EVA and Wealth Creation in the Indian Context

8/7/2019 EVA and Wealth Creation in the Indian Context

1/51

EVA and Wealth Creation in the Indian Context

M.P.Birla Institute of Management 1

RESEARCH PROJECT

On


Submitted in partial fulfillment of the requirement for MBA

Degree of Bangalore University

BY

Deepika Pandya

Registration Number

04XQCM6024

Under the guidance of

Dr. T. V. N. Rao

M.P. Birla Institute of Management

Associate Bharatiya Vidya BhavanBangalore-560001

2004-2006


2/51



DECLARATION

I hereby declare that the research project titled EVA and Wealth

Creation in the Indian Context is prepared under the guidance of Dr. T.V.N. Rao in partial

fulfillment of MBA degree of Bangalore University, and is my original work.

This project does not form a part of any report submitted for degree or diploma

under Bangalore University or any other university.

Place: Bangalore Deepika Pandya


3/51



GUIDES CERTIFICATE

I hereby declare that the research work embodied in this dissertation entitled EVA

and Wealth Creation in the Indian Context has been undertaken and completed

by Ms Deepika Pandya under my guidance and supervision.

I also certify that she has fulfilled all the requirements under the

covenant governing the submission of dissertation to the Bangalore University for

the award of MBA Degree.

Place: Bangalore Dr. T.V.N Rao

Date: Research Guide

MPBIM, Bangalore


4/51


5/51



ACKNOWLEDGEMENT

The successful accomplishment of any task is incomplete without

acknowledging the contributing personalities who both assisted and inspired and

lead us to visualize the things that turn them into successful stories for our

successors.

First of all we thank the Almighty God for his grace bestowed on us

throughout this project.

My special thanks to my project Guide Dr. T.V.N Rao, who guided me

with the timely advice and expertise and has helped remarkably to complete the

project.

Last, but not the least, I would like to thank my parents and all my

friends for their wholehearted support and encouragement.

DEEPIKA PANDYA


6/51



TABLE OF CONTENTS

CHAPTERS PARTICULARS PAGE NO.

ABSTRACT 1

1. INTRODUCTION 2

1.1 Introduction 3

1.2 Background of the study 4

1.3 Purpose of the study 7

1.4 Problem statement 7

1.5 Objectives of the study 7

1.6 Research Questions 7

1.7 Theoretical Framework 8

2. REVIEW OF LITERATURE 15

2.1 The Wealth Creation Framework 16

2.2 Examination of EVA as a performance metrics 18

2.3 The quest for value 20

2.4 The five forces of Wealth creation 21

3. METHODOLOGY 23

3.1 The Sample Size 24

3.2 Data gathering procedure and Instrumentation 27

3.3 Research Calculations 28

3.4 Data Analysis 29

4. RESEARCH FINDINGS & ANALYSIS 30

5. CONCLUSIONS & RECOMMENDATION 41

6. ANNEXURES 44


7/51



LIST OF TABLES

S. No Particulars P.No

1 Table 4.1 The Largest Wealth Creators for

(2000-2005)

31

2 Table 4. The Toppers in terms of Economic

Value Added (2000-2005)

32


(2004-2005)

33

4 Table 4.4 The Toppers in terms of

Economic Value Added (2004-2005)

34


(2003-2004)

35



36


(2002-2003)

37



38


2001-2002

39



40


8/51



Abstract

Wealth Creation is the process by which a company enhances the market value of the

capital entrusted to it by its shareholders. It is a basic measure of success for any

commercial venture. Wealth Creation is achieved by the rational actions of a company in a

sustained manner.

Many organizations devote a significant proportion of management resource thinking on

competitive strategy; however their strategic planning processes often lack the discipline or

analytical rigor of thinking through alternative strategies and their long-term financial risk-

reward implications. The EVA analysis provides the company with profits in real sense and

measures the actual value creation by the organization which benefits its stakeholders.

The research provides a fundamental platform to investors to analyze the companies in

terms of its present position; earning capabilities and the growth potential unleashed which

leads to value addition and subsequently wealth creation.


9/51



Chapter 1

Introduction


10/51



1. Introduction

Creation of shareholders value is the core of every business. This is natural since shareholders

own the company and as rational investors they expect good long-term yield on their investment.Commonly used accounting measures are EPS (Earnings per Share), ROE (Return on Equity),

NPR (Net Profit Ratio) etc. But these metrics may not show a clear picture with respect to the

value created by the company.

Therefore, value based metrics of performance evaluation like EVA (Economic Value Added),

MVA (Market Value Added), CVA (Cash Value Added) and CFROI (Cash Flow Return on

Investment) have come into existence. These new performance metrics seek to measure the

periodic performance in terms of change in value. Maximizing value means maximizing long-term

yield on shareholders investment.

Economic Value Added defined by Stern Stewart & Co. is the financial performance measure that

comes closer than any other to capturing the true economic profit of a company. EVA also is the

performance measure most directly linked to the creation of shareholder wealth over time.

EVA = Net Operating Profit after tax (NOPAT) [Capital * the Cost of Capital]

Put most simply, EVA is 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

shareholder and lenders could get by investing in other securities of comparable risk.

The consulting firm of Stern Stewart published The Real Key to Creating Wealth (John Wiley &

Sons, New York, 1998), which "celebrates a revolution in management known as economic value

added (EVA)." Stern Stewart claims that:

EVA is the only true indicator of business and management performance;

EVA is "today's hottest financial idea and getting hotter;

EVA "allows all financial decisions to be modeled, monitored, evaluated, communicated, and

compensated in terms of a single measure";

"EVA is the only reliable and unambiguous continuous-improvement metric"


11/51



1.2 Background of the study

Wealth Creation is the process by which a company enhances the market value of capital entrusted

to it by its shareholders. It is a basic measure of success for any commercial venture. Wealth

Creation is achieved by rational actions of a company in a sustained manner. The foundation of

Wealth Creation is in buying businesses at a price substantially lower than their intrinsic value.

Lower the market value than the intrinsic value; higher is the margin of safety.

Investors are currently demanding Share value more strongly than ever. So the wealth created by

the company is more linked to the market price of the shares. This study is undertaken to show the

relationship that exists between the various value metrics and wealth creation as the performance

of the company is reflected in the wealth created.

Value investing starts with having a better understanding of the intrinsic value of the company than

rest of the market. A companys intrinsic value can be divided into three parts:

I Asset Replacement Value

II Earning Power Value

III Growth Value


12/51



Asset Replacement Value

o Basic value of a business with no competitive advantage is the replacement cost of assets.

Any new entrant can get these assets by paying the current price.

o Typically found in industries like cement, steel, aluminum, refining and petrochemical.

Earning Power Value

o Competition keeps eroding profitability till it falls below the cost of capital.

o Competitive advantage or some kind of entry barrier allows companies to earn higher

returns than the cost of capital.

o Higher the entry barriers and the longer they last, higher and larger w ill be the profits

above the cost of capital.

o Solidity of the barrier or competitive advantage is the starting point of Wealth Creation. If

it is missing, any amount of growth will be meaningless in the long run.

Growth Value

o Growth is the most difficult to estimate. Especially, to project growth for a long period into

the future is not an easy task.

o All growth is not rewarding. Growth has to be in the same franchise of business.

o Free competition allows all the firms to enter new businesses.

o

New lines of business without competitive advantage are unlikely to earn attractive returns

(> cost of capital) on additional capital for a meaningful period.

o Hence, only 'valuable grow th ' is the grow th in businesses w here the firm enjoys a

competitive advantage.


13/51



Not All Growth Creates Value

We quested further to probe the process of Wealth Creation of Growing companies. Value of a

share is the Present Value of all future free cash flows. Th e formula:

Present Value of Future Cash Flow s = C x (RoC G)/(R -G)

C: Capital Employed

RoC: Return on Incremental Capital Employed / Equity

G: Growth in Capital Employed

R: Cost of Capital

Value created by growth depends on

o Profitability of incremental capital employed. Greater the amount by which incremental

returns (RoC) exceed the cost of capital (R), greater will be the value created.

o Amount of capital that can be deployed in the business. In the long run, growth (G) has to

be a fraction of cost of capital.

o An investor should substitute cost of capital with the return that he/she expects on the

investment to decide on the extent of Margin of Safety.

The academic approach to calculate shareholder value ignores the market price altogether.

According to this approach, value creating companies are those that have positive free cash flows

after applying the cost of capital. Many companies use this yardstick themselves to find out

whether each of their action and divisions are creating free cash flow, the technique is called

Economic Value Added.


14/51



1.3 Purpose of the study

The purpose of the study is to show that EVA has relationship with wealth creation and this

relationship is significant. This shows that value addition by the company is also a dependantfactor for the movement in the share prices.

1.4 Problem Statement

There are various views with respect to whether traditional measures or value-based measures

influence wealth creation. Considering this, it is interesting to examine which of the performance

measures have significant impact on wealth creation.

Question to be addressed is whether there is relationship between EVA and Wealth creation andwhether this relationship is significant.

1.5 Research Question

Is there a significant relationship between EVA and wealth creation? The research question tests

the importance to measure EVA in terms of real profit which in adds wealth to the company.

1.6 Objectives of the study

o To measure wealth creation for the sample companies.

o To judge the relation between EVA and change in market capitalization.

o To analyze the relationship between EVA and wealth.

o To establish that EVA is a better measure of performance.


15/51



1.7 Theoretical framework

Investors analyze and interpret the financial statements so that they can get an insight into the

firms performance. Ratio analysis is one of the tools of financial analysis. It shows the

relationship between two figures in the financial statements. There are various types of ratios used.

Investors of more interested in profitability ratios like Net profit ratio, Return on capital employed,

Return on Equity, etc., and valuation ratios like Price-Earnings ratio, Earnings per share, Yield,

etc.

Net profit ratio

NPR shows the earnings left for the shareholders as a percentage of net sales. It measures the

overall efficiency of production, administration, selling, financing, pricing and provides a valuable

understanding of the cost profit structure of the company. It enables the analysts to identify the

sources of business efficiency/inefficiency.

NPR= Net Profit * 100

Sales

Return on Net worth/Equity

RONW measures the profitability for the shareholders funds invested in the firm. It is an important

measure as it reflects the productivity of the ownership capital in the firm. This measure is of great

interest to the shareholders.

RONW= Earnings for Equity shareholders * 100

Average equity capital

Earnings per share

EPS is also a measure of the profitability of the firm. It indicates the profitability on a per-share

basis.

EPS = Earnings for Equity shareholders * 100

No. of equity shares


16/51



Economic Value Added

The consulting firm Stern Stewart originally proposed it. It is the most popular value-based measure. It is

the surplus left after making an appropriate charge for the capital employed in the business.

EVA = NOPAT WACC (Capital Invested)

NOPAT: Net Operating Profit after Taxes

WACC: Weighted Average Cost of Capital

Market Value Added

MVA is the difference between the companys market value and the capital invested. It is the premium

the market awards a company over and above the amount the investors have invested in it. This helps

in the assessment of how the markets view EVA generating ability of the firm. So, MVA is the market

expectations of future EVAs generated by a firm.

MVA= EVA1 + EVA2 +(1+WACC)1 (1+WACC)2

Cash Flow Return on Investment

The CFROI model avoids the use of accounting book capital in valuing the firms existing assets and

thus provides an accurate estimate in determining shareholder value.

CFROI = Cash flow - Economic depreciation

Cash Invested

Economic depreciation is the amount of annual sinking fund payment earning the cost

of capital required to replace the assets.

Cash Value Added

CVA is based on cash flows and not on earnings. It is the spread between CFROI and the real cost

of capital, multiplied with the investment in fixed assets and working capital.

CVA= Cash flows- Economic Depreciation-(Cash invested* WACC)


17/51



Background of Economic Value Added

EVA is not a new discovery. An accounting performance measure called residual income is

defined to be operating profit subtracted with capital charge. EVA is thus one variation of residual

income with adjustments to how one calculates income and capital. According to Wallace (1997,p.1) one of the earliest to mention the residual income concept was Alfred Marshall in 1890.

Marshall defined economic profit as total net gains less the interest on

invested capital at the current rate. According to Dodd & Chen (1996, p.27) the idea of residual

income appeared first in accounting theory literature early in this century by e.g. Church in 1917

and by Scovell in 1924 and appeared in management accounting literature in the 1960s. Also

Finnish academics and financial press discussed the concept as early as in the 1970s. It was

defined as a good way to complement ROI-control (Virtanen 1975, p.111). Knowing this

background many academics have been wondering about the big publicity and praise that has

surrounded EVA in the recent years. The EVA concept is often called Economic Profit (EP) in

order to avoid problems caused by the trade marking. On the other hand the name "EVA" is so

popular and well known that often all residual income concepts are often called EVA although

they do not include even the main elements defined by Stern Stewart & Co. For example, hardly

any of those Finnish companies that have adopted EVA calculate rate of return based on the

beginning capital as Stewart has defined it, because average capital is in practice a better estimate

of the capital employed. So they do not actually use EVA but other residual income measure. This

insignificance detail is ignored later on in order to avoid more serious misconceptions. It is

justified to say that the EVA concept Finnish companies are using corresponds virtually the EVA

defined by Stern Stewart & Co.

In the 1970s or earlier residual income did not got wide publicity and it did not end up to be the

prime performance measure in great deal of companies. However EVA, practically the same

concept with a different name, has done it in the recent years. Furthermore the spreading of EVA

and other residual income measures does not look to be on a weakening trend. On the contrary the

number of companies adopting EVA is increasing rapidly (Nuelle 1996, p.39, Wallace 1997, p.24

and Economist 1997/2). We can only guess why residual income did never gain a popularity of this

scale. One of the possible reasons is that Economic value added (EVA) was marketed with a

concept of Market value added (MVA) and it did offer a theoretically sound link to market

valuations. In the times when investors demand focus on Shareholder value issues this was a good


18/51



bite. Perhaps also pertinent marketing by Stern Stewart & Co. had and has its contribution. EVA is

one measure that is used to monitor the overall value creation in a business. It is a value based

framework that provides unique insight into the value creation. The idea behind EVA is that

shareholders must earn a return that compensates the risk taken. In other words equity capital has

to earn at least same return as similarly risky investments at equity markets. If that is not the case,

then there is no real profit made and actually the company operates at a loss from the viewpoint of

shareholders. On the other hand if EVA is zero, this should be treated as a sufficient achievement

because the shareholders have earned a return that compensates the risk. This approach - using

average risk-adjusted market return as a minimum requirement - is justified since that average

return is easily obtained from diversified long-term investments on stock markets. Average long-

term stock market return reflects the average return that the public companies generate from their

operations.

What is EVA and how it is calculated?

EVA is the difference between the companys net operating profits aftertaxes and the cost of

capital employed in generating those profits in one financial year. If EVA is positive, the company

creates shareholder wealth. If EVA is negative, the shareholder wealth is destroyed. The concept of

EVA is based on the principle of residual income, which states that the real income generated by a

company is the residue that remains after a companys shareholders and debtors have been paid

their annual required return. The technique of EVA has acquired acceptance as a tool for assessing

the existing financial status and predicting the future performance of the company. The most

important reason to adopt EVA as the main corporate financial goal is that it is directly correlated

to the intrinsic market value. Maximizing EVA consistently would lead to maximization of the

market capitalization.


19/51



EVA has two distinct applications

To measure how much shareholder value the firm has created in the past and to determine investor

expectations as they relate to the stock price. A firm/s present value should equal its invested

capital plus the present value of future EVA. Basically EVA examines the three fundamentalprinciples of value creation: Cash flow, Risk, and Sustainability of Returns.

Uses of EVA

In stock selection the EVA tool can be used in four distinct ways.

1. Analyzing historical trends - EVA can measure a companys historical success in creating

shareholder wealth.

2. Using EVA to forecast a target stock price - EVA can be used to determine whether a stock is

fairly valued based on a forecast of economic profits. Such a forecast converts discounted EVA

into a share price.

3. To quantify Competitive Advantage Period (CAP) - Stock prices in many cases may reflect a

long competitive advantage period. Analysts can use the value driver model to look at their

assumptions regarding risk and CAP.

4. To examine excess returns and its impact on valuation of a stock- Another way of exploring the

explanatory power of the value drivers in an EVA model is to perform a regression analysis of

invested capital (ROIC) minus the weighted average cost of capital (WACC) spread as the

independent variable and enterprise value to invest capital as the dependant variable. The

correlation between return spreads and valuation is quite strong.


20/51



Superiority of EVA can be known from the following comparisons

Conceptually, EVA is superior to accounting profits as a measure of value creation because it

recognizes the cost of capital and, hence, the risk of a firms operations. Furthermore EVA is

constructed so that maximizing it can be set as a target. Traditional measures do not work that way.

Maximizing any accounting profit or accounting rate of return leads to an undesired outcome.

EVA vs. ROE

ROE suffers from the same shortcomings as ROI. Risk component is not included and hence there is no

comparison. The level of ROE does not tell the owners if company is creating shareholders wealth or

destroying it. With ROE this shortcoming is however much more severe than with ROI, because simpl

increasing leverage can increase ROE. As we all know, decreasing solvency does not always make

shareholders position better because of the increased (financial) risk. As ROI, return n equity (ROE) i

also an informative measure but it should not guide the operations.

EVA vs. ROCE

1. Return on capital is very common and relatively good performance measure. Different

companies calculate this return with different formulas and call it also with different names like

Return on investment (ROI), Return on invested capital (ROIC), Return on capital employed

(ROCE), Return on net assets (RONA), Return on assets (ROA) etc. The main shortcoming with

all this rate of return is that maximizing rate of return does not necessarily maximize the return to

shareholders.

2. Also operations should not be guided with the goal to maximize the rate of return. As a relative

measure and without the risk component ROI fails to steer operations correctly. Therefore capital

can be misallocated on the basis of ROI. First of all ROI ignores the definite requirement that the

rate of return should be at least as high as the cost of capital. Secondly ROI does not recognize that

shareholders wealth is not maximized when the rate of return is maximized. Shareholders want

the firm to maximize the absolute return above the cost of capital and not to maximize percentages.

Companies should not ignore projects yielding more than the cost of capital just because the return

happens to be less than their current return. Cost of capital is much more important hurdle rate than

the company's current rate of return.


21/51



EVA vs. EPS

EPS is raised simply by investing more capital in business. If the additional capital is equity (cash flow

then the EPS will rise if the rate of return of the invested capital is just positive. If the additional capital

is debt then the EPS will rise if the rate of return of the invested capital is just above the cost of debt. In

reality the invested capital is a mix of debt and equity and the EPS will rise if the rate of return of that

additional capital invested is somewhere between cost of debt and zero. Therefore EPS is completely

inappropriate measure of corporate performance and still it is very common yardstick and even a

common bonus base. EPS and earnings can be increased simply by pouring more money into business

even though the return on that money would be entirely unacceptable from the viewpoint of owners.

EPS, earnings and earnings/EPS growth should therefore be abandoned as performance measures.


22/51



Chapter 2

Literature Review


23/51



2.1 The Wealth Creation Framework

The Indian Rope TrickThe destruction of wealth (PPAF Services)

The wealth creation framework is the application of the EVA concept to the Indian corporate

world. The model has been tested on the BSE 100 stocks. This universe has been divided into

four sections based on two factors:

- Average EVA per share

- Compounded Average Rate of Growth of capital employed

On these two factors the Indian corporate diaspora can be classified into four types of companies.

These four sections are shown in the "Wealth Creation Matrix" shown below.

The four sections in order of decreasing value are.

TYPE A- This is the best type of company in the matrix as it creates wealth year after year on a

regular basis and also maintains a positive EVA with an increasing amount of capital employed

TYPE B- The companies falling under type B of the matrix are the next preferred companies as

these corporate segments are creating wealth but on a decreasing capital employed.

TYPE C- The corporates associated with this segment are known as destroyers of wealth. The

only remarkable behaviour of theirs is that they are reducing their capital employed; therefore they

are destroying capital on a reducing base.


24/51



TYPE D- The worst type of company in the matrix lies under Type D as it not only destroys

wealth but also taking an increasing amount of capital into operation which are leading to wealth

destruction.

The wealth creation framework brings some amount meaning to an otherwise static EVA

analysis. This concept (EVA) in conjunction with the 'Wealth Creation Matrix' (WCM) can be

used to plot and understand the profitability movement of various economic entities over time.

The two measures used in the model indicates that the growth rate of capital employed reflects

the rate at which the company is growing and the average EVA is then compared to the change

in the capital base. The study of the matrix indicates that if a wealth destroyer is bringing in more

capital it is worse, similarly the logic flows for other segments of wealth creators.

The framework would be an ideal tool to allocate capital in a socialist economy. If the entire

economic capital needs are consolidated and then segmented among different companies, this

framework would help in making decisions.


25/51



2.2 Examination of EVA as a performance measure

CCS.PGP P1-63

Shubra Pandit,IIM Bangalore

The EVA reflects the excess of returns over the opportunity cost of capital for the company. It is

an analysis of the historical performance using a measure that is considered to convey more

information than the traditional accounting measures. EVA competes with other measures in

predicting the true value of a firm and consequently it surrogates the stock price.

MULTIPLE GOALS TO THE COMMON INTEGRATED MEASURE EVA

EVA belongs to the class of metrics that attempt to measure an underlying concept called Residual

income, its based on the premise that in order for a firm to create wealth for its shareholders it

must earn more on its invested capital than the cost of that capital. whereas traditional accounting

net income measures profits net of interest expenses on debt capital, residual income measures

profits net of the full cost of debt and equity capital.

The idea behind EVA is that shareholder must earn a return that compensates the risk. In other

words equity capital has to earn at least same return as similarly risky investments at equity

markets. If that is not the case, then there is no real profit made and actually the company operates

at a loss from the viewpoint of shareholders.

EVATreasury

Management

Cost

Accounting

Human

Resource

Capital

Budgeting

Investors

Relations

Strategic

Planning

Valuation

Annual

Budgeting


26/51



If EVA is zero, this should be treated as a sufficient achievement because the shareholders have

earned a return that compensates the risk. This approach using average risk adjusted market return

as a minimum requirement is justified since the average return is easily obtained from diversified

long term investments on stock markets. Average long term stock market return reflects the

average return that the public companies generate from their operations.


27/51



2.3. The quest for value

Brian Carvalho

Business today, March 2001The EVA is a basis for effective decision making, corporate governance and employee motivation

framework. EVA is superior to traditional measures such as PAT, PBT and rates of return because

it replicates the discipline of the capital market within the firm by explicitly measuring returns

relative to the cost of capital.

EVA as measure states that growth without efficiency is bad and also that efficiency without

growth isnt really much better. Unless a company manages to increase its return on capital

employed, no amount of reduction in the cost of capital can widen the spread.

EVA = {NOPAT/ Capital Cost of capital}* capital

The Key strategies to increase Value are:

OPERATE: Improve the return earned on existing capital.

BUILD: Invest as long as returns exceed the cost of capital

HARVEST: Divest capital when returns fail to achieve the cost of capital.

OPTIMISE: Reduce cost of capital by optimizing capital structure.

The implementation of EVA is done in three phases.

1st

PHASES- Analyses businesses on EVA parameters like ROCE and MVA benchmark them

against peers understand shareholders expectations and work out historical EVAs as well as

projections for next three years.

2nd

PHASE- Train managers in methodologies to optimize EVA how to go about the task of

becoming efficient on the capital and operation fronts, and how to make the decisions to achieve

these efficiency with growth, be it through an investment, an acquisition or a divestiture.

3

rd

PHASE- The implementation of a variable compensation system for all employees. Incentives toteams will be worked out on the basis of how they manage to improve EVA on an incremental basis.


28/51



2.4 Five Forces of Wealth Creations

Force I: High RoE

RoE substantially higher than the cost of capital signifies that the company possesses some edge

over its competitors. Continuation of this competitive advantage imparts longevity to the Wealth

Creation Process.

Force II: High RoE coupled with Increasing Capital Employed

W hen ever the RoE is high, there will be wealth creation. But, size of the wealth created is

dependent on the amount of capital employed. High capital employed is a function of the size of

the opportunity. Businesses which can consume substantial amounts of capital at high incremental

returns only can create Big Wealth because profitable growth through increasing RoE is generally

difficult and limited.


29/51



Force III: Growth

High RoE starts the wealth creation process. Large capital deployment gives it size. But, most

investors are interested in SPEED. This comes from growth in free cash flow,

That is, C * (RoC G).

Growths in free cash flows can come by an increasing RoE or increasing the capital employed.

Generally, under normal circumstances one of the factors is increasing.

But, when a company finds itself in a situation when both the RoC as w ell as capital is growing,

the combination is exponential. This is what has happened in recent years in the Indian technology

stocks. This happens when:

a. Size of the opportunity is huge

b. Competitive advantage is wide and long

c. Managements are capable of seizing the opportunity

Force IV: Cost of Capital

The level of interest rates prevailing in the economy will determine the discount rate (cost of

capital) by which future free cash flows of the companies will be discounted to arrive at the present

value.

Higher the discount rate, lower will be the present value of future cash flows. Thus, the cost of

capital will be a key determinant of valuation of businesses.

Force V: Margin of Safety

Intrinsic value of a company is determined by the interplay of sum of free cash flows and cost of

capital. But, an investor will make money only if he buys at an attractive price. Eventually,

purchase price w ill determine the rate of return.

Never count on making a good sale. Have the purchase price be so attractive, that even a

mediocre sale gives an attractive return"

Warren Buffett

An investor has to understand what the price implied is in terms of free cash flow, growth andlongevity. To adjudge market expectations and a company's inherent capability to deliver free cash

flows in future, we have used our time-tested "Pay back ratio" barometer.


30/51



Chapter 3

METHODOLOGY


31/51



The study type is analytical as facts and existing information is used for the analysis based on

historical data for the period of 2000-2005 with the help of Quantitative toolsas EVA is calculated

and the variables are expressed in measurable terms.

3.1 Sample Profile

The sample undertaken for the research includes 100 companies of BSE100 Index of the Bombay

Stock Exchange (for which relevant data was available), for a period of 5 years starting from FY

2000-2001 to FY 2004-05.

The following are the sample 100 companies:

1) A B B Ltd.

2) Aditya Birla Nuvo Ltd.

3) Allahabad Bank

4) Andhra Bank

5) Arvind Mills Ltd.

6) Ashok Leyland Ltd.

7) Asian Paints Ltd.

8) Associated Cement Cos. Ltd

9) Bajaj Auto Ltd

10)Bank Of Baroda

11)Bank Of India

12)Bharat Electronics Ltd.

13)Bharat Forge Ltd.

14)Bharat Heavy Electricals Ltd

15)Bharat Petroleum Corpn. Ltd

16)Bharti Airtel Ltd.

17)Biocon Ltd.

18)Canara Bank

19)Century Textiles & Inds. Ltd.

20)Chennai Petroleum Corpn. Ltd.

21)Cipla Ltd.

22)Colgate-Palmolive (India) Ltd.


32/51



23)Cummins India Ltd.

24)Dr. Reddy'S Laboratories Ltd.

25)G A I L (India) Ltd.

26)Glaxosmithkline Pharmaceuticals Ltd.

27)Glenmark Pharmaceuticals Ltd.

28)Grasim Industries Ltd.

29)Great Eastern Shipping Co. Ltd.

30)Gujarat Ambuja Cements Ltd.

31)H C L Technologies Ltd.

32)H D F C Bank Ltd.

33)Hero Honda Motors Ltd.

34)Hindalco Industries Ltd

35)Hindustan Lever Ltd.

36)Hindustan Petroleum Corpn. Ltd.

37)Housing Development Finance Corpn. Ltd.

38)I C I C I Bank Ltd.

39)I T C Ltd.

40)I-Flex Solutions Ltd.

41)Indian Hotels Co. Ltd.

42)Indian Oil Corpn. Ltd.

43)Indian Overseas Bank

44)Indian Petrochemicals Corpn. Ltd

45)Industrial Development Bank Of India Ltd

46)Infosys Technologies Ltd.

47)J S W Steel Ltd.

48)Jaiprakash Associates Ltd.

49)Jindal Steel & Power Ltd.

50)Kochi Refineries Ltd.

51)Kotak Mahindra Bank Ltd.

52)Larsen & Toubro Ltd.

53)Lupin Ltd.


33/51



54)Mahanagar Telephone Nigam Ltd.

55)Mahindra & Mahindra Ltd.

56)Mangalore Refinery & Petrochemicals Ltd.

57)Maruti Udyog Ltd.

58)Matrix Laboratories Ltd.

59)Moser Baer India Ltd.

60)Motor Industries Co. Ltd.

61)N T P C Ltd.

62)National Aluminium Co. Ltd.

63)Nestle India Ltd.

64)Neyveli Lignite Corpn. Ltd.

65)Nicholas Piramal India Ltd.

66)Oil & Natural Gas Corpn. Ltd.

67)Oriental Bank Of Commerce

68)Patni Computer Systems Ltd.

69)Petronet L N G Ltd.

70)Pfizer Ltd.

71)Punjab National Bank

72)Ranbaxy Laboratories Ltd.

73)Raymond Ltd.

74)Reliance Capital Ltd.

75)Reliance Energy Ltd.

76)Reliance Industries Ltd.

77)Satyam Computer Services Ltd.

78)Sesa Goa Ltd.

79)Shipping Corpn. Of India Ltd.

80)Siemens Ltd.

81)State Bank Of India

82)Steel Authority of India Ltd.

83)Sterlite Industries (India) Ltd.

84)Sun Pharmaceutical Inds. Ltd.


34/51



85)Tata Chemicals Ltd.

86)Tata Consultancy Services Ltd.

87)Tata Motors Ltd.

88)Tata Power Co. Ltd.

89)Tata Steel Ltd.

90)Tata Tea Ltd.

91)Tata Teleservices (Maharashtra) Ltd.

92)U T I Bank Ltd.

93)Ultratech Cement Ltd.

94)Union Bank Of India

95)United Phosphorus Ltd.

96)Videsh Sanchar Nigam Ltd.

97)Vijaya Bank

98)Wipro Ltd.

99)Wockhardt Ltd.

100) Zee Telefilms Ltd.

3.2 Data gathering procedure and Instrumentation

Data typeThe data required for the research has been collected from secondary resources Prowess and the

database of Capital Market Publishers (India) Ltd., Capitaline 2000 Capitaline Database, historical

earnings and financial Information such as dividend and new equity issue of the sample companies for

the specified time period.

Valuation Parameters

The following parameters are used for valuing the companies:-

1. Net operating profit less adjusted taxes(NOPLAT)

2. Return on capital employed(ROCE)

3. Weighted average cost of capital (WACC)

4. Wealth Added Index

5. Economic Value Added


35/51



3.3 Research Calculations

The specified companies are evaluated for various performance metrics to analyze its impact on

wealth creation or wealth added.Wealth Added =

Change in Market Capitalization

LESS: Required return

ADD: Dividends

LESS New Equity Issues

Wealth Added measures the extent of capital appreciation in the market value of the equity of the

firm netted for new equity issuances plus the extent of cash return to shareowners in the form of

dividend of equity buybacks, less an opportunity cost charge equal to investors cost of equity

expectations.

WAI can help management being more disciplined in creating wealth to shareholders as suggested

by the Nobel Laureates Merton Miller and Franco Modigliani.

o Increase net operating profit after taxes through enhancing operating efficiency

o Rationalize capital expenditure by improving capital efficiency

o Ensure adequate rates of return on new investment by putting in place a world class capital

investment analysis framework

o Managing sources of fund toward optimal capital structure

o WAI is a practical way to measure the ultimate performances of management.


36/51



3.4 Data Analysis

The data considered for the research on wealth creation of the sample companies studies the

amount of wealth added on a year to year basis and its impact on the time period considered for the

research. The study also determines the real economic profit measured in terms of EVA which

benefits the company and its stakeholders in real terms. The research also states that the forces

which drive a company are performance, potential for growth and the position it holds in the

mindset of its shareholders and the market.


37/51



Chapter 4Research

Findings & Analysis


38/51



Table 4.1 The Largest Wealth Creators for 2000-2005

S.NO Company Name

Market

Cap

Required

Return Dividend

New Equity

Issue

WEALTH

ADDED

1Oil & Natural Gas Corpn.Ltd. 89759.61 7819.07 5703.74 10694.4975 76949.78

2 Indian Oil Corpn. Ltd. 39931.19 3306.77 1693.62 0 38318.04

3 Reliance Industries Ltd. 35515.43 5894.53 1045.13 0 30666.03

4 I C I C I Bank Ltd. 19915.07 607.82 626.21 334.9019604 19598.56

5

Steel Authority Of India

Ltd. 16704.44 531.27 1363.03 0 17536.20

6 Tata Motors Ltd. 13729.7 384.33 452.19 0 13797.56

7 Tata Steel Ltd. 12287.95 1139.62 719.51 0 11867.84

8

Bharat Heavy Electricals

Ltd. 11652.41 661.26 195.81 0 11186.96

9 Ranbaxy Laboratories Ltd. 12484.73 1939.48 316.17 0 10861.42

10 State Bank Of India 17523.86 8254.55 657.87 0 9927.18

Interpretation

The research study shows that Oil & Natural Gas Corporation Ltd which is better known as

ONGC has added maximum wealth for the specified time period and provided high returns to itsshareholders in terms of dividend.

Taking an overview of the arrived results, we observe that the major sectors creating wealth are

the industrial-oil & gas, transportation and financial services. The reason behind such behaviour is

that market values are forward looking and include an expectation premium, market prices over the

medium-term are driven more by differences in actual performance and expectations, by the

strength of the actual fundamental performance.

Exceeding the investors expectation alone does not enhance absolute wealth flows; it requires

outperforming expectations by converting currently embedded expectations into observable

profitability.


39/51



The companies should develop growth prospects that can create value and eventually deliver

returns above the cost of capital. This can be achieved by setting a target intrinsic value for the

business and explicit wealth flow goals on the intrinsic value, Use of alternate strategies for

maximizing wealth added and managing medium term performance and design equity linked

rewards.

Table 4.2 The Toppers in terms of Economic Value Added (2000-2005)

S.NoCompany Name EVA

1Oil & Natural Gas Corpn. Ltd. 9436.315

2

Steel Authority Of India Ltd. 6326.803

3I C I C I Bank Ltd. 5623.73

4Reliance Industries Ltd. 4571.595

5Tata Steel Ltd. 3172.197

6Bharti Airtel Ltd. 1401.365

7Tata Motors Ltd. 1325.009

8Indian Oil Corpn. Ltd. 1287.517

9Mangalore Refinery & Petrochemicals Ltd. 1148.371

10Infosys Technologies Ltd. 1093.932

Interpretation

The enterprise value of a firm is equal to the market value of the equity and the market value

of the debt or the present value of all future free cash flows. EVA analysis can be applied to

disaggregate a given enterprise value at any time to explicitly derive investor expectations for

future growth.

The analysis from the EVA outcome states that the investors should focus on cheaply priced

but fundamentally strong companies rather than harping over the irrationally priced stocks in the

market.


40/51



The EVA calculation facilitates the investors in realizing the difference between capital gain

and net earning in terms of returns; also it educates the investors to invest in relatively small

capitalization companies having high potential to create value for the shareholders on a consistent

basis.


S.NO Company Name

MarketCap

Required

Return Dividend

New

Equity

Issue

WEALTH

ADDED

1

Oil & Natural Gas Corpn.

Ltd. 1288.27 41454.10 400 0 39765.83

2 Indian Oil Corpn. Ltd. -350.01 14769.99 145 0 14975.00

3 Infosys Technologies Ltd. 5245.98 18708.15 230 0 13232.17

4 Reliance Industries Ltd. -766.89 11947.14 75 0 12639.03

5 Bharti Airtel Ltd. 3404.62 1412.18 0 0 1992.44

6

Glenmark Pharmaceuticals

Ltd. 554.74 234.22 35 0 355.52

7 Petronet L N G Ltd. 360.09 21.48 0 0 338.61

8 Jindal Steel & Power Ltd. 345.24 391.78 300 0 253.46

9 Sterlite Industries (India) Ltd. 681.85 503.47 60 0 238.38

10 Arvind Mills Ltd. 327.13 153.64 10 0 183.49

Interpretation

The Research study for wealth creation undertaken for the time period 2000-01 to 2004-05 has

been further been analysed to identify the consistent wealth creators. This has been done by

studying the changes in wealth creation from year to year basis, which also reflects the wealth

destroyers.


41/51



The Oil & Natural Gas corporation has a zenith positioned followed by Indian Oil corporation Ltd

and Infosys Technologies Ltd. The analysis reflects that ONGC has the top position also

maintaining an accountable margin with its successive wealth creator.

The top list for wealth creators is mainly formed by stocks of Petroleum, Power and heavy

industries.


S. No Company Name EVA

1 Oil & Natural Gas Corpn. Ltd. 4995.844

2 Steel Authority Of India Ltd. 4532.724

3 Reliance Industries Ltd. 1984.297

4 Tata Steel Ltd. 1836.282

5 Bharti Airtel Ltd. 1406.937

6 National Aluminium Co. Ltd. 558.537

7 Shipping Corpn. Of India Ltd. 530.46

8 Infosys Technologies Ltd. 528.087

9 Mangalore Refinery & Petrochemicals Ltd. 521.787

10 Indian Petrochemicals Corpn. Ltd. 391.391

Interpretation

The top companies in terms of Economic Value addition are ONGC, Steel Authority of India and

Reliance Industries Ltd. On the basis of EVA these companies can be termed as Consistent value

creators. Bharti Airtel Ltd and the National Aluminums Co. Ltd are a new entrant to the list of top

economic value added companies, where as Mangalore Refinery & Petrochemicals Ltd has moved

to a lower position from its last ranking.


42/51




S.NO Company Name

Market

Cap

Required

Return Dividend

New

Equity

Issue

WEALTH

ADDED

1 Bharti Airtel Ltd. 18870.27 470.9285524 0 18399.34

2 Reliance Industries Ltd. 21257.2 8401.0185 52.5 0 12908.68

3 Indian Oil Corpn. Ltd. 20344.1 8980.465448 210 0 11573.63

4


Ltd.38604.37 26777.49547 240 1069.44975 10997.42

5 I C I C I Bank Ltd. 9754.79 2342.919152 75 0 7486.87

6 Tata Motors Ltd. 7924.36 1450.491462 80 0 6553.87

7 Reliance Energy Ltd. 6741.97 395.089748 45 0 6391.88

8


Ltd. 6703.46 1310.100322 60 0 5453.36

9 Infosys Technologies Ltd. 14472.47 12112.17294 2590 0 4950.30

10


Ltd. 7111.25 2279.951149 0 0 4831.30

Interpretation

The research study for the financial period 2002-03 and 2003-04 has shown an interesting

highlight. Bharti Airtel Ltd had been positioned on the top most level, which the traditional players

of wealth creation making their presence in the wealth creation list. ICICI Bank is the only

financial entity which has made its presence in the top wealth creator list.


43/51




S. No Company Name EVA1 Steel Authority Of India Ltd. 1755.964

2 Tata Steel Ltd. 900.599

3 Reliance Industries Ltd. 824.138

4 Indian Oil Corpn. Ltd. 691.131

5 Mangalore Refinery & Petrochemicals Ltd. 554.862

6 Tata Motors Ltd. 481.285

7 Hindustan Petroleum Corpn. Ltd. 329.581

8 Shipping Corpn. Of India Ltd. 299.159

9 Bharat Heavy Electricals Ltd. 221.858


Interpretation

The financial years 2002-03 and 2003-04 compared for the evaluation of highest Economic Value

addition reflects Steel Authority Of India Ltd, Tata Steel Ltd and Reliance Industries Ltd as the top

three players in terms of economic value added.ICICI Bank which had been declared the top EVA

company of 2002-03 has shown complete absence in the top ten list this year.

The Gaining Company of the study is Mangalore Refinery & Petrochemicals Ltd. The company

has been a new entrant in the List of top EVA companies.


44/51




S. NO Company Name Market Cap

Required

Return Dividend

NewEquity

Issue

WEALTH

ADDED

1 Reliance Industries Ltd. 19187.62 5200.14 50 0 14037.48

2 Indian Oil Corpn. Ltd. 15930.68 4446.91 210 0 11693.77

3


Ltd. 26033.38 16880.13 300 0 9453.25

4


Ltd. 6905.73 696.61 160 0 6209.12

5 I C I C I Bank Ltd. 4849.19 1281.92 75 0 3642.27

6

Mangalore Refinery &

Petrochemicals Ltd. 3476.49 81.91 0 0 3394.58

7 Bharti Airtel Ltd. 3419.97 300.34 0 0 3119.63

8 Tata Motors Ltd. 3626.02 779.82 40 0 2886.20

9 Tata Steel Ltd. 3800.42 1215.64 80 0 2664.78

10


Ltd. 3343.18 721.30 40 0 2661.88

Interpretation

The wealth creation research study based on the time period 2001-02 and 2002-03 reflects that the

petroleum companies are the top wealth creators. They are reliance Industries Ltd, Indian Oil

Corporation Ltd and Oil & Natural gas Corporation Ltd.

The Bharti Airtel which has the top position in the last research study has moved to quite a lower

position. ICICI bank maintains a monopoly in the wealth creators list. The investors should

identify the wealth creating stocks and buy them on a lower intrinsic to gain profits.


45/51




S. No Company Name EVA (03-02)

1 I C I C I Bank Ltd. 5199.544



4 Steel Authority Of India Ltd. 837.27

5 Hindustan Petroleum Corpn. Ltd. 733.684

6 Neyveli Lignite Corpn. Ltd. 349.314


8 Ranbaxy Laboratories Ltd. 262.927

9 Indian Petrochemicals Corpn. Ltd. 203.091

10 National Aluminium Co. Ltd. 174.069

Interpretation

The Economic Value Addition has been a measure of efficiency. The competitive list for highest

EVA shows that ICICI Bank had topped the list, also stating that the bank is the only entity that

has marked a presence in the top ten list of economic value addition. The other players preceding

are the traditional players representing Power, Petroleum and Natural gas sector.

The commendable highlight of the EVA study shows that ICICI Bank which was on 4 th position in

the last evaluation had gained EVA to top the list.


46/51




S. NO Company Name

MarketCap

RequiredReturn Dividend

New

EquityIssue

WEALTHADDED

1


Ltd. 23833.59 7819.07 140 0 16154.52

2 I C I C I Bank Ltd. 3080.86 607.82 20 0 2493.04

3

Hindustan Petroleum

Corpn. Ltd. 3295.05 1395.11 100 0 1999.94

4 Neyveli Lignite Corpn. Ltd. 2169.01 323.26 13.5 0 1859.25

5 Tata Motors Ltd. 2138.25 384.33 0 0 1753.92

6

National Aluminium Co.

Ltd. 2364.29 867.46 40 0 1536.83

7 Bajaj Auto Ltd. 1798.12 521.07 140 0 1417.05

8 Ranbaxy Laboratories Ltd. 2915.99 1939.48 150 0 1126.51

9

Shipping Corpn. Of India

Ltd. 1118.28 175.38 35 0 977.90

10

Indian PetrochemicalsCorpn. Ltd. 1102.63 230.25 20 0 892.38

Interpretation

The research study indicates that Oil & Natural Gas Corporation has been positioned the top most

wealth creator for the time period Financial year 2000-01 and 2001-02.The successive to ONGC in

the list are the ICICI Bank which is the only financial entity in the list and Hindustan Petroleum

Corporation.


47/51




S. No Company Name EVA (02-01)1 Reliance Industries Ltd. 1592.738



4 I C I C I Bank Ltd. 612.409

5 Bharat Heavy Electricals Ltd. 317.842

6 Bajaj Auto Ltd. 294.609


8 Ranbaxy Laboratories Ltd. 180.726


10 Neyveli Lignite Corpn. Ltd. 126.413

Interpretation

The Comparison between the financial years 2000-01 and 2001-02 on the basis of EVA reflects

that the petroleum and natural industry had shown a remarkable addition in terms of Economic

Value Added. The top companies in the list are Reliance Industries Ltd, Indian Oil Corporation.

Ltd and Oil & Natural Gas Corporation which has shown an incredible value creation. These

stocks are positioned as hot cakes in the stock market. The only IT player making its presence in

the top Economic Value added list is Infosys Technologies Ltd.


48/51



Chapter 5

Conclusions&

Recommendations


49/51



Consistency in Wealth Creation

New leaders are created and several leaders of the yesteryears face demise

Yet, there are the resilient few that weather all storms and remain in the reckoning

The research provides a fundamental platform to investors to analyze the companies in terms of its

present position; earning capabilities and the growth potential unleashed which leads to value

addition and subsequently wealth creation.

The Investors in the market need identify companies that are strong and posses a future growth

potential. The selection of stocks in an individuals portfolio depends on each individual investors

investment objective and should be clearly defined at the beginning of the investment cycle.

Consistent wealth creators can help meet these investment objectives.

Investors often like to be associated with fast wealth creators; but its difficult to identify such

stocks in their early stages. In fact, several consistent wealth creators have been fast wealth

creators at some point of time such as ONGC, Reliance Industries.

Consistent wealth creators are known for their demonstrated earnings power over a long period of

time.

The first benefit of investing in consistent wealth creators is that the investors are looking at a very

small number of companies, at a given point of time. Secondly, these are established large

companies and leaders in their own fields. Safety of capital invested in them would be very high.

The EVA analysis draws attention towards economic profit and Market value added, but while

economic value added is a more scientific approach, it has been hyped too much. Not all corporate

actions may meet the EVA criteria but otherwise may be strategically right. EVA contributes to

wealth creation but high EVA may not lead to higher market value. EVA recognizes that in

capital-intensive industries returns cannot be expected in a short time. The initial EVA-negativeyears will be built into the EVA capital budgeting framework, as is the year in which the company

is scheduled to go EVA-positive. If company fails to achieve the desired level of performance as

forecasted in the capital approval process it will be an accounting issue.


50/51



Many have argued that EVA has its most appropriate use in asset rich companies and less useful in

companies with a large price to book ratio. (Value Enhancement Strategies: Damodaran) however,

this does not account for the successful EVA implementation in Coca Cola.

Studies reflect that the success of EVA is more dependent on whether the company is in a growth

or a more stagnant stage of its life cycle.

Critics claim that EVA is too short sighted a measure in order to capture value creation. By cutting

down on investments a company can boost its EVA; however this might not be the right move in

the long run. Stern Stewart argues that this is a mistaken notion; EVA does not penalize large

investments-as long as the new projects are able to earn more than their opportunity cost of capital.


51/51


Annexures

Websites:

www.motilaloswal.com

www.EVA.com

www.icfai.org

www.valuebasedmanagement.com

Journals:

Business Today- stem steward survey (April 2004)

Motilal Oswals 10th Wealth Creating Study

Brian Carvalho, Business today, March 2001

CCS.PGP P1-63, Shubra Pandit,IIM Bangalore

The Indian Rope TrickThe destruction of wealth (PPAF Services)
http://www.valuebasedmanagement.com/http://www.icfai.org/http://www.eva.com/http://www.motilaloswal.com/

Documents

EVA and Wealth Creation in the Indian Context