Enhancing Company Value – EVA

In the dynamic world of business, CEOs, CFOs, and entrepreneurs constantly face the challenge of increasing their company’s value. The key question is: How can you significantly boost your company’s valuation without extending your work hours or adding to your workload?

In this article, we will explore how decisions on financing impact your company’s valuation. Specifically, we will delve deeper into the concept of Economic Value Added (EVA) and its key components: Return on Invested Capital (ROIC) and Weighted Average Cost of Capital (WACC).

Key Take-aways

• Economic Value Added (EVA) serves as a profitability metric to measure the economic profit of a company or project. A positive EVA indicates that the company is creating value.
• Focusing on decreasing WACC can help enhance the company’s value.
• Projected EVA helps determine whether future projects or ventures will contribute to the company’s value creation.

Economic Value Added

Economic Value Added (EVA) is arguably one of the most comprehensive metrics for a company that aims to uphold the highest standards. It not only focuses on returns for equity and shareholders but also considers its contribution to the economic market and, at least in theory, the broader society that benefits from that market. This makes EVA an essential metric for CFOs to monitor and for investors to evaluate before committing capital.

One of the key principles of the free market is economic growth, measured through value creation. In theory, a highly profitable company provides goods and/or services to its economic market. When demand is sufficient, the company generates revenue. Another key principle is that with sufficient competition, the most efficiently operating companies achieve the highest success, as their efficiency determines how much of their revenue can be converted into profit.

The formula for EVA is:

Essentially, the formula dictates that we deduct the cost of capital from the return generated on that capital. The result is then applied to the numeric value of the initial capital invested. A positive EVA indicates that a company has created value after covering all costs, taxes, debts, interest and shareholder returns. Only then can a company be considered to have generated actual value for the economic market.

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Performance Evaluation: ROIC vs. WACC

Comparing Return on Invested Capital (ROIC) to the Weighted Average Cost of Capital (WACC) helps companies determine whether they are creating or destroying value. In essence, ROIC measures efficiency, while WACC serves as the benchmark for costs. If a company consistently achieves a ROIC higher than its WACC, it is considered to be operating efficiently and creating value for shareholders and market.

Calculating EVA for Value Creation

Once ROIC and WACC are calculated, companies use Economic Value Added (EVA) to quantify the value being created. EVA represents the excess profit after covering the company’s cost of capital (WACC). A positive EVA indicates that the company is generating real economic profit beyond what is required to compensate its debt and equity holders.

For example, if ROIC is 12% and WACC is 8%, the company is generating a 4% excess return on its capital. EVA helps express this value in monetary terms, showing whether the company is maximizing wealth.

*CFOrent-tip*: Do Not Count Taxes Twice!

The calculation of Return On Invested Capital (ROIC) is prone to errors. The definition NOPAT / (Average) Invested Capital requires to calculate after-tax operating income.

One way is to use reported earnings before tax and interest (EBIT) and adjust for tax liability.

$$\text{NOPAT} = \text{EBIT}*(1-\text{tax rate})$$

In this case, we assume to pay taxes on the measure of income. The error lies in using the actual taxes paid and deducting them from EBIT. This results in a higher after-tax income because actual taxes paid include tax reduction.

In turn, WACC will be deducted, which also incorporates the tax deduction with the factor R_D* (1- tax rate), as seen here. The resulting ROIC will thus be higher because tax deduction has been accounted for twice.

Another possibility is to start from net income and add interest expenses but deduct non-operating income. In this case, no explicit tax adjustment is made.

$$\text{NOPAT} = \text{Net Income} + \text{Interest Expenses} * (1- \text{tax rate}) – \text{Non-operating income} * (1 -\text{tax rate})$$

Capital Allocation and Investment Decisions

There is a strong argument for considering Economic Value Added (EVA) when evaluating new projects. Typically, project evaluations focus on Net Present Value (NPV) and Internal Rate of Return (IRR), both of which account for the time value of money.

While Return on Invested Capital is generally used to assess ongoing or completed investments, it can also be projected for future investments. If the projected ROIC exceeds the WACC, the project is expected to create value and increase EVA. Conversely, if the projected ROIC is lower than the WACC, the project may destroy value.

This approach helps companies allocate capital efficiently to projects and ventures that drive growth and enhance overall company EVA, complementing other project evaluation metrics.

Case In Point

Consider company A to be a tech-innovator and company B to be a manufacturer of industrial machines.

So how should we interpret these numbers? Company A has a positive EVA of twelve million, indicating it is effectively generating returns that exceed its cost of capital. This signifies strong value creation and efficient use of capital. Company B has a negative EVA of minus four million, indicating it is not generating sufficient returns to cover its cost of capital. This suggests value destruction and highlights inefficiencies in capital utilisation.

Both companies can take strategic actions to enhance their EVA. Below are tailored recommendations for each:

For company A, enhancing an already positive EVA.

While Company A is performing well, there’s always room for improvement to further boost EVA.

• Optimise Capital Structure:
  • Increase Low-Cost Debt: With a solid ROIC, Tech Innovators Inc. can consider taking on more debt to finance growth, as long as it doesn’t compromise financial stability. The tax-deductible nature of interest can lower WACC.
  • Buybacks or Dividends: Reducing equity through buybacks can decrease WACC, as equity is typically more expensive than debt.
• Invest in High-Return Projects:
  • Expand R&D Initiatives: Continue investing in innovative projects that promise ROIC well above the current WACC. This ensures sustained EVA growth.
  • Strategic Acquisitions: Acquire companies that complement existing operations and can generate high returns, further enhancing overall ROIC.
• Improve Operational Efficiency:
  • Processes: Implement lean management techniques to reduce operational costs, thereby increasing NOPAT (Net Operating Profit After Tax).
  • Enhance Asset Utilisation: Use existing assets more efficiently to generate higher returns without increasing capital employed.

By optimising the capital structure and continuing to invest in high-return projects, Company A can further increase its EVA, reinforcing its strong market position and enhancing shareholder value.

For Company B: Turning Negative EVA into Positive

Company B faces a challenge with a negative EVA, signaling the need for strategic interventions to create value.

• Reduce WACC:
  • Improve Credit Rating: Strengthen the balance sheet by paying down high-interest debt and managing liabilities effectively. A better credit rating can secure lower interest rates, reducing the cost of debt.
  • Enhance Financial Transparency: Provide clear and comprehensive financial reporting to build investor confidence, potentially lowering both debt and equity costs.
• Increase ROIC:
  • Boost Operational Efficiency: Identify and eliminate inefficiencies in production processes to increase profit margins. Implementing cost-saving measures can directly enhance ROIC.
  • Divest Underperforming Assets: Sell off non-core or underperforming assets to reduce capital employed, thereby increasing ROIC.
• Optimise Capital Allocation:
  • Focus on High-Return Projects: Shift investment towards projects with a ROIC significantly higher than the current WACC. This ensures new investments contribute positively to EVA.
  • Reinvest Profits Wisely: Instead of relying heavily on equity, consider financing growth through debt, provided it’s managed prudently to avoid excessive leverage.
• Enhance Revenue Streams:
  • Diversify Product Offerings: Introduce new products or services that can generate higher margins and contribute to increased NOPAT.
  • Expand Market Reach: Enter new markets or segments to boost sales and profitability without a proportional increase in capital employed.

While the provided solutions serve financial optimisation, other interventions such as enhancing transparency and improve the ESG-score, can benefit the WACC, and thus EVA.

By focusing on reducing WACC and increasing ROIC, Company B can transform its negative EVA into a positive figure. These strategic actions will not only reverse value destruction but also set the stage for sustainable growth and enhanced company valuation.

Conclusion

Economic Value Added and its individual components are essential tools for evaluating corporate financial health and guiding decision-making. Apart from focusing on operational revenues and costs, the best in class companies focus additionally on:

• Reducing costs of financing by prudently increasing low cost debt.
• Move forward with high returning investment projects.
• Divest underperforming assets.

In today’s competitive business environment, these approaches help companies outperforming their peers who do not and are more likely to succeed in creating sustainable, long-term value.

At CFOrent, we assist companies in calculating EVA, ROIC and WACC, carefully assessing which values should be included, by understanding the bigger picture of your business. Get in touch for a personalised chat.