Performance Evaluation part 2

Summary

This video explains the concept of Economic Value Added (EVA), a financial metric used to measure whether a company is creating value beyond its cost of capital. It covers how EVA is calculated using operating income after tax, accounting adjustments, and the cost of capital. Key advantages of EVA include its ability to provide a clear view of value creation and help manage working capital, while its disadvantages include being an absolute measure and complex to calculate. The video also links EVA to Net Present Value (NPV), showing how both tools aim to maximize shareholder value.

Takeaways

• 😀 Economic Value Added (EVA) is a financial metric that measures the return on capital employed, aiming to exceed the cost of capital invested.
• 😀 EVA compares the rate of return on invested capital with the opportunity cost of investing, helping businesses assess the value created by their capital.
• 😀 A positive EVA indicates value creation, while a negative EVA suggests value destruction, showing whether capital could be better allocated elsewhere.
• 😀 The main objective of EVA is to convert accounting profits into economic profits by adjusting for the true costs of financing activities.
• 😀 Adjustments to EVA include reversing accounting entries, accounting for economic substance, and replacing accounting depreciation with economic depreciation.
• 😀 Items that distort long-term profit, such as one-off transactions (e.g., asset sales), are adjusted out to ensure the calculation reflects sustainable performance.
• 😀 Non-cash entries, such as depreciation and amortization, are adjusted to reflect real cash flows as closely as possible.
• 😀 EVA provides a more accurate picture of managerial performance by considering the true cost of capital and excluding non-sustainable factors.
• 😀 A key advantage of EVA is its ability to remove accounting distortions, giving a more accurate measure of value creation and managerial effectiveness.
• 😀 A disadvantage of EVA is that it is an absolute measure, meaning it can't easily be compared across companies of different sizes or industries without adjusting for scale.
• 😀 EVA is closely related to Net Present Value (NPV), as both aim to maximize shareholder value by considering the long-term economic performance of investments.

Q & A

What is Economic Value Added (EVA)?

EVA is a financial metric used to measure the value a company generates from its capital investments. It compares the rate of return on invested capital to the cost of capital required to satisfy shareholders.

How does EVA link to a company's performance?

EVA measures a company's ability to create value for shareholders by determining if the return on capital exceeds the cost of that capital. A positive EVA indicates value creation, while a negative EVA suggests value destruction.

What is the formula for calculating EVA?

The formula for EVA is Operating Income After Tax (OIAT) plus or minus adjustments, multiplied by the difference between total assets and current liabilities.

Why is it important to adjust for accounting entries when calculating EVA?

Adjusting for accounting entries is crucial to ensure that EVA reflects real economic performance. Adjustments help eliminate distortions caused by accounting practices, such as depreciation, non-sustainable income items, and non-cash entries.

What types of items should be excluded or adjusted in EVA calculations?

Items that should be excluded or adjusted include non-sustainable gains or losses from asset sales, one-off items, non-cash expenses like depreciation, and accounting treatments that do not reflect true economic usage of assets.

What is the advantage of using EVA over traditional accounting measures?

EVA eliminates distortions from accounting practices, provides a more accurate reflection of a company's ability to generate real economic profit, and aligns performance with shareholder value creation.

What is the main disadvantage of EVA?

The main disadvantage of EVA is that it is an absolute measure, making it difficult to compare the performance of companies of different sizes or investment scales.

How does EVA help manage working capital?

EVA rewards companies that effectively manage their working capital, as it reflects how well capital is used to generate returns. This encourages better liquidity management and more efficient use of financial resources.

What is the relationship between EVA and Net Present Value (NPV)?

EVA and NPV are closely related in that both aim to maximize shareholder value. EVA provides a measure of value creation on an annual basis, while NPV evaluates the value of future cash flows from a project. The present value of EVA is equal to NPV when calculating long-term shareholder value.

What is Market Value Added (MVA) and how does it relate to EVA?

MVA is a long-term measure of value creation that indicates whether a company has increased or decreased its value for shareholders over time. Like EVA, positive MVA reflects effective capital use, while negative MVA suggests capital destruction.