Economic Value Added

Economic Value Added

Introduction

Economic value added (EVA) has been getting plenty of attention in recent years as a new form of performance measurement. In a recent Fortune article entitled "The Real Key to Creating Wealth," the author claims that using EVA can "give you a marked competitive advantage" over the competition (Tully, 1993). Furthermore, the author states that EVA is "today's hottest financial idea and getting hotter (Harcourt 1965 66-80)." An increasing number of companies are responding to this kind of hype by relying heavily upon EVA to evaluate and reward managers from all functional departments.

If a company is not able to generate enough economic profit over time, its survival is questionable. Moreover, companies making little or no profit are not very attractive for potential investors looking for returns. Management interested in investors' satisfaction has to manage cost and economic value while maintaining at least some minimum profitability level. There needs to be a move towards real improvement and value creation as opposed to clever manipulation of financial data for short- term performance gains.

The preceding discussion puts EVA in a positive light. However, we can certainly find much to criticize with EVA as well. We now focus on two well-known problems with EVA. First, the preceding example uses EVA for performance measurement, where we believe it properly belongs. To us, EVA seems a clear improvement over ROA and other financial ratios. However, EVA has little to offer for capital budgeting because EVA focuses only on current earnings. By contrast, net present value analysis uses projections of all future cash flows, where the cash flows will generally differ from year to year. Thus, as far as capital budgeting is concerned, NPV analysis has a richness that EVA does not have. Although supporters may argue that EVA correctly incorporates the weighted average cost of capi- tal, remember that the discount rate in NPV analysis is the same weighted average cost of capital. That is, both approaches take the cost of equity capital based on beta and combine it with the cost of debt to get an estimate of this weighted average. 

A second problem with EVA is that it may increase the shortsightedness of managers. Under EVA, a manager will be well rewarded today if earnings are high today. Future losses may not harm the manager because there is a good chance that she will be promoted or have left the firm by then. Thus, the manager has an incentive to run a division with more regard for short-term than long-term value (Tippett and Hoekstra 2003 37-42). By raising prices or cutting quality, the manager may increase current profits (and therefore current EVA). However, to the extent that customer satisfaction is reduced, future profits (and, therefore, future EVA) are likely to fall. But we should not be too harsh with EVA here because the same problem occurs with ROA. A manager who raises prices or cuts quality will increase current ROA at the expense of future ROA. The problem, then, is not EVA per se but with the use of accounting numbers in general. Because stockholders want the discounted present value of all cash flows to be maximized, managers with bonuses based on some ...