When buying shares, most people look at the company's profits. But life is not so simple. Despite being profitable, a company may actually be destroying shareholder wealth.
Let us look at an example to understand this paradox.
Vijay received Rs.10 lakhs from his father as capital to start a small stationery shop.
The business did quite well and achieved a sales turnover of Rs.5 lakhs in the first year itself. After deducting all the expenses aggregating Rs.4.25 lakhs, the net profit was Rs.75,000. Assuming a 30% tax, the profit after tax worked out to Rs.52,500. Vijay is happy at running a profitable venture.
But, Vijay’s father is not so happy. If, instead of giving money to his son, he had put this money in a fixed deposit @8.5% p.a. interest rate (and paid 30% tax on the interest income), they would have earned Rs.59,500.
Thus, Vijay has destroyed Rs.7000 of his father’s wealth by earning less that what he could have otherwise earned.
So if profit is not the true indicator of performance, what is? It is Economic Value Added or EVA.
EVA can be broadly understood as the difference between the actual profit and the investor’s minimum profit expectation. Accordingly, EVA in the above example is Rs.-7,000 (=Rs.52,500 – Rs.59,500).
As we can intuitively deduce, the EVA should be positive if the company has to add to the shareholder value. Negative EVA means shareholder’s wealth is destroyed.
The concept, therefore, is very simple and logical.
Before a person invests in a company, he does a comparative analysis of the returns he can earn from various options. He decides to invest in the company only because he expects to earn better returns than the other options. And this is the minimum that the company must generate, else the investor will be forced to move his capital elsewhere.
EVA also helps the management to take "right" decisions.
Logically speaking, higher the sales the better it is! And every sales manager would like to increase sales. Suppose he does so...but by giving higher credit period. This would mean that the company’s borrowing will go up and hence higher interest cost. If this interest cost is more than the profit that the company can earn thru’ higher sales, the company is actually losing by increasing sales.
Logically speaking, less the m/c downtime the better it is! Suppose the maintenance manager achieves this but in the process he has to keep extra spares. If this cost is more than say keeping the m/c shut for 1-2 days till he gets the necessary parts, it may be better to keep the m/c shut.
Thus, what may appear to be logically correct, need not always be true.
This is where EVA proves very useful. The management should calculate the impact of any decision on the EVA. If the EVA is improving, the solution is acceptable, else it is rejected. Therefore, now the management will not mindlessly increase the sales, if the net effect is reduction in profits. It may keep the m/c shut rather than keep high inventory of spares.
All this is commonsense. Yet in actual scenario decisions are not always taken rationally. Therefore, you will find many profitable companies with negative EVA.
A company that strives to improve the EVA and hence add to the shareholder’s wealth, is a better investing bet than the others. The potential for the share prices of such companies to outperform over time is much higher. It may, therefore, be worthwhile to also look at EVA besides the PE, EPS and other numbers which we usually analyze before investing in a stock.
Let us look at an example to understand this paradox.
Vijay received Rs.10 lakhs from his father as capital to start a small stationery shop.
The business did quite well and achieved a sales turnover of Rs.5 lakhs in the first year itself. After deducting all the expenses aggregating Rs.4.25 lakhs, the net profit was Rs.75,000. Assuming a 30% tax, the profit after tax worked out to Rs.52,500. Vijay is happy at running a profitable venture.
But, Vijay’s father is not so happy. If, instead of giving money to his son, he had put this money in a fixed deposit @8.5% p.a. interest rate (and paid 30% tax on the interest income), they would have earned Rs.59,500.
Thus, Vijay has destroyed Rs.7000 of his father’s wealth by earning less that what he could have otherwise earned.
So if profit is not the true indicator of performance, what is? It is Economic Value Added or EVA.
EVA can be broadly understood as the difference between the actual profit and the investor’s minimum profit expectation. Accordingly, EVA in the above example is Rs.-7,000 (=Rs.52,500 – Rs.59,500).
As we can intuitively deduce, the EVA should be positive if the company has to add to the shareholder value. Negative EVA means shareholder’s wealth is destroyed.
The concept, therefore, is very simple and logical.
Before a person invests in a company, he does a comparative analysis of the returns he can earn from various options. He decides to invest in the company only because he expects to earn better returns than the other options. And this is the minimum that the company must generate, else the investor will be forced to move his capital elsewhere.
EVA also helps the management to take "right" decisions.
Logically speaking, higher the sales the better it is! And every sales manager would like to increase sales. Suppose he does so...but by giving higher credit period. This would mean that the company’s borrowing will go up and hence higher interest cost. If this interest cost is more than the profit that the company can earn thru’ higher sales, the company is actually losing by increasing sales.
Logically speaking, less the m/c downtime the better it is! Suppose the maintenance manager achieves this but in the process he has to keep extra spares. If this cost is more than say keeping the m/c shut for 1-2 days till he gets the necessary parts, it may be better to keep the m/c shut.
Thus, what may appear to be logically correct, need not always be true.
This is where EVA proves very useful. The management should calculate the impact of any decision on the EVA. If the EVA is improving, the solution is acceptable, else it is rejected. Therefore, now the management will not mindlessly increase the sales, if the net effect is reduction in profits. It may keep the m/c shut rather than keep high inventory of spares.
All this is commonsense. Yet in actual scenario decisions are not always taken rationally. Therefore, you will find many profitable companies with negative EVA.
A company that strives to improve the EVA and hence add to the shareholder’s wealth, is a better investing bet than the others. The potential for the share prices of such companies to outperform over time is much higher. It may, therefore, be worthwhile to also look at EVA besides the PE, EPS and other numbers which we usually analyze before investing in a stock.