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Economic value added (EVA) and market value added (MVA): weighing some policy implications

What is economic value added (EVA)? What is Market Value Added (MVA)? How do companies choose their value creation strategies? Do higher cash flows automatically result in higher economic profit? How do firms that opt ​​for maximum economic value-add compare with firms that opt ​​for maximum market value-add? What informs 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 flow enhancement strategies: the right mix of cash inflows and outflows that maximizes net cash flows and thus therefore, return on investment and shareholder wealth while minimizing the cost of operations. simultaneously.

One of management’s strategic objectives is to maximize shareholder value, which is based on the company’s future cash flows. In addition, other management objectives include maximizing the company’s stock price; 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 can differ markedly, but they lie in a careful analysis of the financial statements that publicly traded companies are required to provide to investors and regulators.

There are divergent cash flow improvement objectives, and many factors influence effective cash flow improvement strategies. For those familiar with the relevant academic literature, the critical factors are well known and supported by contemporary research. The main objectives of effective cash flow improvement strategies and the core elements of effective cash flow improvement strategies are equally well established in the existing academic and professional literature. However, some industry observers and professionals continue to identify profit maximization as the primary goal of a business venture. As we have warned in previous reviews and guides, this focus on profit maximization is a bit myopic 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 clear differences between these two valuation strategies, and investors need to know 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 company’s economic success, or lack thereof, over a specific period of time, MVA is useful as a measure of wealth, assessing the level of value a company has accumulated over a period of time. time frame.

Some practical guidelines

As we explained in a previous review, cash flows provide critical information about company performance that cannot be discerned through net income analysis. Additionally, financial accounting students and professionals know that net income data is more susceptible to accounting methods, such as inventory and depreciation methods.

The financial statements often do not reflect the market values ​​of the companies, so they are not adequate for the purposes of evaluating the performance of managers. To fill this assessment gap, financial analysts developed two additional performance measures: Economic Market Added (EVA) and Market Value Added (MVA).

The Economic Value Added (EVA) is a performance measure that tries to measure the true economic benefit produced by a company. EVA is often called “economic profit” and provides a measure of a company’s economic success (or failure) over a period. Such a benchmark is useful for investors looking to determine how well a company has produced value for its investors, and can be compared to industry benchmarks – company peers for a quick analysis of how well the business is operating in your industry.

Economic profit can be calculated by taking a company’s after-tax net 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 of the wealth that the company generated above its cost of capital during the year.

In practice, the profitability of a company can be evaluated by calculating the EVA, since it focuses on the profitability of a company’s project and, therefore, on the efficiency of the company’s management. Economic Value Added (EVA) weights the opportunity cost of alternative investments, while Market Value Added (MVA) does not. EVA as an estimate of a company’s true economic profit often differs greatly from accounting net income because it considers the cost of debt and equity, while accounting income only considers the cost of debt capital.

Market Value Added (MVA), on the other hand, is simply the difference between a company’s current total market value and the capital contributed by investors (including shareholders and bondholders). It is used for companies that are larger and publicly traded. MVA is not a performance benchmark like EVA, but rather a wealth benchmark, which measures the level of value a company has accumulated over time.

As a company performs well over time, it will retain earnings. This will improve the book value of the company’s shares, and investors are likely to raise the prices of those shares in anticipation of future earnings, thus increasing the market value of the company. When this occurs, the difference between the company’s market value and the capital contributed by investors (its MVA) represents the excess or overcharge price that the market assigns to the company as a result of its past operating successes or failures, respectively. .

In summary, unlike EVA, MVA is a simple metric of a company’s operating capacity and as such does not incorporate the opportunity cost of alternative investments. Positive trending EVA will also help ensure positive trending MVA. Additionally, while MVA applies to the entire company, EVA can be determined for both business units and the entire company, making it useful as a guide to reasonable compensation for corporate and unit managers.

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