FINANCIAL MANAGEMENT

Economic Value Added (EVA):

Creating a new bottom line

Prepared by

Try L. Muller

March 16, 2010

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Economic Value Added (EVA)

The Economic Value Added (EVA) is a financial performance measure based on

three financial components: 1) net operating income (NOPAT), 2) investment in assets,

and 3) the cost of capital (WACC). EVA is a dollar amount that will show whether or not

the company is generating wealth or simply consuming capital (Hock, 2009). The

formula for calculating EVA is as follows:

EVA = NOPAT – (Asset Investment x WACC).

If EVA is positive then the firm is earning more NOPAT than the cost of the assets

employed to generate income and is creating wealth. The opposite applies for a

negative EVA which would indicate that the firm is doing a poor job of generating

earnings from its assets.

Market Value Added (MVA)

Market value added (MVA) is a related measure that shows the difference

between the current market value of a firm and the capital contributed by its investors

(Hock, 2009). The higher the market value the better it is for the firm. A good MVA is

indicative of the capability of the firm to create wealth for its investors (Hock, 2009). A

negative MVA means that the value of management’s investments is less than the

capital the firm acquires from the market. However, unlike EVA, it does not take into

consideration WACC nor does it have significant implications for a firms intrinsic value.

MVA can be found by subtracting invested capital from the company’s market value.

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Small case study: CB Richard Ellis (CBRE)

We will use CB Richard Ellis (CBRE) as a small case study by which to analyze

EVA and the implications it has for a firm’s operations. CBRE is a commercial real

estate services firm that operates worldwide. The following equation will help determine

how CBRE is performing based on its EVA:

NOPAT = $241.84M – $26.99M = $214.85M

Investment Capital = $503.94B – $1.00B = $4.04B

WACC = ($32.6M + 1.19B)/4.04B = .30

EVA = $214.85M – ($4.03B * .30) = ($999.15M)

The fact that CBRE has a negative EVA means that it is not generating any wealth with

its capital and its capital resources are not being compensated adequately. A better

measure of EVA would be to look at how the EVA has changed over time to see if

management has improved its investment decisions. CBRE’s strategy to remain a

leader in the market through global expansion would make one believe that the firm’s

balance sheet is asset-heavy. So it needs to direct more energy to asset turnover and

make sure that investments will either be close to or exceed WACC. This means that

under utilized assets and underperforming assets need to eventually be removed from

the balance sheet. Subsequently, portfolios must be reassessed so that investments are

allocated in the most EVA-maximizing way.

Implications for today’s markets

EVA is a great tool to facilitate the relationship between management decisions

and doing what is best for the firm. Goal congruence is one of the major strengths

derived from EVA because it encourages wealth-maximizing decision making (Boehlje,

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2010). Furthermore, it is often tied into management compensation because it helps

eliminate the potential for managers to benefit from decisions made in self-interest. The

application of EVA would ultimately have the most impact on the firm through the role of

corporate governance. Corporate governance can approach wealth-maximization with a

more holistic understanding of how to actually achieve such goals. It can provide

corporate governance with a universal bottom line that can be used as a monitor for all

divisions of the firm (Boehllje, 2010). Board member will have better criteria from which

to make decisions and the organization can be structured in such a way that all

operations are geared towards the most efficient work system. Thus, firms will strive to

be more economically efficient in how they allocate capital resources (Boehlje, 2010).

The economy needs the markets to realign themselves to be economically

efficient. EVA can play a major role in this because it requires a holistic approach that

takes into both qualitative and quantitative factors. ROI has been the default metric for

measuring the relationship between firm performance and managerial decisions. The

problem with ROI is that it still entices managers to make decisions based on self-

interest instead of the long-term well-being of the firm. EVA focuses on fulfilling WACC,

being profitable, and is not a financial component that can render extraordinary results

in the short-term. These factors make it a vital measure in obtaining sustainable growth.

There is the potential to experience economic stability if EVA becomes the universal

market grading scale for creditors, firms, and investors.

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Stocker Researcher Pro. (2009). “What is the difference between EVA and

MVA?”. Retrieved from the Stock Researcher Pro databse.

http://www.stockresearchpro.com/the-definition-of-market-value-added-mva

Boehlje, M. (2009). “Economic Value Added”. Strategic Business Planning for

Commercial Producers. Purdue University.

Hock, C. A. (2009). “Economic Value Added (EVA): its uses and limitations”.

Retrieved from the SAM Advanced Management Journal database

http://www.allbusiness.com/management/276343-1.html

Stern, J.M. (2009). “Value Based Judgment: The Third Generation”.

Retrieved March 23, 2010 Stern Stewart & Co. website:

http://seminars.sternstewart.com/articles.asp