ROI, EVA and MVA

The purpose of a business is to make profits, and the purpose of a shareholder is to create shareholder wealth. There are various measures to determine the profitability of a business, and the extent to which it is enhancing shareholder value. The measures include Return on Investment, Economic Value Added and Market Value Added. Each of them is significant in their own right, and is interconnected with the other measures. Any business must be evaluated based on all the three measures, as each shows a different aspect of the company. Return on Investment Profits are the acid test of the existence of a company, the all-important indicator of the fortunes of a company from the investors point of view. Profit is the residual amount that is retained by the business after subtracting all expenses from the revenues earned during that accounting period. Profits = (Income during the period) (Expenses incurred to earn such income) Profit is a measure of how much of the revenue received from customers for goods and services is available for reinvestment in the business or distribution to owners. However, profit as a stand-alone measure does not take into account the level of investment needed to generate that profit. ROI = Profit / Investment The ROI can also be evaluated as ROE, ROCE or ROTA, all of which indicate the amount earned as against the amount invested to create such income. What is important in calculating the ROI or the ROTA measures in the consistency between the aim of the measure and the constituents of the denominator and the numerator. For example, the finance manager must decide that if he/she were measuring the ROTA, would the total assets include Net Book Value or Gross book value or the replacement cost of the Fixed Assets. If the ROCE was being measured, Summary prepared by PGP student Page 1

then only the productive assets should be taken into account. Hence, the manager must take two important decisions what constituents the assets/ investment in the above measure what is the valuation to be used for fixed assets on which depreciation is charged The consistency of the numerator and the denominator becomes a major issue when measuring the performance of a company, as otherwise it may present a distorted picture. An example of this can be wrongly taking PBIT/Equity as a measure of ROI. Here the PBIT accrues to both debt holders and shareholders, while the denominator presents only the equity shareholders. Since PBIT is not the income earned by the shareholders, it cannot be used to show the ROI on their investment (share capital). The main constraint of ROI as a measure of performance of a company is that it does not indicate whether the company is adding any value or not. This means that even though the business may be earning an positive ROI, it may be possible that the cost of capital is more than that, indicating value erosion rather than value creation. Economic Value Added The fact whether the company is creating value can be verified using the EVA as a measure. It computes the value created or destroyed each year by deducting a charge for capital from the NOPAT of the companies. EVA = NOPAT - Capital Charge (Capital * CoC) EVA implementation improves overall capital efficiency and ensures that the company is moving forward in the right direction. It also integrates financial measurement with business imperatives in a comprehensible form. EVA makes adjustments for many items that are treated differently from the GAAP practices. The off balance sheet items, Research & Development expenditure, interest expenditure, deferred tax expenses, amortization of goodwill etc. This is the greatest advantage of EVA, since it helps to generate a profit number that more closely represents economic cash flows and restates the balance sheet to reflect the true value of resources used to generate income. Summary prepared by PGP student Page 2

The EVA is based on the same concept of choosing those projects that have a positive NPV, since they add to the value of the firm. Similarly, companies are evaluated based on whether they add to shareholder value or not. EVA also makes the managers accountable for those factors that are within his/her control, like the return on capital or the cost of capital (provided these decisions are actually vested with each investment centre). He is not taken to task for the factors out of his control like the market sentiments regarding the stocks. Further, it tests all aspects of the functioning of the manager, with the feasibility of his/her investment, and financing decisions. Market Value Added MVA, or market value added, is the differential in the book value of a firms equity and the market value of its equity. It is the difference between the market value of a company (both equity and debt) and the capital contributed by investors. MVA is the difference between what investors have contributed and what they could get by selling at today's prices. If MVA is positive, it means that the company has increased the value of the capital entrusted to it and thus created shareholder wealth. If MVA is negative, the company has destroyed wealth. MVA = Total Market Value - Total Invested Capital Hence, the primary objective of the firm is to maximize the value added as perceived in the market. MVA is essentially the premium over book value of equity. MVA and EVA EVA is a function of the relationship between a firms earnings and its cost of capital, and MVA is a function of that firms expected future EVA. So market value added is clearly a function of a firms earnings. The current year MVA is approximately the discounted present values of future expected EVAs. MVA = Firm Value - Total Capital MVA = [Debt plus Equity Value] - Total Capital MVA = PV of Expected Future EVA

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EVA and ROI EVA is a function of a firms net income less its cost of equity capital (KE*BVE). This would suggest that EVA is maximized by maximizing the differential between earnings and the cost of equity capital. MVA, EVA and ROI MVA is the surplus of the markets valuation of a firms equity over the book value of that equity. In other words, MVA is the value premium over the shareholders historical investment in a firm. If a firm is adding economic value by maximizing its return on equity (and its EVA), the market may reward it with a large MVA. Thus we can see that the MVA in percentage terms is as follows: %MVA = ((Price/Earnings) x ROE) 1 Since %MVA is a function of both the price/earnings multiple and ROE, it is clear that a firms value is related to things that management can influence, and things that management cannot influence. Management can influence the aspects of a business that ultimately are reflected in a firms ROE. However, management cannot influence overall market or industry trends and the impact that those trends may have on prevailing price/earnings multiples or the pricing of individual securities. It is seen that MVA, EVA and ROI are interconnected in a very intricate pattern, one reflecting in the other. The measures must be used in conjunction with each other, as analysing the performance of a company would be incomplete without assessing its performance on all 3 fronts. Hence, for purposes such as performance evaluation of the employees and such, the measure must be fixed as preferably EVA. But for valuing the company, it is essential to test performance on the market perceptions, the actual shareholder value created and the earnings made as compared to the investment required to create that income.

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