to consider risk.
Slide 11
EVA-© Baba
EPS
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•
•
EPS is such an unreliable measure of value that managers often make “dumb” decisions to increase it Prompts managers to misallocate capital – Treats retained earnings as a free source of capital – Promotes retaining capital and using it wastefully. Accounting rules discourage EPS-manic mangers from spending capital on value enhancing investments in intangibles like brands, research and training Why? – GAAP requires outlays to be written off immediately against earnings EPS focus may cause management to refrain from issuing equity at times when the company really needs it Fabricate EPS gains by using more debt than prudent Both on and off the balance sheet Accept weak projects that happen to be financed with debt.
EVA-© Baba Slide 12
EPS…
?
Earnings manipulation often used
?
?
?
Establish reserves Invest pension funds in equities Extreme cases, make up numbers as you go
?
Worldcom and HealthSouth.
?
Today’s market perception:
“Management that aims to boost earnings at the expense of quality will be more certainly penalized then ever before with a lower stock price and a sullied reputation
EVA-© Baba Slide 13
Cash Flows
Statement of Cash Flows (SFC)
?
SCF combines balance sheet and income info
? Eliminates
the “sins of accrual accounting”
?
SCF consists of:
? Operating
cash flows ? Investing cash flows ? Financing cash flows.
EVA-© Baba
Free cash flow
Slide 15
Cash Flow Not the Answer
?
Cash flow has problems as a valid performance measure
?
So long as investments in projects earn a return higher than shareholders could earn by investing on their own, then the more investment a company makes and the more negative its cash flow becomes, the higher its share price will be.
Slide 16
EVA-© Baba
Better Than Some Alternatives
?
?
Accounting profits versus cash operating profits Cash flow frequently defined as:
Net income + depreciation or as EBITDA
?
3000 2500 2000 1500 1000 500 0 -500 '97 '98 '99 '00 '01 '02 NI + depr. NI CFFO
Poor definition
?
Quality of earnings ...
EVA-© Baba
Slide 17
Free Cash Flows
?
Definition:
?
?
After-tax operating earnings + non-cash charges - investments in operating working capital, PP&E (Property,Plant & Equipment) and other assets It doesn’t incorporate financing related cash flows
?
Represents cash flow available to service debt and equity.
?
When used in capital budgeting proposals
?
Based on expectations.
Slide 18
EVA-© Baba
FCF & Capital Budgeting
?
?
FCF is the method of choice of most firms for evaluating capital budgets Identify incremental
? ? ?
?
Investment in PP&E + working capital Revenues Costs (excluding financing) Depreciation tax shields.
Slide 19
EVA-© Baba
Common Techniques
?
Evaluation techniques:
? ? ?
Payback Accounting rate of return DCF analysis
? ?
Consists of NPV and IRR DCF analysis is not a problem in theory
?
Only in practice.
EVA-© Baba
Slide 20
NPV Methodology
?
Net present value (NPV)
?
?
Estimate of change in the value of equity if the firm invests in the project Forward looking
?
If NPV>0
?
Investment is expected to add value Investment is expected to erode value
?
If NPV<0
?
?
Decision rule
?
Invest in projects expected to enhance value.
Slide 21
EVA-© Baba
Internal Rate of Return
?
?
Practice is to compare IRR with weighted average cost of capital Problem:
? ?
IRR fails to measure scale or growth It sees no difference between earning a 20% return on a Rs. 1 million investment or a Rs. 1 billion investment
?
These two projects are very different with distinctly different NPVs.
Slide 22
EVA-© Baba
Conflicts: NPV & IRR
Which to Choose? NPV Marketing Campaign IRR = 16.35% Discount rate
10% 10.7%
Product development IRR = 13.24%
Select project with higher NPV (product development project)
EVA-© Baba Slide 23
Value Enhanced?
?
Once a project is applied, the investment becomes buried in the balance sheet
?
How is its contribution measured?
?
No idea whether project generates value
?
Accounting measure relied upon
? ?
EBITDA and EPS generally increase Means? Bonuses probably will be paid
?
Motivation:
?
Get your hands on as much capital as possible.
Slide 24
EVA-© Baba
Focused Finance & EVA
Interpreting EVA
? ?
?
Calculation reflects the idea that firm must earn enough to cover the cost of debt and the opportunity cost of equity before it even begins to create value. Representing real profit versus paper profit, EVA underlies shareholder value, increasingly the main target of leading companies' strategies. A positive EVA means the firm generated a return to invested capital that exceeds the opportunity cost of capital
?
The “value” of the firm should increase
?
A negative EVA means the firm did not generate sufficient return to cover it’s cost of capital
?
The “value” of the firm should decline
?
The absolute value of EVA is less important than the trend in EVA
EVA-© Baba
Slide 26
EVA & Wealth Creation
?
Warren Buffet:
We feel noble intentions should be checked periodically against results. We test the wisdom of retaining earnings by assessing whether retention, over time, delivers shareholders at least Rs. 1 of market value for each Rs. 1 retained.
?
Translation:
Ultimate litmus test of any company’s success lies in increasing its market value by more than it increases its capital.
EVA-© Baba
Slide 27
View of the Firm
Market Valued Balance Sheet Assets Debt Equity
?
?
Value of firm = Value of debt + value of stock Market value of a company reflects: ? Earning power of invested assets
? Present
value of current operations ? Present value of expected improvement in operating performance.
EVA-© Baba Slide 28
What is Required to Focus?
?
Tie performance methods to capital budgeting techniques:
? ?
Economic value added (EVA) Market value added (MVA)
Links to NPV
?
Want to gauge management’s performance
?
Focus on:
?
Decisions made in the past to help project the future.
Slide 29
EVA-© Baba
What is EVA?
?
EVA = Economic profit
?
Not the same as accounting profit
?
Difference between revenues and costs
?
Costs include not only expenses but also cost of capital
?
Economic profit adjusts for distortions caused by accounting methods
?
Doesn’t have to follow GAAP
?
R&D, advertising, restructuring costs, ...
?
Cost of capital accounted for explicitly
?
?
Rate of return required by suppliers of a firm’s debt and equity capital Represents minimum acceptable return.
Slide 30
EVA-© Baba
Components of EVA
?
NOPLAT
? ?
?
Operating capital
Net operating profit after tax Net operating working capital, net PP&E (Plant, Property & Equipment) goodwill, and other operating assets Weighted average cost of capital % Cost of capital % * operating capital NOPLAT less the capital charge.
?
Cost of capital
? ?
?
Capital charge
?
?
Economic value added
EVA-© Baba
Slide 31
What is NOPAT?
Net sales Cost of sales Depreciation SG&A Net Operating profit Taxes @ 40% NOPAT 150,000 135,000 2,000 7,000 6,000 2,400 3,600
Excludes financing charges
EVA-© Baba Slide 32
What is Operating Capital?
?
Capital: Net operating assets adjusted for certain accounting distortions
?
Asset write-downs, restructuring charges, …
?
Net operating assets:
?
? ?
Cash, receivables, inventory, prepaids Trade payable, accruals, deferred taxes Net property, plant, and equipment
Marketable securities, investments,...
Slide 33
?
Exclude non-operating assets:
?
EVA-© Baba
What is Cost of Capital?
?
Weighted average cost of capital consists of:
Cost of debt after taxes = Market interest rate x (1 – tax rate) Cost of equity = Risk-free rate + beta x (market risk premium) WACC = Cost of debt after taxes x % debt + cost of equity x % equity where % debt + % equity = 100%.
EVA-© Baba Slide 34
?
?
? ?
?
Risk Premium used in the CAPM (Capital Asset Pricing Model) is the excess average return on select stocks over average return on risk free securities over the measurement period. Damodaran has suggested use of lone run average taking the measurement period of at least ten years. There is also disagreement as regards type of mean to be used . Arithmetic mean is justified as it is more consistent with the mean – variance framework of the CAPM . Whereas the geometric mean is justified on the grounds that it takes compounding into account and that is a better predictor of the average premium in the long term. There can be significant difference in premiums depending upon the choice of average. For computing risk premium , it is possible to take return on broad based market index over risk free rate.
EVA-© Baba Slide 35
Risk Premium
Risk Free Rate
?
Variants on the risk free rate - Damodaran explained
use of three variants of risk free rate for computing cost of equity : Short term government security rate : This may be justified in the CAPM framework which is considered as a one – period model; Short term forward rate : This is based on superiority of the forward rate in forecasting future short term rate; and Current long term government bond rate : This takes a strict view of matching the duration of the risk free security with the duration of assets being nalyzed. Damodaran has finally used long term rate for computing risk free rate.
Slide 36
?
?
?
?
EVA-© Baba
Risk Free Rate
?
?
As per Indian Fixed Income Securities Market , National Stock Exchange , April 2002 issue Yield on Government Securities of maturity range over 10 years was 8.05% in February 2002 , 8.06% in March 2002 and 7.79% in April 2002. So for illustrative purpose 8.06% can be taken as risk free rate, which is maximum of the latest yield.
EVA-© Baba
Slide 37
What is the Capital Charge?
?
?
?
Represents a rental charge for the use of the operating capital Minimum rate of return the operating capital should earn Calculated as the firm’s weighted average cost of capital % x invested capital.
EVA-© Baba
Slide 38
Calculating EVA
NOPAT/Average capital = Return on invested operating capital (ROIC) - Weight average cost of capital (WACC) = Spread (= ROIC - WACC) X Operating capital = Economic value added (EVA) Net operating profit after tax (NOPAT) - Capital charge (= WACC * Capital) = Economic value added (EVA)
EVA-© Baba
Slide 39
Calculating EVA
1] NOPAT (Net Operating Profits After Tax) PPBT (Profits Before Tax) Add back interest Add/Deduct Adjustments for non operating income & expenses) = OPERATING PBT Less Taxes =NOPAT (Net Operating Profits After Tax) 2]EVA= NOPAT/Average capital = Return on invested operating capital (ROIC) - Weight average cost of capital (WACC) = Spread(= ROIC - WACC) X Operating capital = Economic value added (EVA) 3] Net operating profit after tax (NOPAT) - Less Capital charge (= WACC * Capital) = Economic value added (EVA)
?
Relationship to Market Value Added The firm's market value added, or MVA, is the discounted sum of all future expected economic value added: ? Note that MVA = NPV of company. EVA-© Baba Slide 40
What’s Affecting EVA?
Sales - Operating expenses - Taxes = NOPAT
Market potential COGS, SG&A + other Potential gov’t actions Net working capital PP&E WACC
- Capital charge
= EVA
Evaluate the many assumptions!
EVA-© Baba Slide 41
?
Stern Stewart developed EVA to help managers incorporate two basic principles of finance into their decision making. The first is that the primary financial objective of any company should be to maximize the wealth of its shareholders. The second is that the value of a company n depends on the extent to which investors expect future profits to exceed or fall short of the cost of capital. By definition, a sustained increase in EVA will bring an increase in the market value of a company the level of EVA isn't what really matters. Current performance already is reflected in share prices. It is the continuous improvement in EVA that brings continuous increases in shareholder wealth.
EVA-© Baba Slide 42
Forward Looking Relationship for EVA & MVA
EVA Year 1 EVA Year 2 EVA EVA Year 3 .... Year n
Market Value Market value
MVA
EVA + EVA + 1+r (1 + r)2 EVA + ... + EVA (1 + r)3 (1 + r)n
=
Book value capital
Market value is based on establishing the economic investment made in the company (capital), making a best guess about what economic profits (EVA) will happen in the future, and discounting those EVAs to the present to get market value added.
Slide 43
EVA-© Baba
EVA Drives MVA
Companies that consistently earn profits in excess of their required return ...
NOPAT EVA
Charge
… are typically valued at premiums to book value.
Market Value
Capital
EVA-© Baba Slide 44
MVA
Fundamental Strategies
? NOPAT ? EVA ? ? ? Cost of capital ? * Capital ? Capital ?
Operate: Improve the return on existing operating capital Decrease: WACC Build: Invest as long as returns exceed the cost of capital Harvest: Re-deploy capital when returns fail to achieve the cost of capital.
EVA-© Baba Slide 45
An Example of Drivers
EVA-© Baba
Slide 46
Focus on EVA Improvement
?
A positive change in EVA is better than a positive yet unchanging base level of EVA
? Why?
?
?
Positive changes in EVA are consistent with “shareholder value added” -- whether from a positive or negative base Positive changes in EVA are consistent with the managerial notion of continuous improvement in performance.
Slide 47
EVA-© Baba
Why Use EVA & Not NPV?
?
? ? ?
Present value of EVA = Present value of NPV Provides insight into each period Is a direct link to performance More useful for future project audits.
EVA-© Baba
Slide 48
An Example Revisited
(See Slides 27 & 28)
Asset's Balance 200 190 180 170 160 150 140 130 120 110 100 90 80 70 60 50 40 30 20 10 0 Period 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 NPV IRR WACC NOPAT 115 110 90 70 60 40 30 20 15 15 15 15 15 15 15 15 15 15 15 15 Deprec 10 10 10 10 10 10 10 10 10 10 10 10 10 10 10 10 10 10 10 10 FCF -200 125 120 100 80 70 50 40 30 25 25 25 25 25 25 25 25 25 25 25 25 $125.86 50.4% 25% CapChg 50.0 47.5 45.0 42.5 40.0 37.5 35.0 32.5 30.0 27.5 25.0 22.5 20.0 17.5 15.0 12.5 10.0 7.5 5.0 2.5 EVA 65.0 62.5 45.0 27.5 20.0 2.5 -5.0 -12.5 -15.0 -12.5 -10.0 -7.5 -5.0 -2.5 0.0 2.5 5.0 7.5 10.0 12.5 $125.86
EVA = NOPAT – WACC * Beginning Balance = 110 – 25% * 190 = 110 = 47.5 = 62.5
EVA-© Baba
Slide 49
Measure Earnings with EVA
? ?
Simple to explain and understand EPS (and NI) ignore cost of equity capital
?
EVA doesn’t
?
Retained earnings no longer considered free
?
Benefits:
? ? ? ?
Reduce cost of capital Improve operational efficiency Better management of assets Profitable growth.
Slide 50
EVA-© Baba
EVA-incentives
EVA introduces four powerful incentives: Improve efficiency, and thus returns. ? Grow, but only if new investments can earn the cost of capital. ? Redeploy capital from underperforming operations. ? Manage risk, and therefore the cost of capital.
?
EVA-© Baba Slide 51
Measurement Challenges:
?
Differentiate substantive performance from bookkeeping:
? ?
? ?
? ?
Acquisition accounting Write-offs and restructuring charges Off balance-sheet financing Expensing of long-term investments Capture the real cost of money: Cash-basis versus accrual accounting
Slide 52
EVA-© Baba
Why are incentives so important?
Pressure on Performance
Tremendous opportunities ? Fewer competitive barriers ? Accelerating change ? Rapid competitive response ? Investor pressure
?
Executive Talent
?
Decisive edge in value creation ? Highly sought
Strategy: Use performance-based pay to attract top talent and and encourage value creation
EVA-© Baba Slide 53
The Reality: Most incentive plans aren’t designed to drive value creation
Stock and Options
? ?
Cash Incentives
?
Linked to stock price ? Competitive Line of sight often poor ? No focus on goals
Mainly annual EPS, ROE goals, capped ? Weak link to value ? Battles over fairness
?
?
Value-based plans, in contrast, clearly link decisions, results and shareholder value.
EVA-© Baba Slide 54
The traditional annual incentive plan
Rs. Bonus
Target
Operating Profit 80%
EVA-© Baba
Budget
120%
Slide 55
The EVA-based incentive plan
Rs. Bonus
Key Features:
?
No caps (or floors) A bonus “bank”
?
?
Greater leverage
Target
Self-adjusting Deferred “at risk” targets
?
portion of award
EVA Performance Target
EVA-© Baba Slide 56
The EVA-based incentive plan: Target-Setting
Targets can reflect:
Rs. Bonus ? Uniform improvement level ? Peer performance ? Market expectations Target
?
Key Features:
?
No caps (or floors) A bonus “bank”
?
?
Greater leverage
Self-adjusting targets EVA
Performance Target
EVA-© Baba Slide 57
Measure Earnings with EVA
? ?
Simple to explain and understand EPS (and NI) ignore cost of equity capital
?
EVA doesn’t
?
Retained earnings no longer considered free
?
Benefits:
? ? ? ?
Reduce cost of capital Improve operational efficiency Better management of assets Profitable growth.
Slide 58
EVA-© Baba
Improvement in EVA
Sales
Customer Satisfaction Volume Product Pricing New Products Marketing Growth
Operating Expenses
Overhead Account Management Manufacturing Costs Compensation Training & Development
Capital Charge
Acquisitions & Divestitures Alliances R&D Decisions Working Capital Management Accounts Receivable Inventory Management
Manufacturing EVA Drivers
Reduce inventory Reduce cycle time Improve yields Reduce scrap/waste Maximize labor efficiencies Improve vendor efficiencies Process improvements
Research & Development EVA Drivers
Improve “to-market” process Reduce R&D expenses as % of new product sales Strategic partners for R&D Stronger links to product marketing New products via: - Research - Formulation - Development -Acquisition
Staff EVA Drivers
Work group/process simplification Consistency “monitors” – audit Centralizing resources/synergies Best practices benchmarking Insourcing/outsourcing decisions Simplify EVA measurements/reporting Ensure compliance with legislation
Marketing EVA Drivers
Increase market share / revenue New markets More focused channel programs Voice of customer / consumer Leverage advertising / promotion Build brand awareness Slide 59
EVA-© Baba
COMPANIES REPORTING EVA The concept of EVA is well established in financial theory, but only recently has the term moved into the mainstream of corporate finance, as more and more firms adopt it as the base for business planning and performance monitoring. There is growing evidence that EVA, not earnings, determines the value of a firm. •HUL
•Godrej Consumer Products Limited
•Infosys Technologies Ltd •Satyam Computer Services Ltd •Dr Reddy’s Lab •Tata Steels
EVA-© Baba Slide 60
IMPLEMENTATION OF EVA IN GODREJ
GROUP OF COMPANIES “EVA will be the main financial parameter by which we measure our performance. It will also be used in all capital expenditure decisions including acquisitions. We have just completed an exhaustive modular training on EVA and its application for all employees. The objective is to make all employees think like owners. This should be supported by an open-ended variable remuneration scheme.” C K Vaidya Executive Director EVA-© Baba Slide 61 (Corporate Personnel)
BOOH Factor in the implementation of EVA at Godrej
Build --- Invest as long as returns exceed the cost of capital
Optimise---Reduce cost of capital by optimising capital structure Operate---Improve the return on existing capital Harvest---Divest capital when the returns fail to achieve the cost of capital
EVA-© Baba Slide 62
Market Value Added
Total market value
Premium
Market value added
Book value debt + equity
Investment
EVA-© Baba
Slide 63
Also, Market Value Added
MVA = Present value of all future EVA
Expected improvement in EVA
Total market value
MVA
Book value debt + equity
Current level of EVA
EVA-© Baba
Slide 64
How do you drive MVA?
?
MVA comes from operations, not finance. MVA depends on the future, not the past.
?
EVA-© Baba
Slide 65
How do you drive MVA?
The Performance Measurement Challenge
?
Reconcile the discrete and often conflicting value drivers of a business. ? Differentiate substantive economic performance from bookkeeping entries. ? Capture the real time cost of money.
EVA-© Baba
Slide 66
The End
EVA-© Baba
Slide 67
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