1、,Introduction to Economic Value Added,September 2003, Esa Mkelinen, Valuatum OyContents 1. Basis of EVA: alternative return of capital 2. Definition of capital costs and EVA (practical level, not detail) 3. Characters, comparison to ROI, EBIT etc. 4. EVA and market values 5. Implementation, EVA bonu
2、s systems,History and background,Old concept (Residual Income = Operating profit - capital costs) (1800-century) However: the development level of capital markets, estimation of cc, Shareholder Value -approach. were not supporting it those days In the late 1980s Stern Stewart & Co (U.S.) name and tr
3、ademark EVATM (Economic Value Added) presented the superior characters in perform. measurement, link to market values (the bigger EVA, the bigger m-cap), bonus systems presented some very successful EVA management and bonus systems (e.g. (Coca-Cola, WalMart, Briggs & Stratton, AT&T) During 90s to al
4、most every big US-company (most used measure) What EVA has had to give in order to expand like this? First financial performance measure for which maximizing is a sensible objective Superior performance measure compared to e.g. operating profit, profit after fin. items, EPS, ROI, ROE (explained late
5、r in detail why) Still very simple and practical also in operational level Improves profitability normally first through improved capital turnover Very suitable for bonus systems (logically after the first point),The basis of EVA: The average return on stock market,The return of the most important s
6、tock indices during the last 20 years,The basis of EVA: The average return on stock market,The return on stock markets has always (whole 20th century) been stable in the long term (about 6%-points above the long-term risk-free rate) Nominal yields are not reliable comparison basis without considerin
7、g inflation, therefore it is easier to talk about return in excess of the risk free rate)Investors can easily achieve the average index return with long-term investments (diversified portfolio)Therefore owners do not in the long-term have to accept returns below this average = the average long term
8、equity return is also the alternative return for equity investments. Keeping money in companies producing less in the long-term is not sensible,Return to owners,Let us assume that the companies at the market achieve a return of 10% on average. The following figure represents how the owners treat the
9、ir holdings in different companies,Company A: Negative return: discontinued,Companies B and C: Insufficient yield: Capital will be withdrawn gradually: (investments to minimum),Companies F and G: Above average yield: more investments, operations will be expanded,Company D: Sufficient return: Operati
10、ons continue as before,Average return 10%,Average cost of capital,The cost of capital of a company is the average cost of equity and debt The cost of debt should be defined as the (long term) risk free rate + company premium, e.g. 3,5% + 0,3% = 3,8% Cost of equity - average return on similar risky i
11、nvestment Cost of Equity: (long term) risk free rate + beta x (equity risk premium) =3,5% + 0,9 x 5% = 8,0% Cost of capital (with target solvency) : (45% * 8,0%) + ( 55% * 3,8%)1 6%,Cost 8,0%,Cost 3,8%,WACC 6,0%,1Tax-schield of debt not included here,Cost of capital (summary),Every company has certa
12、in average cost of capital which depends only on operative risk and long term interest rate levels (6% in the example) In operations only thing that matters is the average cost of capital (6%), the individual costs of debt / equity and the actual solvency can be ignored at this levelCost of capital
13、means the minimum return requirement, which must be achieved in order to get the owners to keep their money in these operations The cost of all assets is the same (6%) Cost of capital should not be mixed up with the return objectives of the company If company produces good return on capital and big
14、EVA, the profit objectives/targets should be given as big EVA targets and not by increasing the cost of capital,Calculation of EVA,Traditional performance measures,EVA vs. traditional performance measures,Measures from income statement; operating profit, profit before extras, net income, earnings pe
15、r share The investors are interested mainly on how much resources are employed by generating the profits (what is the return on their capital) Absolute terms (euros, dollars) make these measures good from operative perspectiveROI, RONA, ROCE, ROIC. Fixed the main deficiency of income statement measu
16、res; capital was brought into the picture Are still not measures that could be maximised (steering failure) Unillustrative and non-practical in operative level,EVA vs return on investment (steering failure),Example: ROI 30%. How ROI and EVA change after an investment producing a return of 20% ? ROI
17、does not take into account the increase or decrease in invested capital.Therefore it does not necessarily describe whether the profitability has decreasedor improved = non-optimal controlling tool and bonus base,EVA vs return on investment, example 2,Example: ROI 2%. How ROI and EVA change after an
18、investment producing a return of 6% ?,Calculation of EVA,Calculation of EVA,EVA vs ROI, ROCE, RONA in operative level,Return on capital is very unillustrative measure in operative level The costs/cost-savings of some process, function or line (production line, sales department etc.) is very difficul
19、t to convert into change in ROI. Even if this would be done the result is very uninformative With the EVA concept all costs, cost-savings, increased revenues and costs of employed capital are comparable and are in terms of final profitability (in absolute terms like EVA itself) Usually the importanc
20、e of capital efficiency has been left aside as it has not been understood on operative level in ROI-steered companies Therefore usually implementing EVA improves first capital turnover (decreases working capital) as the cost of employed capital comes out clearly - after these costs are taken in the
21、monthly reporting (income statement),Summary: EVA as a measure of profitability,First financial performance measure for which maximizing is a sensible objective Capital and the growth of capital employed is integrated (compared to Operating profit and ROI) Simplifies the whole concept of profitabili
22、ty With traditional measures this concept has been ambiguous and complicated Integrates the effects of profitability and growth into same measure The main objective of any company is to increase the value of the company. EVA measures value creation and by maximising long-term EVA the company is maxi
23、mising its own value Very suitable as a bonus base logically after the first point above Unifies the goals of the owners and the company Compensation tied to increasing the value of the company,EVA and market value,Financial theory suggests that the value of the company depends directly on the futur
24、e EVA:The value of the company = Book value of equity + the value of future EVAMathematically equal to Discounted Cash Flow -formula Investors and analysts use EVA heavily (e.g. CS First Boston, Goldman Sachs, Morgan Stanley, Merita Securities Ltd., Mandatum Stockbrokers, Opstock) Compare to the val
25、uation of a bond (next slide),Value of a bond,The bond is valued with a premium or a discount depending on the relationship between current interest rate on markets and coupon rate,Bond market value 105,Market value premium,Bond market value 80,Discount,Coupon rate market rate,Coupon rate market rat
26、e,Interest rate (market) 4% Coupon rate 5%,Interest rate (market) 10% Coupon rate 5%,Bond nominal value 100,Bond market value 100,Coupon rate = market rate,Interest rate (market) 5% Coupon rate 5%,Valuation of a bond 1/3,”The price paid for any asset should reflect the cash flows that asset is expec
27、ted to generate”. E.g. ordinary government bond, with 5 years maturity and 5% coupon rate is valued in a following manner as the market interest rate is 5%:,Bond market value 100,Bond nominal value 100,Bond coupon rate = market interest rate,Interest rate 5% Coupon rate 5%,Discount factor for cash f
28、low occurring next year: 1/(1,05) = 0,95,Discounting: change future values to present values,Valuation of a bond 2/3,Example how the bond value changes as interest rate rises from 5% (last page) to 10% (this page).,Bond nominal value 100,Bond market value 81,Bond coupon rate market interest rate,Int
29、erest rate 10% Coupon rate 5%,Discount factor for cash flow occurring next year: 1/(1,10) = 0,91,Discounting: change future values to present values,Bond nominal value 100,Bond market value 81,Market Value Lost 19,-5,Valuation of a bond 3/3 (EVA approach),-5,-5,-5,-5,The same bond market value can b
30、e calculated by focusing on the difference between annual coupon (5) and capital cost per year (10% x 100 = 10). As we discount these differences: (5 10 = -5 each year) to present, we see how much the market value will be below (or above) capital invested i.e. bond nominal value.,Interest rate 10% C
31、oupon rate 5%,Analogy between bond and company valuation,In principle the valuation of a bond and a valuation of a company is the same: You discount the future cash-flows into present, sum them up and thus get the bond/company value OR: you calculate how much the company/bond earns above or below it
32、s opportunity cost (cost of capital) , discount these values to present and add this to or subtract this from the book value We see the latter method more illustrative and practical with company valuation and thus the following pages will demonstrate how to use this method in theory and in practice.
33、 We call the difference between companys return and its capital costs with the name “EVA” (Economic Value Added) which is often called also Residual Income or Economic Profit as the term EVA is registered trademark of Stern Stewart & Co.,EVA valuation of a company,Market value of profitable company,
34、Capital Invested in the company(we can use Book value of Equity if we assume that book value and market value of debt is the same),Market value Added,Capital Invested in the company(or book value of equity),Market value of unprofitable company,Market Value Lost,The value of the company = Book value
35、of equity + the value of future EVA,EVA2002 + EVA2003 + EVA2004 + ,(-EVA2002) + (- EVA2003)+,(future EVA-values are discounted to present),EVA and market value, Nokia (29.11.2002),Book value of Equity 15 Billion EUR 3,1 EUR/share,Market value of Nokia Oyj95 Billion EUR19,9 EUR /share,Market Value Ad
36、ded80 Billion EUR 16,8 EUR /share,/1.72,/1.92,.,Bn EUR,Current market value of Nokia and investors current EVA expectations for 2002E-2007E. (in this example the estimates from 2004E- onwards are generated from current market value: what these estimates should be so that the current market value wou
37、ld be justified),2002E 2003E 2004E 2005E 2006E 2007E,Real life:,/1.115,/1.72,/1.54,/1.38,/1.24,/1.92,Jump to updated Finnish EVA-MVA values,EVA and market value, Metso (20.11.2002),Book value of EquityMetso Oyj 1434 million EUR10,58 EUR/ share,Market value of Metso1338 Billion EUR9,82 EUR/ share,Mar
38、ket Value Lost 96 Me 0,76 e/share,-145 Me,+24 Me,-55 Me,/1.72,/1.54,/1.92,2002E 2003E 2004E 2005E 2006E 2007E,+24 Me,+24 Me,+24 Me,Real life:,Current market value of Metso and investors current EVA expectations for 2002E-2007E. (in this example the estimates from 2004E- onwards are generated from cu
39、rrent market value: what these estimates should be so that the current market value would be justified),Jump to updated Finnish EVA-MVA values,EVA and market value of a company,Book value of Equity,Market value of unprofitable company,Market Value Lost,When they say, that you can lose money by losin
40、g the alternative return they mean this.Finnish companies in this situation currently e.g.: Rautaruukki, Mets-Serla, many small IT-companies,EVA vs MVA,Source: Stewart 1991,Change in EVA vs change in MVA,Source: Stewart 1991,EVA vs market value with Finnish companies 1/2,Source: Merita Securities 19
41、99 (current Aros-Maizals Equities Ltd. , part of Merita-Nordbanken-Unidanmark Group),Right scale: EVA - Blue bars (million euros) Left scale: Market value: Dark bars - book value, Yellow bars - MVA (up if positive, down if negative),Right scale: EVA - Blue bars (million euros) Left scale: Market val
42、ue: Dark bars - book value, Yellow bars - MVA (up if positive, down if negative),EVA vs market value with Finnish companies 2/2,Source: Merita Securities 1999 (current Aros-Maizals Equities Ltd. , part of Merita-Nordbanken-Unidanmark Group),Implementation of EVA,The benefits of EVA materialise as th
43、e key persons of the company: Understand what real profitability is all about Get motivated to improve profitabilityThis provides that: Key persons must understand what EVA is: where cost of capital comes from, why EVA is an important measure and better that traditional measures EVA is shown also in
44、 operative level reports The compensation is tied to EVA or to its driversIf the implementation of EVA is failed the reasons have normally been the lack of EVA training among key persons or the lack of commitment from the whole upper management team,Individual steps in implementation,Top management
45、commits to EVA and communicates it downwards Training of key persons EVA part of operative reporting Bonus schemes to support improving EVA,EVA and Balanced scorecard,Increased revenues,Smaller costs,Smaller capital invested,-Smaller inventories -Less work in production -Smaller sales receivables (b
46、etter turnover) -Bigger accounts payable (slower turnover) -Better capacity utilization factorProcess passing times, inventory turnover ratios,Better customer satisfaction-Delivery accuracy -Flexibility -Quality -Brand ,-Smaller fixed costs -Smaller variable costs-Smaller spillagecost per unit in th
47、e process spillage ,Other Balanced Scorecard measures,How EVA can be improved,By improving operating profit (increasing revenues, decreasing costs) EVA = Operating profit - WACC x Capital invested By decreasing capital invested in current businesses (without affecting current operating profit) EVA =
48、 Operating profit - WACC x Capital invested (less working capital)By investing more money in profitable projects EVA = Operating profit - WACC x Capital invested (Investment)By withdrawing from unprofitable businesses EVA = Operating profit - WACC x Capital invested (Divestment),EVA and compensation
49、 systems,Adequate level As a kind of ”excess return” EVA is very suitable for bonus base, it does not give bonuses if the shareholders can not get adequate returns in relation to risk involved Very different compared e.g. to Operating profit and Earnings Steering: Increase in EVA (in long -term) mea
50、ns also increase in profitability and company value (in contrary to traditional performance measures) Objective level Features above enable also big bonuses if the shareholders first benefit clearly The management is often able to achieve big increases in shareowners wealth Bonuses should not be limited as we do not want the EVA to be limited Compensation systems the most essential area of EVA Academic research (e.g. Wallace 1997) gives empirical support,
