EVA
EVA or Economic Value Added is the proprietary tool, Stern Stewart & Co. have developed to end insufficient use of capital. The crux of EVA is to effectively put a cost to equity capital and make it a pre-tax charge while calculating returns. In effect, a company is said to be EVA-positive as long as its net operating profit after tax (NOPAT) is higher than the cost of the capital
The EVA presents the analysis of the Economic Value Added. It is an advance evaluation method that measures the performance and the profitability of the business by taking in to account cost of capital that business employs. This method is invented by Stern Stewart & Co. is used by more and more companies to framework of their financial management and their incentive compensation system for the manager and the employees.
Calculating EVA
Internationally, multinationals like Coca-Cola, Siemens, Bausch & Lomb and Dun & Bradstreet have been sold on EVA for long. Back home, though, EVA’s allure is less than captivating primarily because it is a difficult animal to understand. Most companies probably can’t make it effective on their own. It begins by looking simple, but as you get deeper into it the calculations begin to look daunting. EVA is defined as a company’s net operating profit after tax (NOPAT) minus the weighted average cost of capital (WACC). NOPAT is a no-brainer, and the cost of debt (the interest rate) is simple to understand.
But try calculating the cost of equity. The real cost of equity is the expected return on it, after working in the risk premium. Clearly, it has to earn more than debt, or else shareholders wouldn’t be investing in it. So you have to add the risk premium to the equity part of capital. But this premium would again depend on the kind of industry you are in: if you run a pharma business, the risk premium may be higher than if you were running a cement business.
The EVA is calculated by following method.
EVA = NOPAT – (WACC)*TC
Where,
NOPAT = Net Operating Profit after Tax
WACC = Weight Average cost of capital
TC = Total capital employed
From the above method we can calculate EVA of the company and find out profitability of a company. If EVA is in negative than company is in trouble and they have to concentrate on the basic fundamentals and trading of the company on their basic operation of the company.
If you seek to maximize EVA in the long run, the fundamental performance of the business improves. Capital efficiency will improve because there is a more explicit capital charge; the capital structure will be more optimal because there is greater awareness of the cost of equity. People will be much more bottom line conscious – and conscious about sustainable results – because their own incentives are tied to getting a part of the action.
Following are the example of companies who is implementing EVA
Godrej
Many companies are beginning to be convinced. We have example like The Godrej Soaps group of six companies, headed by Adi and Nadir Godrej, is of them. The group’s experience in just one year: four of the six companies have outperformed on stretch targets, and most employees are awaiting huge bonus payouts. As EVA aligns employee goals with shareholder interests, flagship Godrej Consumer Products has been busy handing over dividends hand over fist and buying back shares to bring down the cost of capital.
TCS
Tata Consultancy Services has put almost all its 15, 000-plus employees into EVA-linked variable pay under which performance above EVA targets fetches you bonuses every year. The only employees excluded are entry-level employees who are yet to complete a year in service, says S Mahalingam, executive vice-president of TCS, and the main spearhead for the EVA initiative in the organisation.
Infosys
Others have customized EVA for their own purposes. Marico Industries, makers of Parachute coconut oil, has worked out a simplified version of EVA (styled Seva) but uses it more as a signaling device to tell people that capital is important, that investments and acquisitions must have a justification in terms of shareholder value. At Infosys, EVA is used as a tool to calculate the value delivered to customers. Infosys reasons that if it can tell its customers that what it is delivering in terms of value is higher than what the customer pays Infosys for the service, the customer will be less worried about price alone.
Dr. Reddy
Pharma major Dr Reddy’s Laboratories does not use EVA as a measuring device to reward performance. However, it uses EVA as a qualifying criterion for granting performance-based rewards such as variable pay, performance bonuses and stock options (ESOPs), says Saumen Chakrabarthy, senior vice-president (HR). “ We use EVA as a qualifying criterion for the grant of ESOPs. Maximising EVA is the basic objective of a business,” says Chakrabarthy.
Implementing EVA
When a company decides to adopt EVA as a corporate performance measure, here is what it must do:
Step 1: Run an EVA analysis of the company, its publicly traded peers and business units
Step 2: Draw up a definition of EVA that is simple and meets the company’s information needs, existing accounting data, organization and management
Step 3: Work out a compensation scheme that fits into the company’s business and culture. The incentive plan has to marry the EVA design with traditional concerns of shareholders and directors
Step 4: Train all employees on the basics of EVA and how it affects shareholder value
Step 5: Demonstrate the difference between EVA-led decisions vis-à-vis conventional methods through computer simulation exercises
Positives of EVA
No ceiling on the amount managers can take home as incentive pay
Managers think like, act like and are paid like owners.
Targets are set over a time horizon that is more than one year – usually three to five years – forcing a long-term view into managerial decision-making
Cuts capital cost and inculcates financial discipline among employees
Increasing EVA directly benefits the shareholder and has been found to have a positive influence on a company’s stock price
Negatives of EVA
Involves lots of complexity. Globally, Stern Stewart is said, in some cases, to make as many as 165 adjustments to work out the weighted average capital cost of companies
Works better at the individual level than team level, unless goals are appropriately structured.
May make companies risk-averse. New investments that look risky or difficult to quantify in terms of expected payback may never be made using EVA.
Keys to make EVA successful.
For successful implementation of EVA, top management commitment, patience and perseverance to see through a complex implementation process is important. TCS is going through this. Failure of implementation is hard to define. Some large software companies publish EVA in their annual reports. They do not allow EVA to influence any decisions internally. For such companies there is no question of any failure.
Infosys
Infosys Technologies Limited is a multinational information technology Services Company headquartered in Bangalore, India. It is one of India’s largest IT companies with 103, 905 professionals (including subsidiaries) as of Jun 30, 2009. It has offices in 22 countries and development centers in India, China, Australia, UK, Canada and Japan.
Economic Value Added is the surplus generated by an entity after meeting an equitable charge towards provides of capital. It is just post tax return on capital employed less the cost of capital employed of Infosys. Companies which are can earn higher return than cost of capital than cost of capital creates value otherwise if the company cannot earn higher return than cost of capital is deemed destroyers for share holder’s value.
EVA of Infosys of Last 6 years (Rs. In Crore)
2009
2008
2007
2006
2005
2004
Operating profit
6434
4, 640
3, 877
2654
2048
1357
Tax
-919
-685
-386
-313
-326
-228
NOPAT (A)
5, 515
3, 955
3, 491
2, 341
1, 722
1, 129
WACC
12. 18%
13. 32%
14. 97%
12. 96%
13. 63%
14. 09%
Avg. capital employed
16025
12527
9147
6177
4331
3125
COC (B)
1951. 845
1668. 60
1369. 31
800. 54
590. 32
440. 31
EVA (A-B)
3563. 155
2286. 40
2121. 69
1540. 46
1131. 68
688. 69
Growth Of EVA
55. 84%
7. 76%
37. 73%
36. 12%
64. 32%
51. 76%
In this EVA approach Infosys’s Economic Value Added (EVA) grew 55. 9% in Fiscal 2009, according to the company’s Annual Report 2008-09.
Economic Value Added is a performance metric developed by Stern Stewart & Co. that measures all operating and financing costs of running a business. It is a measure of economic profit that is most closely aligned with the creation of shareholder value.
So we can say that up to 2008 the growth rate continuously declining and reached to 7. 76% but after that because of the concentrating on basic operation the growth rate is increases and reaches to 55. 6% and that shows that they are concentrating on basic operation and that helps them to earn more profit from business and maintain EVA as per the standard of Infosys.
But if we look at the amount of the EVA then the amount will continously increasing up to 2009 so there is no problem for the company that their EVA is declining.
From the above table we can figure out that EVA of infosys is positive in all the year so cost of capital is not harmful to the sahre holder but if we look at the table and analyse that than we come to know that EVA is continuously declining. In 2005 EVA is at its peak and reaches at 64. 32% of growth but after that it started declining up to 2008 and reaches at the lowest in the last 10 years and reaches at growth rate of 7. 76% but still the EVA is not in nagative so it is not harmful to the value of share holder’s value. If we look at the value in Rs. Then it never goes in red and the valye of it (EVA) is always increase. The problem is only that the rate at which it is incresing is continuously decling up to 2008 but after that it again jumping at 55. 84% of growth rate.
Reasons for Volatility in EVA of Infosys
The main reason for the decline in the operating profitof infosys is because of the volatility in exchange rates.
The exchange rates are at the lowest it means that Rs. Is becoming stronger and reaches to lowest level at 39 Rs/$ so the income of the Infosys is reducing and that reduced the NOPAT of the Infosys and that is why the rate of return with repect to NOPAT is reducing and that is why it reaches to 7. 76% of growth rate. But in 2009 the Rs. Is again become weak against the dollor and EURO so that will fetch some more amount for infosys and that will help to increase in the net operating profit after tax and that will help them to achieve high growth rate of EVA in 2009.
The cost of acquring capital or the rate at which we acquire capital (WACC) is continously increasing up to 2008 so it will also reduce the growth rate of EVA but in 2009 the WACC is reduce and on the other hand the Net operating profit after tax is also jumped so it will ultimately affect the EVA and that is why the EVA in 2009 is growing at 55. 84%.
So from the EVA analysis we can come to know that Infosys is very strong company which EVA never goes in to nagative even though bad situation of market and other bad macro economical factor but the lowest growth EVA of infosys is 7. 76% so even the growth rate is never in red so the value of the share holder is not danger but after that Infosys has started concentrating on profit and their basic operation and maintain geowth of EVA.
