Corporate Finance Essentials will enable you to understand key financial issues related to companies, investors, and the interaction between them in the capital markets. By the end of this course you should be able to understand most of what you read in the financial press and use the essential financial vocabulary of companies and finance professionals.
3. Economic value added (EVA)
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Do curso por IESE Business School
Fundamentos de finanças corporativas
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Corporate Value Creation
In this session we will discuss EVA, a tool widely used to assess whether a company is creating or destroying value. We will also put this tool into practice by estimating the EVA of two companies.
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Javier EstradaProfessor of Financial Management
Department of Financial Management
[MUSIC]
Now we move on to EVA.
What is EVA or Economic value added?
Well, first of all, it's a measure of profitability.
As a measure of profitability, it's just another way to calculate profits.
And so, this is not really the accounting profits that you
find in any income statement as we will talk a little bit about that in,
in just a minute, but it's just another way of calculating profit.
And, and as we'll clarify it a couple minutes from now there, there's a very
important distinction between economic profits and accounting profits, and
the profits that you probably hear all the time are actually accounting profits.
All those that you have to file on a quarterly basis because
the regulations say so.
All those are accounting profits, they're based on accounting standards, and
that gives, gives you an accounting number.
What we're going to do today, is focus on economic number.
And, and that is what we call economic profit, and
we'll define that in just a second.
But, point number one, EVA is just another way of calculating profits.
We're not going to go back to the history of EVA.
Strictly speaking it was introduced by a company called Stern Stewart, and
they did so in the early 80's.
Whether they actually introduced something that is completely new, or
they sort of piggy backed on an older idea that some people call residual income,
that some people call economic profit.
We're not going to go there either.
I guess that people at Stern Stewart,
they would tell you we created something very original.
Some people say,
well, this is just a rehash of an old idea, it doesn't really matter for us.
What really matters for us is that there's this valuable called economic value added.
That it is true that it's related to an older idea that some people have
been calling for many years, either economic profit or residual income.
So, you know, you can give to Stern Stewart all the credit or
little credit that, that is actually your, your decision.
But what is important is that, really the name EVA is a trademarked concept that was
actually pioneered by Stern and Stewart in the ear, early 80's.
What is the idea behind EVA?
The idea behind EVA is exactly the same idea behind the id,
the concept of economic profit or residual income.
And that is the very a basic notion of charging managers,
let me say that again, charging managers for the capital that they use.
In other words this is nothing that is going to be shown in an accounting income
statement but what we want to do is to force managers to
recognize that the using capital, that the capital providers want a return.
They demand a return on the capital provider provided.
And that you cannot really say that you have created value if you have not
first compensated the capital providers with the return that they expect.
So that is a very simple idea.
What we're going to do is we're going to charge managers for the use of capital.
If there's any cash left after that, then we're creating value.
But if we fall short of compensating capital providers,
then we will not be creating value.
So EVA economic profit residual income, all of them are just a slight variations
of the idea that we need to make managers recognize built into their decisions,
that they're using capital and that there's a return required on that capital.
So at the end of the day when we say,
well, you know, we go by our accounting standards in whatever country you are.
There must be accounting standards that companies actually need to follow.
Then you get to the bottom line, which some people call the, the,
the profit or the net income of, of, of the company.
That is basically the bottom line result.
That is what we call an accounting profit.
But that accounting profit may actually be, however large that
number may happen to be, may be hiding a process of value destruction.
That is, it's perfectly possible for a company to have
positive accounting profits, and at the same time, destroying economic value.
And that is why the number that we're going to calculate,
we're going to call it economic profit.
So again, EVA residual income economic profit, for
our purposes, all these terms are going to be interchangeable.
Because they all point in the same direction, which is forcing managers to
admit that there's a cost to the capital they're using and that, when they say
we're creating or destroying value, they're taking that cost into account.
So let's go with the expressions.
There's two ways of writing EVA, and mathematically they're identical.
Some people like one better, some people like the other better,
it doesn't really matter.
I'm going to present both of them to you and
you're going to decide whether you like one better than the other.
They're both equally intuitive, although they, they reflect a slightly different
ways of thinking about the process of value creation.
The first expression that you're seeing there of EVA, economic value added,
basically starts with a NOPAT and then you subtracts the Capital that
we're using in the corporation, multiply by the weighted average cost of capital or
the capital as we define the, the cost of capital as we define it before.
Now, the NOPAT there's going to be a, a neater and,
and more precise definition in the reading that goes with this session, but
for our purposes now, just think of a quick and dirty cash flow.
This is the cash flow generated by the company.
And what comes after that, capital multiplies by the cost of
capital is what some people would call the capital chart.
That is, there's a capital being invested in this company.
There's a return required on that capital and
when you multiply one times the other, it gives you in dollars and
cents what is the return that you need to deliver to the capital providers.
we'll, we'll be looking at a couple of examples in couple minutes from now when
it's going to be more clear.
But notice what we're saying, is that we are making money.
But before we say that we're creating or destroying value, we need to
take into account that we're using capital, and that that capital has a cost.
After taking into account that capital charge, if there's something left,
we're creating value.
In other words, if EVA is positive, we're creating value.
If EVA is negative, that means that we have actually produced some cash, but
it's not enough to compensate the capital providers,
given the required return on that capital.
So, a positive EVA in this framework says that you're creating value,
and a negative EVA says that you're not creating value.
Now, as you see there there, there's the both, the NOPAT and
the capital, that they're sub subject to some proprietary adjustments.
And that basically is a fancy way of saying that,
when a company provides this service to you.
They will tell you something like look, for for
the reason of being this particular company in this particular sector and
the type of company that you are.
Then we need to calculate the NOPAT in this specific way, and
we need to calculate the capital in this specific way.
So there's a lot of adjustments that need to be made on the calculations of
this we're going to try to understand the measure,
not getting into the nitty gritty of the calculation.
We'll get into a little bit,
just a little bit of nitty gritty, in the reading that goes with this session, but
we're not going to get into that nit that nitty gritty now.
I do want to give you one example though.
And the example is a very simple that, again, sort of
reflects the difference between accounting profits and economic profits and, and
thinking properly or improperly about the process of value creation.
And that is, suppose that as a company,
you invest $1 billion in R&D, big amount of money in, in R&D.
From an accounting point of view, $1 billion dollars in R&D is a cost.
All right, so you basically take out $1 billion out of your profits and
then, you keep going the the income statement.
Now if you really think about it, no company would invest $1 billion today,
if they didn't expect to get something in the future.
So, $1 billion investment in R&D is just that, it's an investment.
So you expect to get a return in the future.
So, if you're actually using the idea of EVA residual income, economic profit.
What you would probably do is the following.
You would say look, I'm going to build this $1 billion of R&D into my capital.
Because that is what it really is, I'm making an investment here,
and I'm going to be depreciating this capital over time.
And that depreciation is what I'm going to be charging, so
earnings, period after period after period.
So there's a fundamental difference there in the way you think about R&D.
One way is to say R&D is an expense today, I charge it to earnings today,
end of the story.
But that's not really what R&D is from an economic point of view.
We're making a capital investment.
That capital investment is going to be depreciating over time.
And that depreciation is what we would charge to earning.
So this is just to clarify some of the many adjustments that you could
actually do to the NOPAT, to the capital, and to the traditional accounting in
order to go from the accounting profit into the economic profit, right.
So that's enough for definition number one.
Let's bring now definition number two.
And let me hasten to add once again, these two definitions are identical.
If you define the Return on Capital as the NOPAT divided by Capital,
you can algebraically go between one definition and the other back and forth.
But notice what that second definition says.
And a lot of people that like that because it takes us back to some of
the issues we were discussing before.
It says something that is very simple.
If you create a positive spread between the Return on Capital and
the cost of Capital, you're going to be creating value.
And if you find activities, you find investments, you find things that you
can do in which you can create a positive spread between the Return and
the Cost of Capital, then put Capital into those activities.
And if you do that, then you're going to be creating value.
So in the same way as we, we said before,
positive EVA indicates value creation and negative EVA indicates value destruction.
Here we actually have exactly the same thing.
Now, let's put these two expressions together.
And in order to, to,
to do that then we're going to focus how do we create value at the end of the day?
Well, you know,
if you put the two expressions together, it's pretty much in front of your eyes.
One is you can increase the company's profitability, and
that basically means to create more NOPAT.
So, if you create more cash, if your investment activities,
if your operations, if the product and services that you sell create more cash,
then you're going to be increasing the process of value creation.
Now, let's go to the second expression.
You can create more value by investing more capital in
activities in which you have a positive spread.
Because if you have a positive spread if you're beating the cost of Capital,
more Capital is going to increase the process of value creations, so
that's possibility number two.
Possibility number three, very often overlooked.
If you are investing in activities in which you have a negative spread,
that is in which the return of cap, on Capital is lower than the cost of Capital,
take Capital out of those activities.
That is very important, and that's sometimes again overlooked.
If we are doing things in which we're destroying value, take the Capital out and
put it somewhere else.
You'll be creating value.
You'll be enhancing value creation by doing that.
And the fourth, which sometimes is, is,
is overlooked when we're discussing these issues but, but only because of that.
Because we know that this is an important thing to do is to
optimize the Capital structure.
And that, remember that although with this is not one of those topics that
we're going to be addressing specifically.
Minimum of the optimal Capital structure is
the one that minimizes the cost of Capital.
And so you can look at expression one, or you can look at expression two.
But everything else equal the lower cost of Capital,
the higher is going to be the, the EVA.
So the four ways in which you can create value in this framework is,
increase the profitability of the company, increase the NOPAT,
put more Capital into activities in which you have a positive spread,
return on Capital higher than the cost of Capital.
Take out Capital from activities in which the return of cap,
on Capital is lower than the cost of Capital, and
minimize your Capital structure so as though you minimize the cost of Capital.
If you do those four things,
if you improve in the direction of doing those four things, you're going to be
creating more value according to this framework that we're discussing here.
[MUSIC]
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