Pros and Cons of EVA:
The advantages and disadvantages of EVA are as listed below:
Pros (Advantages) of EVA:
EVA, economic profit and other residual income measures are clearly better than earnings or earnings growth for measuring performance. EVA is conceptually the same as the residual income measure long advocated by some accounting scholars (Source: R. Anthony, “Accounting for the Cost of Equity,” Harvard Business Review (1973), pp. 88-102 and “Equity Interest – Its Time Has Come,” Journal of Accountancy 154 (1982)) for its managers as well as value for shareholders. EVA may also highlight parts of the business that are not performing up to scratch. If a division is failing to earn a positive EVA, its management is likely to face some pointed questions about whether the division’s assets could be better employed elsewhere. EVA sends a message to managers: Invest if and only if the increase in earnings is enough to cover the cost of capital. For managers who are used to tracking earnings or growth in earnings, this is a relatively easy message to grasp. Therefore EVA can be used down deep in the organization as an incentive compensation system. It is a substitute for explicit monitoring by top management. Instead of telling plant and divisional managers not to waste capital and then for careful and thoughtful investment decisions. Of course, if the junior managers compensation is tied to their economic value added, then they must also be given the power over those decisions that effect EVA. Thus the use of EVA implies delegated decision making. EVA makes the cost of capital visible to operating managers. A plant manager can improve EVA by (a) increasing earnings or (b) reducing capital employed. Therefore underutilized assets tend to be flushed out and disposed of. Working capital may be reduced, or atleast not added too casually. Introduction of residual income measures often leads to surprising reductions in assets employed – not from one or two big capital disinvestment decisions, but from many small ones. EVA lets the business managers, realize that even assets have a cost and hence stock won’t be lying
idle. The firm will start using JIT and change the way they connect with their suppliers, and have them deliver raw materials more often.
Cons (Limitations) of EVA:
EVA does not involve forecasts of future cash flows and does not measure present value. Instead, EVA depends on the current level of earnings. It may, therefore, reward managers who take on projects with quick paybacks and penalize those who invest in projects with long gestation periods. Think of the difficulties in applying EVA to a pharmaceutical research program, where it typically takes 10 to 12 years to bring a new drug from discovery to final regulatory approval and the drug’s first revenues. That means 10 to 12 years of guaranteed losses, even if the managers in charge do everything right. Similar problems occur in startup ventures, where there may be heavy capital outlays but low or negative earnings in the first years of operation. This does not imply negative NPV, so long as operating earnings and cash flows are sufficiently high later on. But EVA would be negative in startup years, even if the project were on track to a strong positive NPV. The problem in these cases lies not so much in EVA as in the measurement of income. The pharmaceutical R&D program may be showing accounting losses, because the accounting principles require that outlays for R&D be written off as a current expense. But from an economic point of view, the outlays are an investment, not an expense. If a proposal for a
new business forecasts accounting losses during a startup period, but the proposal nevertheless shows positive NPV, then the startup losses are really an investment – cash outlays made to generate larger cash inflows when the new business hits its stride. In short, EVA and other measures of residual income depend on accurate measures of economic income and investment. Applying EVA effectively requires major changes in income statements and balance sheets.
Criticisms of EVA:
- 1. EVA could be misleading as a wealth metric because it reflects momentary swings in the capital markets rather than inherent company performance.
- 2. EVA is also shareholder-centric and hence of little relevance to the rest of the stake holders.
- 3. EVA is identical to residual income, which was largely abandoned by companyies years ago.
Significance of EVA:
The concept of Economic Value Added (EVA) that is gaining popularity globally was found by the Stern & Stewart Company. EVA can be used by corporate to measure the financial performance. Many companies globally seems to have destroyed shareholder’s wealth over a period of time and only a few have positively contributed to their wealth. With the help of Economic Value Added (EVA) which tells what the institution is doing with investor’s hard earned money and it also finds out whether companies have been able to create (or destroy) shareholders wealth. The overriding message is that corporate must always strive to maximize shareholders value without which their stocks (shares) can never be fancied by the market. The EVA analysis helps us to dig below the surface numbers to tell us more about the underlying business and whether there is another case for using EVA as one of the range of performance measurement tools. EVA is a mirror reflection of an organizations true performance. EVA is the invention of Stern Stewart & Co., a global consulting firm, which launched EVA in 1989. EVA is Economic Value Added, a measure of economic profit. EVA is the most misunderstood term among the practitioners of corporate finance. The proponents of EVA are presenting it as the wonder drug of the millennium in overcoming all corporate ills at one stroke and ultimately help in increasing the wealth of the shareholder, which is synonymous with the maximization of the firm value. EVA is nothing but a new version of the age-old residual income concept recognized by economists since the 1770’s. Both EVA and ‘residual income’ concepts are based on the principle that a firm creates wealth for its owners only if it generates surplus over the cost of the total invested capital. Perhaps EVA could bring back the lost focus on ‘economic surplus’ from the current emphasis on accounting profit.