Value Added: Market Value Added and Economic Value Added

VALUE ADDED

• MARKET VALUE ADDED
• ECONOMIC VALUE ADDED

MARKET VALUE ADDED (MVA)

Market value added (MVA) 

= Current market value or capitalisation (to which debt may be added) – Total shareholders’ equity  

Example:

Capitalisation of a company is $100

Shareholders’ equity in balance sheet is $50

For every $1 of shareholders’ equity, the company has added $1.

ECONOMIC VALUE ADDED (EVA)

Companies should be expected to produce not only an accounting profit but also one that more than covers their cost of capital.

It is argued that EVA is better than earnings per share or price/earnings ratios as these do not take account of the real cost of capital.

Example:

After the charge of $10 ($100 x 10%) representing the estimated cost of capital, the company shows an EVA of $30 for the period.

After tax profit $40

Capital Employed $100

Cost of Capital 10%

After tax profit $40

Cost of Capital $10

ECONOMIC VALUE ADDED $30

A positive EVA indicates that a company is providing investors with added value.

A company with a consistent EVA should have an increasing MVA; it will be generating a rate of return above the cost of capital so the share price should rise.

Examples:

These three companies are all generating a positive return on capital employed.

Company A

After-tax profit $50

Capital employed $200

Cost of capital (10%) $20

ROCE (%)  25

EVA ($)  $30

Company B

After-tax profit $60

Capital employed $400

Cost of capital (10%) $40

ROCE (%)  15

EVA ($)  $20

Company C

After-tax profit $50

Capital employed $600

Cost of capital (10%) $60

ROCE (%)  8

EVA ($)  -10

Although company C produces a positive 8% return on capital employed, it is actually destroying shareholder value with a negative $10 EVA.

In practice, the calculation of EVA requires several adjustments – to allow for the treatment of R&D, goodwill, and brand values, leases and depreciation – to be made to the after-tax profit figure.

It is claimed that EVA, as a single monetary figure, is better at concentrating management attention on the “real” results of running the business than are standard performance ratios such as ROTA.

EVA is often used as a basis for managers’ performance-related incentives.

Economic value refers to intrinsic, long-term, ultimate value of an operating enterprise as determined by net cash flow analysis.

The term value can refer to either accounting value, market value, or economic value. 


Measures of accounting value include book value per share, net worth per share, net asset value per share, and net tangible asset value per share. 


Market value refers to common stock equity capitalization or financial "size", and is equal to the share price times the number of shares outstanding. Publicly-traded market value includes only those shares that are not held in private accounts. 


Measures of accounting value and market value can be used for quick mechanical screening criteria for filtering out common stocks for further investigation. 


In contrast, economic value refers to intrinsic, long-term, ultimate value of an operating enterprise as determined by net cash flow analysis using spreadsheets and formulas. 

Intrinsic value is independent of quoted market prices. Accounting value is commonly confused with economic value. 

Shareholder value and Economic Profit

Shareholders invest in a company to make a profit.  This can come from an increase in the share price and/or the dividends the company pays.

The challenge is to find a measure of business performance that correlates with share price movements.  Then, if we plan our business to raise this measure, we should raise the share price, and hence create value for our shareholders.



EBITDA

Earnings before interest, tax, depreciation and amortisation (EBITDA)

Profit is not a good measure of the value a business is generating for its shareholders.  Ultimately, a shareholder is interested in the amount of cash generated, rather than profit (which is after all only an accounting calculation). It is cash which enables the business to expand and develop, and pay dividends.  And it is the expectation of future cash flows that drives the share price up, and creates values for shareholders.

In calculating profit, depreciation is included as a cost.

Depreciation and amortisation are not cash transactions but an accounting exercise to balance the reducing value of assets over time.  We can measure earnings before interest, tax, depreciation and amortisation - EBITDA!  This is the amount of operating profit that will eventually be turned into cash.  But EBITDA alone doesn't tell us if we are creating value.


Economic profit or Economic Value Added (EVA)

Economic profit (EP) takes account of the fact that investors have choices.  They can invest in your company, or your competitor; in art; in another industry; or put their money in the bank.  Every investment has a certain amount of risk, and a level of reward.

If your company generates more cash for each pound invested than other investments with a similar level of risk, it is making an 'economic profit'.  

• Studies of real companies show clearly that an increase in EP correlates strongly with an increase in share price, and the creation of shareholder value.  
• A fall in EP goes with a reduction in share price, and destruction of shareholder value.

Economic profit is calculated by taking the cash flow generated by the business (EBITDA) and subtracting a 'charge' for the 'cost of capital'.  The cost of capital is the profit the business must make, simply to meet the expectations of investors who take this level of risk.

If the company was financed only by shareholders' funds, the cost of capital would be the average return of investments after tax with the same level of risk; for example, a group of companies of similar size in the same industry.  This is the 'cost of equity'.

Most companies are financed partly by shareholders' funds, and partly by bank loans.  So, their cost of capital is not simply the cost of equity, but takes into account the interest paid on loans as well.  This is known as the 'weighted average cost of capital', or the WACC rate.

Economic profit is calculated by

• subtracting a capital charge (the net asset value of a business multiplied by the WACC rate) from EBITDA.  
• Tax is also deducted because this is paid out of cash flow.  
• Interest is not deducted, as the capital charge has already taken this into account.

Economic profit = Profit (Earnings) - Tax - Capital charge

Capital charge = Net Asset Value of a business X WACC rate


Example of application of Economic Profit
http://spreadsheets.google.com/pub?key=t7BiKoYpNh8QNDvzcZoN8xA&output=html