Traditional methods of measuring a company’s performance such as Earnings Per Share (EPS) can be very misleading, according to an expert from the Indian Institute of Management in Bangalore. Speaking at a CFO Forum organised by the Institute of Chartered Accountants of Sri Lanka (ICASL) this week, Professor P.C. Narayan said using Economic Value Addition (EVA) as a performance measurement tool is the ultimate litmus test of any company’s success.
He said he has already used the EVA on smaller companies and is planning on using it for larger corporations in India to ascertain if those companies are enjoying premiums in the market which they should not.
Professor Narayan said methods such as EPS may cause the management to refrain from issuing equity at times when the company really needs it. Other concerns include the possibility of fabricating EPS gains by using more debt than prudent as well as accepting weak projects that happen to be financed by debt.
EVA was developed by Stern Stewart which defines it as a financial performance measure that comes closer than any other to capturing the true economic profit of an enterprise. EVA is also the performance measure most directly linked to the creation of shareholder wealth over time. Put simply, EVA is a net operating profit minus an appropriate charge for the opportunity cost of all capital invested in an enterprise. As such, EVA is an estimate of true ‘economic’ profit, or the amount by which earnings exceed or fall short of the required minimum rate of return that shareholders and lenders could gain by investing in other securities of comparable risk.
“The basic premise of the EVA is that managers are obliged to create value for the firm’s investors”, Professor Narayan said.
He added that investors place money in a company because they expect returns. There is also a minimum level of profitability expected by investors called ‘Capital Charge’ A company generating a return less than the capital charge is economically not acceptable.
EVA is calculated through a simple formula. EVA equals the Net Operating Tax After Profit (NOPAT) minus the Capital multiplied by the Capital Charged Rate (CCR). In simplified form, EVA = NOPAT – Capital x CCR. Professor Narayan explained that the EVA can be calculated at the end of the financial year or done quarterly or monthly, by taking the capital cost proportionately.
Professor Narayan said the EVA should be implemented since it is an indicator of whether a company has created or destroyed its profits. He said it is a consistent way to improve a firm’s financial performance and aligns the interests of management and investors. EVA is also the most appropriate measure of shareholder earnings. He added that EVA requires consistent and continuous improvement which in turn will improve stock price. |
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