ECONOMIC VALUE ADDED: THE REAL KEY TO CREATING SHAREHOLDER WEALTH

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ECONOMIC VALUE ADDED THE REAL KEY TO CREATING
SHAREHOLDER WEALTH

• A PRESENTATION BROUGHT TO YOU BY CONSULTANTS OF
  STERN STEWART Co.
• Stephanie N. Marusak
• Carlos Abueg
• Jennifer Jones
• Jay Bonnett

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Stern Stewart Co.

• A global consulting firm established in 1982 by
  Joel M. Stern and Bennett Stewart
• Pioneered the EVA concept in 1989
• A financial performance measure that captures the
  true economic profit of an enterprise is needed
• EVA is used by over 300 successful companies

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EVA Defined...

• EVA is a financial measurement tool that
  determines if a business is earning more than its
  true cost of capital.
• EVA is the net operating profit minus an
  appropriate charge for the opportunity cost of
  all capital invested in an enterprise or project,
  or net income minus dollar cost of equity
  capital.

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EVA is ...

• An estimate of true economic profit.
• A tool that focuses on maximizing shareholder
  wealth.
• A fundamental measure of Return on Capital.

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EVA is True Economic Profit

• Until a business returns a profit that is
  greater than its cost of capital, it operates at
  a loss.
• -Harvard Business Review

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Accounting Profit vs Economic Profit

• Just because you have an accounting profit does
  not mean that you have an economic profit.

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History of EVA

• EVA is not a new concept Alfred Marshall
  mentioned the concept of Residual Income in 1890.
  
• Adam Smith Maximize wealth of owners
• Modigliani Miller Net Present Value (long
  term tool)
• Established by Stern Stewart in 1989

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Why use EVA? The Four Ms

• Management System
• Motivation
• Mindset
• Measurement

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Management System

• Simply measuring EVA can give managers a better
  focus on performance.
• Provides a foundation for a comprehensive
  financial management system

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Motivation

• Incentive plans to make managers think like
  owners because they are paid like owners.
• EVA Bonus Plan

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Mindset

• Changes corporate culture
• EVA system provides a common language for
  employees across all corporate functions.
• Facilitates decentralized decision making

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Measurement

• Most accurate measure of corporate performance
  over any given period.
• Translates accounting profits into economic
  reality.

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Prime Directive Maximize Shareholder Wealth

• Primary Goal Maximize Shareholder Wealth
• Maximizing Shareholder Wealth ? Maximizing
  Market Value, or Total Value

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Maximizing Shareholder Wealth and Market Value
Added

• Maximize shareholder wealth only if the companys
  managers are able to add value to the Total
  Equity Capital
• This added value is what we call, Market Value
  Added, or MVA

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Market Value Added

• MVA is the difference between a companys Total
  Value and its Total Equity Capital.
• MVA Total Value Total Equity Capital

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MVA Component Total Value

• Total Value Market Value of Equity
• Market Capitalization
• Current Market Share
  Price x (No. of Shares
  Outstanding)

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MVA Component Total Equity Capital

• Total Equity Capital Book Value of Equity
• Common Stock Capital Surplus
  Retained Earnings
• Treasury Stock

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Importance between Market Value and MVA GM
Example

• In 1988, General Motors
• Market Value 25 billion
• Total Equity Capital 45 billion
• MVAGM 25 billion - 45 billion
• - 20 billion

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Importance between Market Value and MVA Merck
Example

• In 1988, Merck
• Market Value 25 billion
• Total Equity Capital 5 billion
• MVAMERCK 25 billion - 5 billion
• 20 billion

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MVA GM and Merck

• Same Market Values at the end of 1988.
• However, Merck created 20 billion while GM
  destroyed roughly the same amount.
• MVAGM - 20 billion
• MVAMERCK 20 billion

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Shareholder Wealth and MVA

• Maximize not only Total Market Value
• But the difference of Total Market Value and
  Total Equity Capital
• In short,
• Maximize Shareholder Wealth
  Maximizing MVA

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How does MVA relate to EVA?

• To increase MVA increase Economic Value
  Added, or EVA
• MVA is a premium based on market expectations of
  future EVAs
• Shareholders Wealth MVA PV of Future
  EVAs

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Calculating EVA

• Estimate based on revised reported earnings
• EVA Sales Operating Expenses -
• Depreciation - Interest Expenses
  (includingTaxes) Equity Financing
  Expenses ( or, Cost of Equity x Total
  Equity Capital
• Net Income - Keq x Total Equity Capital
• Net Income - Cost of Equity Capital

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The Coca-Cola Company Example

• EVA Net Income Keq x Total Equity
  Capital
• 3,533 million 12 x 7,700
  million
• 3,533 million 924 million
• 2,609 million
• The 2.6 billion is an estimate of the companys
  true economic profit for 1998.

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Why should you implement EVA?

• A consistent way of improving firm
• Allows Managers to make better decisions
• Aligns interests of Managers and investors
• Improves communication
• Used to Evaluate Corporate Management
• Best measurement of shareholder wealth

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EVA is Consistent

• Financial Management System or Framework
• Goal is continuous improvement of EVA to increase
  stock price
• Ends confusion of multiple goals

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Managers behave like owners

• Incentive package offers rewards based on EVA
  improvement
• Cash bonuses have no limit
• Plan is Long-term

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Improves Communication

• Decentralizes authority
• Motivates management and workers to cooperate
• Investors understand goals

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Evaluating Managers

• Measures true profitability
• Higher correlation with Stock Price
• Keq gives investors opportunity cost
• Evaluate divisions of company

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Best Measurement of Shareholder Wealth

• Accounts for all capital costs (Kdebt and Keq)
• Shows wealth created or destroyed

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Calculating MVA

• MVA1 TV-BV of Equity Capital
• PV of future EVAs

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Given

• Assumptions No debt
• No retained earnings
• BV Equity CapitalAssetsInvested 1000
  Capital
• WACCKeq12
• Expected ReturnRIC115

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Calculating MVA using TV-Book Value of Equity
Cap.

• Net Income(Invested CapitalExp. Return)
• 100015
• 150
• Retention Rate 0
• Net Income Divs.150

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Continued

• Total Value of the companyPV of the Div
• 150/.12
• 1250
• MVA1 TV-Book Value of Equity Capital
• 1250-1000
• 250

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Calculating MVA using PV of EVA

• EVA1NI-(Book Value of EquityKeq)
  150-(1000.12)
• 30
• MVA1PV of future EVAs
• 30/.12
• 250

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Does a positive EVA mean that MVA increases?

• Book Value of Equity 1000
• WACC 12
• Expected Return RIC213
• Net Income (1000.13)
• 130
• EVA2 NI-(Book value of EquityKeq)
• 130-(1000.12)
• 10

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MVA lowered

• MVA2 PV of the expected future EVAs
• 10/.12
• 83.33
• Even though EVA was positive, MVA was lowered

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Why should you implement EVA?

• Best measurement of shareholder wealth
• A consistent way of improving wealth
• Allows Managers to make better decisions
• Aligns interests of Managers and investors
• Improves communication

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Five Step Process

• Introduce EVA to management and the board of
  directors
• Establish EVA centers, define EVA, and provide
  EVA training
• Develop the EVA financial management and
  reporting system
• Refocus and strengthen incentives
• Train line managers

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Critical Success Factors of Implementing EVA

• Education
• Commitment from Top Management
• Systems support
• Compensation Integration

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Common Mistakes

• Failure to fully integrate EVA
• Implementing EVA too fast
• Top management lacks commitment
• Insufficient training

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SUMMARY

• EVA is a financial measurement tool that
  determines if a business is earning more than its
  true cost of capital
• Most accurate in measuring true profitability
  motivates managers to think like owners and
  provides a common language within the corporate
  culture.
• Shareholder Wealth MVA PV of future EVAs

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THE END