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  Economic Value Added

Introduction to Economic Value Added (EVA®)

Performance targets based on economic value added (EVA®) offer another approach. This measure has been developed and trade marked by a US management consultancy firm, Stern Stewart. EVA®, however, is based on the idea of economic profit, which has been around for many years. The measure imitates the aim made earlier that for a company to be profitable in an economic sense, it must produce returns which exceed the returns required through investors. It is not sufficient just to make an accounting profit because this measure does not take full account of the returns required by investors.

EVA® indicates whether the returns generated exceed the returns required by investors.

The formula is:

EVA® = NOPAT - (R × C)

Where

NOPAT stands for = Net operating profit after tax

R stands for = Returns required by investors (that is, the weighted average cost of     capital)

C stands for = Capital invested (that is, the net assets of the company).

Only when EVA® is positive can we say that the company is increasing shareholder wealth. To maximise shareholder wealth, managers must increase EVA® by as much as possible.

EVA® relies on conventional financial statements to measure the wealth created for shareholders. Though, the NOPAT and capital figures displayed on these statements are used only as a starting point. They have to be adjusted due to the problems and limitations of conventional measures. According to Stern Stewart, the major problem is that profit and capital are understated because of the conservative bias in accounting measurement. Profit may be understated as a result of arbitrary write-offs such as research and development expenditure written off and as a result of excessive provisions being created (such as allowances for trade receivables). Capital may also be understated because assets are reported at their original cost (less amounts written off), which can produce figures considerably below current market values. In addition, specific assets like internally generated goodwill and brand names are normally omitted from the financial statements because no external transactions have occurred.

Stern Stewart has identified more than a hundred adjustments that could be made to the conventional financial statements to eliminate the conservative bias. However, it believes that, actually, only a handful of adjustments to the accounting figures of any particular business tend to be required. If not an adjustment is going to have a significant effect on the calculation of EVA® it is really not worth making. The adjustments made should imitate the nature of the particular business. Each business is unique and so must customise the calculation of EVA® to its particular circumstances. (This aspect of EVA® can be seen as either indicating flexibility or as being open to manipulation depending on whether you support this measure!)

Under EVA®, managers can receive bonuses based on actual achievement during a specific period. If management rewards are related to a single period, however, there is a danger that managers will place undue attention to increasing EVA® during this period rather than over the long term. This may be attained in the short term, for example, by cutting back on necessary investment. The objective should be to maximise EVA® over the longer term. In which a business has a stable level of sales revenue, operating assets and borrowing, a current-period focus is probable to be less of a problem than in which these elements are unstable over time. The operations' stable pattern minimises the risk that enhancements in EVA® during the current period are achieved at the expense of future periods. However, any reward system for managers have to be encourages a long term perspective and so rewards should be based on the ability of managers to improve EVA® over a number of years rather than a single year.

The amount of EVA® generated during a period is rarely reported to shareholders. This means that shareholders will be unable to check whether rewards given to directors are appropriate.

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