Valuation : Question 11
What are the different ways and formulas for calculating EVA and MVA, and what are they useful for?
Economic Value Added (EVA) is an idea that has been around for a long time but was popularised by the firm Stern Stewart. It is an annual measure of the company's creation of value, established by comparing the cost of capital invested and the return on capital invested: EVA = Capital employed x (Return on capital employed - Cost of capital).
See chapter 19 of the Vernimmen for definitions of these terms.
EVA will always be high if:
1. Return on capital employed is high
2. The cost of financing the company's capital (equity and debt) is low
3. Growth of capital employed is high
Market Value Added (MVA) measures the creation of stock market value. It is calculated as the difference between market capitalisation + value of debt - capital employed (fixed assets plus working capital).
In efficient markets, MVA is equal to the sum of expected EVA over the coming years, discounted by the weighted average cost of capital.
To summarise, these measures have several advantages:
- MVA measures the creation of the company's stock market value.
- EVA is used by several large groups to calculated management bonuses, as it provides a snap-shot of results which factor in the specific features of the different activities. The interests of management are thus closely aligned with the interests of shareholders, which helps to reduce agency costs (see chapter 32 of the Vernimmen).
- Using EVA as a management control tool is relatively simple and easy to explain to employees.
There has however been some criticism of EVA such as: relying only on EVA can encourage some managers to reduce capital expenditure in the short term, which will have consequences on the company's value in the medium to long term.
For more information, see chapter 27 of the Vernimmen.
See chapter 19 of the Vernimmen for definitions of these terms.
EVA will always be high if:
1. Return on capital employed is high
2. The cost of financing the company's capital (equity and debt) is low
3. Growth of capital employed is high
Market Value Added (MVA) measures the creation of stock market value. It is calculated as the difference between market capitalisation + value of debt - capital employed (fixed assets plus working capital).
In efficient markets, MVA is equal to the sum of expected EVA over the coming years, discounted by the weighted average cost of capital.
To summarise, these measures have several advantages:
- MVA measures the creation of the company's stock market value.
- EVA is used by several large groups to calculated management bonuses, as it provides a snap-shot of results which factor in the specific features of the different activities. The interests of management are thus closely aligned with the interests of shareholders, which helps to reduce agency costs (see chapter 32 of the Vernimmen).
- Using EVA as a management control tool is relatively simple and easy to explain to employees.
There has however been some criticism of EVA such as: relying only on EVA can encourage some managers to reduce capital expenditure in the short term, which will have consequences on the company's value in the medium to long term.
For more information, see chapter 27 of the Vernimmen.