Open any equity research report by a leading broker or foreign institutional investor and the latest fad is to justify investment recommendations is through Economic Value Added (EVA) analysis. Simply put EVA is the excess of what the company earns over its cost of capital, meaning the cost of equity and debt.

EVA is conceptually attractive and intuitively appealing. The reasons are not far to seek. Traditional measures of corporate performance like the EPS, Return on Equity and Return on Assets are flawed in the sense that they use a standard barometer irrespective of the industry and the dynamics of the company. Since EVA considers the cost of capital it shows the extent to which shareholders are rewarded over and above their required rate of returns. For example, if Reliance and Tisco have the same net profits and the same equity base then they would rank at par as per the ROE measure. If Tisco is in a business that is more cyclical than Reliance then it is a more risky stock. ROE fails to capture this. But in the case of EVA, since risk is factored through the cost of capital, then the EVA of Reliance will be higher than Tisco thus showing that in risk adjusted terms Reliance is a better stock as compared to Tisco. Having said that EVA is more sophisticated than traditional measures like ROE and EPS, on needs to understand the shortcomings of EVA and the popular myths associated with this concept.

The first myth about EVA is that as a measure it is free from accounting bias. The fact is that the topline for EVA is the excess of the operating profit over the cost of capital. Operating profit being an accounting measure, this measure is obviously not free from accounting anomalies.

The second myth about EVA is that it is less cumbersome to calculate. Actually EVA calls for a host of accounting adjustments and financial assumptions for calculating cost of capital making it susceptible to manipulation. Also risk is a dynamic concept and keeps changing making EVA a highly volatile measure.

The third myth about EVA is that it can be applied across the board irrespective of the nature of the industry. The major shortcoming of EVA is that it still calculates the cost only of physical capital. Hence manufacturing companies with huge assets and a bloated capital structure tend to lower EVAs as compared to companies which are in service oriented sectors, since they are by nature less capital intensive.

The last and biggest myth about EVA is that market valuations are positively correlated to the EVA. Usually the causal link is misunderstood. High market valuations are the cause rather than the result of high EVA. This is because at high valuation levels the market liquidity and the consequent volatility is severely restrained. Hence the Beta tends to get understated and consequently the cost of capital also tends to be understated. As a result the EVA tends to be artificially high. Most investors usually misunderstand this cause-effect relationship.

The question then is why is EVA being touted as the most sophisticated tool by most investors. The answer once again is simple. It provides a scientific method to rationalize atrocious valuations. EVA is basically common sense in a pinstriped suit, packaged in a manner as to be hard to fathom but a powerful statement nevertheless.

 T S Harihar