Measure of Company's Financial Performance beyond the financial statements www.vikashgoel.com, www.investmentvaluation.in

1. Economic Value AddedTM
True Economic performance of an enterprise
Vikash Goel, FCA, MS Finance
www.vikashgoel.com | www.investmentvaluation.in

2. Historical performance measures in an organisation
includes:
 Profit Maximisation – age old
 Wealth Maximisation - matured
 Value Maximisation – today’s wisdom
“Until a business returns profit that is greater than the cost
of capital, it is operating at a loss” – Peter Drucker in HBR
© Vikash Goel | www.vikashgoel.com , www.investmentvaluation.in

3. • New York Based Consulting firm Stern Steward & Co.
developed the concept of EVA in 1982.
• Economic Value Added
TM
is a value based performance measure
that appreciates values created by the management for its
owners.
• It evaluates how well the organisation performs in relation to its
objectives – wealth maximisation for the shareholders.
• It is most directly linked to creating shareholder wealth over
time.
©VikashGoel|www.vikashgoel.com,www.investmentvaluation.in

4. EVA helps organizations determine their actual profit
once the taxes and capital amount has been taken
under consideration.
This helps companies determine whether their
business or a particular project is making more money
than what was invested in it.
EVA = Net Operating Profit After Tax – Currency Cost of Capital
©VikashGoel|www.vikashgoel.com,www.investmentvaluation.in

5. EVA = Net Operating Profit After Tax – (Capital Employed x Cost of Capital)
Net Operating Profit After Tax (NOPAT) is calculated as follows:
Net profit available to Equity Shareholders
Add: Interest Expense (1 - Tax rate)
Add: Preferred Dividends
Add: Minority Interest
Add: Amortisation of Goodwill
Add: Non recurring (unusual) losses or expenses
Less: Non recurring (unusual) gains
Alternatively,
NOPAT = Operating Income x (1 – Tax rate)
©VikashGoel|www.vikashgoel.com,www.investmentvaluation.in

6. Capital Employed is calculated as follows:
Book Value of Equity
Add: Debt
Add: Preferred Stock
Add: Minority Interest
Add: Equity Equivalents
Alternatively, Capital Employed = Total Assets – Current Liabilities
Cost of Capital
Calculate Cost of Equity using CAPM viz. Re = Rf + (Rm - Rf) x Beta
Calculate After Tax Cost of Debt viz. Kd = Cost of Debt x (1-tax Rate)
Calculate Weighted Average Cost of Capital based on the weights of Debt and Equity.
WACC = [ E / ( E + D ) x Ke ] + [ D / ( E + D ) x Kd ( 1 - t ) ]
©VikashGoel|www.vikashgoel.com,www.investmentvaluation.in

7. EBIT = Rs 5 million
Tax rate = 40%
WACC = 12%
Debt = 10 million
Equity = 10 million
EVA = [EBIT x (1 - Tax Rate)] - [WACC x Capital Employed]
EVA = [5 x ( 1 - 0.40)] - [0.12 x (10 + 10)]
EVA = 3.0 - 2.4
EVA = 0.6 million
©VikashGoel|www.vikashgoel.com,www.investmentvaluation.in

8. Profit based measure as primary measure of financial
performance has at least 2 limitations:
• Profits ignore cost of capital
 While profits take into account the interest charge – cost of debt
finance, they done take into account the cost of equity. Thus it
doesn’t tell us if the organisation has generated wealth in excess of
return required by equity shareholders – providers of equity capital.
• Profits calculated are subject to manipulation by
accountants.
©VikashGoel|www.vikashgoel.com,www.investmentvaluation.in

9. Residual Income approaches have been used since 20th
century and is calculated as
Residual Income = Profit After Tax – (Capital Employed x Cost of
Capital)
Example:
A division A earns a profit of Rs 10000 and also has Capital
(Debt + Equity) of Rs 70000 @ 12% Cost of Capital.
Residual income = 10,000 – (70,000x12%)
Residual income = 1,600
©VikashGoel|www.vikashgoel.com,www.investmentvaluation.in

10. Residual Income approach relies heavily on the
Accounting Profits and does not adjust it.
Adjustments are needed to convert from accrual profits to cash
flows
Unusual items of incomes/expenditures / gains / losses should
be ignored.
Other adjustments: E.g. Some items such as advertising, staff
training costs that bring long term benefits are expensed
whereas they should be capitalised, hence these are added back
to profits.
©VikashGoel|www.vikashgoel.com,www.investmentvaluation.in

11. • If EVA is Positive, business has created wealth for
shareholders
• If EVA is Negative, business has destroyed wealth for
shareholders
©VikashGoel|www.vikashgoel.com,www.investmentvaluation.in

12. • It is considered to be a short term measure of financial
performance
• It is not a suitable measure for a company which has
invested heavily today but expects returns in long
term
• It is prone to estimation errors inherent in calculating
Cost of Capital
©VikashGoel|www.vikashgoel.com,www.investmentvaluation.in