Economic Value Added

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EVA: An Introduction

Economic Value Added


• Economic value added (EVA) is a measure of a company’s financial
performance based on the residual wealth calculated by deducting its
cost of capital from its operating profit, adjusted for taxes on a cash
basis.
• EVA can also be referred to as economic profit as it attempts to
capture the true economic profit of a company. This measure was
devised by management consulting firm Stern Value Management,
originally incorporated as Stern Stewart & Co.
• The formula for calculating EVA is:
Net Operating Profit After Taxes (NOPAT)
- Invested Capital * Weighted Average Cost of Capital (WACC)

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Stern Stewart & Co.

• The term “Economic Value Added (EVA)” is a registered trademark of


Stern Stewart & Co, a consulting firm which implements the EVA
concept for large companies. Joel M. Stern, managing partner of
Stern Stewart since its inception, is a recognised authority on
corporate performance measurement and a pioneer and proponent
of shareholder value.

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Increased Shareholder Value

Revenue • Greater customer service


(higher market share,
increased gross margins).
• Greater product availability
Profitability
• Lower cost of goods sold,
transportation, warehousing,
Costs
material handling and
distribution management
costs
Shareholder
value
• Lower raw materials and
Working finished goods inventory
capital • Shorter ‘order-to-cash’
cycles
Invested
capital •Fewer physical assets (e.g.
trucks, warehouses, material
Fixed
handling equipment)
capital
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Economic value addded

Sales Market potential


- Operating expenses COGS, SG&A + other expn
- Taxes Govt charge
= NOPAT
Net working capital
- Capital charge
PP&E
= EVA WACC

How is EVA affected?

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Fundamental Strategies

 NOPAT 
EVA    Cost of capital * Capital
 Capital 

Operate: Improve the Decrease: WACC


return on existing
operating capital Build: Invest as long as returns
exceed the cost of capital

Harvest: Re-deploy capital when returns


fail to achieve the cost of capital.
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Hindustan Unilever

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See EVA Calculation in NIFTY INDEX DATA

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COST OF EQUITY

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Rf – Risk-free rate - This is the amount obtained from investing in securities considered free from credit
risk, such as government bonds from developed countries. The interest rate of U.S. Treasury Bills is
frequently used as a proxy for the risk-free rate.

ß – Beta - This measures how much a company's share price reacts against the market as a whole. A beta of
one, for instance, indicates that the company moves in line with the market. If the beta is in excess of one,
the share is exaggerating the market's movements; less than one means the share is more stable.
Occasionally, a company may have a negative beta (e.g. a gold-mining company), which means the share
price moves in the opposite direction to the broader market.
For public companies, you can find database services that publish betas. Few services do a better job of
estimating betas than BARRA.

(Rm – Rf) = Equity Market Risk Premium (EMRP) - The equity market risk premium (EMRP) represents
the returns investors expect to compensate them for taking extra risk by investing in the stock market over
and above the risk-free rate. In other words, it is the difference between the risk-free rate and the market
rate. It is a highly contentious figure.
Many commentators argue that it has gone up due to the notion that holding shares has become more risky.

The EMRP frequently cited is based on the historical average annual excess return obtained from investing
in the stock market above the risk-free rate. The average may either be calculated using an arithmetic mean
or a geometric mean. The geometric mean provides an annually compounded rate of excess return and will
in most cases be lower than the arithmetic mean. Both methods are popular, but the arithmetic average has
gained widespread acceptance.

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CAPM: Market Return - Indian Scenario

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Average Nifty return 2010-2018 =

Financial Reporting & Analysis


2010.00 17.90%
2011.00 -24.60%
2012.00 27.70%
2013.00 6.80%
2014.00 31.40%
2015.00 -4.10%
2016.00 3.00%
2017.00 28.60%
2018.00 3.20%
NIFTY
Average
Return 9.99%

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Analysis of NIFTY Return 2000-2014 was
different
2010-2018 is a different return format

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Year Nifty return %
2000 -20.64%
2001 -15.57%
2002 3.62%
2003 70.86%
2004 8.80%
2005 34.12%
2006 39.86%
2007 53.18%
2008 -51.84%
2009 71.46%
2010 17.25%
2011 -24.90%
2012 27.35%
2013 5.93%
2014 31.44%
Simple average 16.73%
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Expected return on equity =
Risk free rate
+ ( Market return – Risk free rate) x Beta (β)

Economy specific information :


Risk-free rate =7.73%
Market return = 16.73%

Beta is company specific.

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slope ( NIFTY, HUL) 0.25
slope ( NIFTY, FMCG) 0.44
slope(FMCG, HUL) 0.71

Understanding beta is critical. HUL computed cost


of equity at 10.91% .
But based slope of 0.71 , it may b e worked out as
7.73% +(16.73%-7.73%) x 0.71 = 14.12%.

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Infosys 2008-2012

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