06 December 2012

EVA - Another Way to Access Quality of Management

I attended a seminar conducted by CFA Singapore. The Speaker was Mr. Joel M. Stern from Stern Stewart & Co. The topic was "Fixing the Corporate Governance Crisis: Converting the Human Capital into Partners in the Creation of Value".

During his speech, he mentioned that it is important to calculate the economy profit of the company, compared to the accounting profit recorded in the book value. For example, different company has its own risk profile (e.g. Business Risk & Financial Risk etc), so it is crucial that we can estimate the economic profit the company generates compared to accounting profit.

Accounting Profit: The Net Profit recorded in the Book Value.

Economic Profit: The "Real Profit" the company can generate after take into account the cost of financing (e.g. Debt Loan Interest (1 - Tax%) & Equity). So it does not mean that the company can get real profit if it achieved net positive amount in accounting profit.

Economy Value Added (EVA): Free Cash Flow is crucial to a company to survive in long run. This is because the company cannot be forever borrow debt or raise new ordinary shares through private placement or other methods to fund their working capital and CAPEX requirements. The formula of EVA is (r - c) * K, where K = Economy Capital Employed or Total Assets - Current Liabilities, r = Return on Net Assets or Net Operating Profit After Tax / Economy Capital Employed, C = weighted Average Cost of Capital. So as long as r > c, the Economy Value Added is positive. Else, it could destroy the company future value.

So Mr. Stern mentioned that to improve EVA or company future value (that can be shown from company share price), he suggested to improve return on net assets (RONA) or optimize the weighted average cost of capital, and to reduce the number of inefficiency workers. If a company can treat its workers as partners, it can encourage all the workers to be a positive economic value contributors, and it can improve the value of the company later on.

In conclusion, EVA is not only a measurement by the management to give how many months bonus to the top performers, but it also a parameter to improve the company's real value in long run. As long as the r > c, then the company future value is greater than current value.

Source: http://en.wikipedia.org/wiki/Economic_Value_Added

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