What is economic value- added (EVA)? What is market value-added (MVA)? How do firms choose their value creation strategies? Do higher cash flows automatically result in higher economic profit? How do firms that opt for maximum economic value-added compare to firms that opt for maximum market value-added? What informs a reasonable compensation for managers based on performance metrics? These strategic policy questions relate to the profit producing capacity of a business enterprise and optimal cash flows enhancement strategies-the appropriate mix of cash inflows and outflows that maximizes net cashflows and thus the return on investment and shareholders’ wealth while minimizing the cost of operations, simultaneously.
One of the management’s strategic goals is to maximize shareholder value, which is based on the firm’s future cash flows. Further, other management’s goals include maximizing the price of the firm’s stock; and the value of any asset based on the cash flows the asset is expected to produce. Therefore, management strives to maximize the cash flows available to investors. But how does management decide which business actions are most likely to increase those cash flows, and how do investors estimate future cash flows? The answers to these questions may differ markedly but lie in careful analysis of financial statements that publicly traded companies must provide to investors and regulators.
There are divergent cashflows enhancement objectives, and many factors influence effective cashflows enhancement strategies. For those familiar with the relevant academic literature, the critical factors are well-known and supported by contemporary research. The primary goals of effective cashflows enhancement strategies and core elements of effective cashflows enhancement strategies are equally well established in the extant academic and professional literature. However, some industry watchers and practitioners continue to identify profit maximization as the primary goal of a business enterprise. As we have advised in previous review and guidance, this focus on profit maximization is a bit short-sighted and misguided.
The most common metrics used to determine a company’s value include Economic Value Added (EVA) and Market Value Added (MVA). In practice, there are distinct differences between these two valuation strategies, and investors need to be aware of how to use each. Economic Value-Added (EVA) and Market Value-Added (MVA) are common ways an investor can assess a company’s value. While EVA is useful as a way to assess a firm’s economic success, or lack thereof, over a specific period of time, MVA is useful as a wealth measure, assessing the level of value that a firm has built up over a period of time.
Some Practical Guidance
As we have already explained in previous review, cashflows provide critical insights about firm’s performance not discernable through analysis of net income. Further, financial accounting students and practitioners know net income data are more susceptible to accounting methods such inventory and depreciation methods.
The accounting statements often do not reflect market values of firms, so they are not adequate for the purposes of evaluating managers’ performance. To fill this assessment gap, financial analysts developed two additional performance measures: Economic Market Added (EVA) and Market Value Added (MVA).
Economic Value Added (EVA) is a performance measure that attempts to measure the true economic profit produced by a firm. EVA is often referred to as “economic profit,” and provides a measurement of a firm’s economic success (or failure) over a period. Such a benchmark is useful for investors seeking to determine how well a firm has produced value for its investors, and it can be compared against the industry benchmarks-firm’s peers for a quick analysis of how well the firm is operating in its industry.
Economic profit can be calculated by taking a firm’s net after-tax operating profit and subtracting from it the product of the company’s invested capital multiplied by its percentage cost of capital. EVA provides a standardized measure for the wealth the firm generated over and above its cost of capital during the year.
In practice, a firm’s profitability can be evaluated by calculating EVA, as its focus is on a firm’s project’s profitability and thus the efficiency of firm management. Economic value added (EVA) weighs the opportunity cost of alternative investments, while market value added (MVA) does not. EVA as an estimate of a firm’s true economic profit often differs sharply from accounting net income because it considers the cost of both debt and equity capital while accounting income only considers cost of debt capital.
Market Value Added (MVA), on the other hand, is simply the difference between the current total market value of a firm and the capital contributed by investors (including both shareholders and bondholders). It is used for firms that are larger and publicly traded. MVA is not a performance benchmark like EVA but instead is a wealth benchmark, measuring the level of value a firm has accumulated over time.
As a firm performs well over time, it will retain earnings. This will improve the book value of the firm’s shares, and investors will likely bid up to the prices of those shares in expectation of future earnings, causing the firm’s market value to rise. As this occurs, the difference between the firm’s market value and the capital contributed by investors (its MVA) represents the excess or surcharge price tag the market assigns to the firm as a result of its past operating successes or failures, respectively.
In sum, unlike EVA, MVA is a simple metric of the operational capability of a firm and, as such, does not incorporate the opportunity cost of alternative investments. Positively trending EVA will help ensure a positively trending MVA as well. Further, while MVA applies to the entire firm, EVA can be determined for business units as well as for the entire firm, therefore it is useful as a guide to reasonable compensation for unit and corporate managers.
