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1- SHIPPING: THE LOOMING CRISIS
2- LG & CRICKET WORLD CUP
3-
NEW DEVELOPMENT IN TAP GAS-PIPE PROJECT
4- MUTUAL FUNDS RIDING IN
5-
EVA SUPPLEMENT
6- STANDARD CHARTERED: ANNUAL RESULTS

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EVA SUPPLEMENTS

 

 

  By Nayantara Noorani
(Research Analyst, AKD Securities)
Mar 03 - 09, 2003.

 

 

When the Indian company, Tata Steel, declared that it would aim to become an "EVA™" company, some shareholders were upset at the company's admission that it in the past it had not been adding value. On the flip side, there was appreciation for the fact that the company had recognized its shortcomings and was doing something to rectify the situation. We take a look at how EVA™ is a relatively unbiased measure of value creation/destruction for shareholders, which makes it a useful tool for analysing shareholder returns.

What is EVA and how is it calculated? The difference between a company's return and its cost of raising capital is called "EVA™" (Economic Value Added). Since the term EVA™ is a registered trademark of Stern Stewart & Co., the measure is also referred to as Residual Income or Economic Profit. Unlike traditional measures, (EPS and ROI) EVA™ focuses on economic profit rather than accounting profit and hence calculates shareholder value creation/destruction over the relevant period of time.

EVA™ is a useful tool for choosing the most promising financial investments and a suitable tool to control operations. This makes it a useful tool for long-term, as opposed to speculative, investors. It measures the real profit that is of interest to investors after deducting the capital costs as follows:

EVA™ = Net Operating Profit After Tax (NOPLAT) - [Capital* Cost of Capital]

All capital employed (fixed assets, inventory, receivables, cash at bank and others) have the same cost of capital, which is the Weighted Average Cost of Capital (WACC) determined with the costs of both debt and equity. In the following table, we calculate the EVA™ for Unilever Pakistan.

UNLIEVER'S VALUE CREATION FOR SHAREHOLDER'S FOLLOWS THE CYCLICAL TREND OF ITS INDUSTRY

 

2000A

2001A

2002A

2003E

2004E

WACC

11.1%

16.1%

14.0%

13.3%

13.3%

Operating Profit

2,396

2,343

3,033

3,677

3,840

-Fixed Assets

(1,753)

(1,541)

(1,578)

(1,615)

(1,652)

-Inventory

(2,844)

(2,332)

(1,996)

(2,201)

(2,260)

-Sales receivable

(253)

(187)

(200)

(214)

(226)

+Accounts payable

215

266

277

307

323

-Cash Taxes

(540)

(472)

(1,244)

(1,306)

(1,274)

Sum

(5,176)

(4,266)

(4,741)

(5,029)

(5,089)

Sum x WACC

(572)

(687)

(664)

(669)

(677)

EVA™

1,824

1,656

2,370

3,008

3,163

EVA™ per share

137

125

178

226

238

 

 

EVA™ PROVIDES ADDITIONAL INSIGHT. In our opinion, though it is easier to calculate EPS and ROI, EVA™ avoids some of the steering failures that these measures possess. For instance a company that is maximizing ROI and EPS is not necessarily optimizing shareholder value. Ignoring below average projects can increase ROI and simply investing more money in the company can increase EPS/Operating Profit/Net profit, however, in both cases shareholder value is not being optimized.

At the same time, EVA™ also pushes the analyst to compare the cost of capital to the returns on the business and analyze a company's capital efficiency. For a firm to be an attractive investment, it must provide a higher return to its shareholders as compared to the capital charge, which is the average return on equity markets that investors can achieve easily with diversified, long-term equity market investment. Thus over the long run, creating less return than the capital charge is economically not acceptable from a shareholders' perspective. In such a situation, investors can take their money away from the firm since they have other investment alternatives.

EVA™ AND SHARE PRICE. Due to its accurate representation of shareholder wealth, EVA is closely correlated with stock price.

INVESTMENT RECOMMENDATION. If that is the case, you say, then lets dump other valuations and stick to EVA™ alone to make our investment decisions. Not really, EVA™ has its share of shortcomings as well. Firstly, EVA™ uses operating profit, which is an accounting measure and hence is obviously not free from accounting anomalies, though admittedly less prone to window dressing than PBIT and NPAT. Secondly, all said and done EVA™ is relatively cumbersome to calculate, as compared to EPS and ROI and other traditional measures of value, since it requires a number of accounting adjustments and financial assumptions for calculating cost of capital.

Finally, the biggest shortcoming of EVA™ is that it lacks value in a bull run of the stock. Higher market valuations may be the cause rather than the result of high EVA™. This is because at high valuation levels the market liquidity and the consequent volatility is severely restrained. Hence the Beta tends to get understated and consequently the cost of capital also tends to be understated. As a result, the EVA™ tends to be artificially high. In this case high share price lead to high EVA™ and not the other way around. Having said that, a longer-term analysis of share price in relation to the index tends to mitigate this fallacy of EVA™ by calculating beta on extended period price data.