Economic Value Added, has become a much discussed and increasingly widely used corporate performance measure. Briefly outline the key elements of the measure and critically consider why its use has spread in the corporate sector in the recent years and whether that has advantaged investors and/or managers. In this essay I intend to firstly elucidate what Economic Value Added (EVA) is and where it came from. Then I will attempt to identify the key elements used within the measuring system. Following this, I will explain why its spread has become popular in recent years with both corporations and investors. I will then explain both the short and long-term benefits of the EVA system for both investors and corporations.
EVA is the trademark of the Stern Stewart consulting organisation. The EVA system was developed by the above-mentioned consulting organisation during the 1990’s. EVA is basically a different way of measuring a firm’s residual income. Stern Stewart developed a system by which if the existing and future accounting data were calculated in a different manner then the firm could be shown to be making different (usually better) returns on its assets. As the structure of large organisations naturally lend themselves to the scientific management principles it is easy to see why simple systematic performance measures are welcomed by both corporate managers and investors, seeking greater lucidity in information used to make strategic decisions. This point is supported by the adoption of the system by firms such as Boots, Coca-Cola, AT&T, ICI. The measure is seen by its adoptees as a convenient way to motivate current staff.
The one-dimensional aim that the Stern Stewart consulting organisation intended for there system of Economic Value Added was to deliver a measure which would give shareholders a generously proportioned return on there investment. Essentially this is done by dispersal of the cost of the asset over the period of asset productivity, instead of spreading the cost of the asset over one financial period. The formula used to calculate EVA is; Conventional divisional profit based on GAAP (generally accepted accounting practices) + accounting adjustments – cost of capital charge on divisional assets.
The key elements within EVA lie in the accounting adjustments made to the conventional divisional profit measure. Stern Stewart consulting organisation identified 160 accounting adjustments that may be required in order to convert a firma historic accounting data in order for it to express an EVA value. Most firms only need ten or so accounting adjustments though. The most common reason as to the adoption of the EVA measurement system is that it is the most directly linked system measuring the creation of shareholder opulence over time. As the primary function of a firm is to create a return on investment greater than that of its competitors, EVA gives investors a useful tool for measuring current performance.
EVA gives managers superior information that aids motivation of staff and others involved in the strategic setting and execution levels of a firm. This system allows management to see clearly how they are performing and, theoretically, it should motivate them to work harder and thus achieve greater shareholder wealth in any publicly traded company. Put in simpler terms it is an estimate of the “ECONOMIC” profit not of the “ACCOUNTING” profit in comparison to the required minimum rate of return, which the shareholders could get when, comparing them to other investments that would have comparable statistically calculated risk values.
Thus, it can be seen that EVA is a powerful and useful tool for shareholders, and potential investors. EVA helps establish the differences between those businesses that seem to make conventional accounting profit from those that seem to make an accounting profit. Ray Kroc eloquently illustrated this point in his book Grinding It Out. The founder of McDonalds said, “Until the business returns an income greater than the capital outlay, we are running at a loss. It is irrelevant if we pay taxes. The aim of the expansion is to strategically deploy the capital in creating an infrastructure that when all the expansion plans are met, we deliver stable profitability to other investors”