Shareholders Wealth Creation through Economic Value Added (EVA):

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Background:
Maximizing shareholder’s wealth has become the new corporate paradigm. Maximizing the shareholders wealth means maximizing the net worth of the company for its shareholders. This is reflected in the market price of the shares held by them. Therefore wealth maximization means creation of maximum value for company’s shareholders which mean maximizing the market price of the shares. Shareholders value maximization, which is the heart of economic output and prosperity through productivity gains, employment growth and higher wages. Management’s most important mission is to dependent on management’s performance. In order to measure the performance of company’s management; accountant, finance managers, investors, analysis and other users use several tools.
In the past decade sea changes has been made in the performance and measurement criteria of corporate entities, from the traditional profit based measures like, Earning Per Share (EPS), Return On Capital Employed (ROCE), Return On Net Worth (RONW), Net Operational Profit After Tax (NOPAT) and Earning Before Interest and Tax (EBIT), to the new ‘trendier’ value based performance measures, like Market Value Added (MVA), Shareholder Value Added (EVA). Shareholders need some tools, which would enable them to assess and forecast the performance of company’s management. Shareholders expect to achieve the required return from their investments. In order to measure the performance of company’s management, various users use several tools. Major problem of the shareholders is to understand that among various tools available in order to measure the performance of company’s wealth creation. Among the modern tools, Economic Value Added (EVA) has received attention and recognition in accounting and financial areas as a vital tool to measure corporate performance. Economic Value Added (EVA) concept is a correct criterion in performance management, because it includes all the cost of capital employed.

Introduction:
Maximizing shareholder’s wealth has become the new corporate paradigm. Managers and researchers have traditionally recognized shareholders wealth maximization as the ultimate corporate goal. The owners of the company i.e. the shareholders are more interested in maximizing their wealth. Maximizing the shareholders wealth means maximizing the net worth of the company for its shareholders. This is reflected in the market price of the shares held by them. Therefore wealth maximization means creation of maximum value for company’s shareholders which mean maximizing the market price of the shares. Shareholders value maximization, which is the heart of economic growth, as a long term proposition that delivers higher economic output and prosperity through productivity gains, employment growth and higher wages. Management’s most important mission is to maximize shareholders wealth. Therefore wealth creation is dependent on management’s performance. In order to measure the performance of company’s management; accountants, finance managers, investors, analysis and other users use several tools.
In recent years it is believed that, measuring shareholders wealth on the basis of Economic Value Added concept is more meaningful than traditional concept. Economic Value Added being the modern parameter for measuring shareholders wealth is termed better than traditional parameters of shareholders wealth creation, viz. Earning Per Share and Share Price in stock exchange/ market.
 
Measures and Indications:
Companies are using various measures and indicators for measuring the financial performance. These indicators help in identifying the performance and its strengths and weaknesses and suggesting improvement in its future course of actions. It is thus very important for business concerns to analyse its financial performance at the end of each financial year, to know the trend and progress over the period of time along with its extent and change in it. In order to analyse the performance of the selected and companies, the following measures and indicators has to be considered as the basis:
 
Parameters for measurement:
In the past decade sea changes has been made in the performance and measurement criteria of corporate entities, from the traditional profit based measures like, Earning Per Share (EPS), Return On Capital Employed (ROCE), Return On Net Worth (RONW), Net Operational Profit After Tax (NOPAT) and Earning Before Interest and Tax (EBIT), to the new ‘trendier’ value based performance measures, like Market Value Added (MVA), Shareholder Value Added (SVA), Cash Value Added (CVA), and Economic Value Added (EVA). It would be very useful to measure and compare the shareholders wealth created by company on the basis of traditional and modern measurement criteria for the purpose of best corporate governance and improving credit worthiness. It is important to measure the shareholders wealth on the basis of traditional and modern methods and compare them to know relative importance of measurement.

Parameter – I: Return On Net Worth (RONW)
 Formulae:
Return On Net Worth (RONW) =  Profit After Tax × 100
Net Worth
Rationale: The profits earned by the firm have to be related to Net Worth, which is the actual shareholders investment made in the business.

Utility:

a.      It measures productivity of shareholders funds.
b.      Higher ratio signifies better utilization of shareholders funds or higher productivity of shareholders funds or higher productivity of owner’s funds.
c.       It indicates to an investor in shares of a company that whether continued investment is worthwhile or not.
d.      It enables investors to compare the earning capacity of the company with that of other companies.
Applicability: It is used to calculate the returns available on Net Worth in terms of percentage.

Parameter – II: Return On Capital Employed (ROCE)
Formulae:
Return On Capital Employed (ROCE) = Profit Before Interest and Tax × 100
Debt + Equity
 
Rationale: The earnings before interest and tax earned by the firm has to be related to the total Capital Employed in the business.
 
Utility:
i.              It is also termed as Return on Investment (ROI).
ii.            It indicates earning capacity of business.
iii.          It measures overall performance of a company vis-à-vis utilization for management of total resources or funds available with the company.
iv.          Higher ratio indicates better utilization of funds.
v.            It gives idea as to overall efficiency of company’s working.
vi.          It also indicates extent of utilization of total available funds by the management.
vii.        It measures management’s performance.
viii.      The ratio is used for comparison of similar ratio of other company to make choice of company for investment decision.
 
Parameter – III: Earning Per Share (EPS)
 
Formulae:
Earning Per Share (EPS) = Profit After Tax – Performance Dividend × 100
Number of Shares Outstanding
 
Rationale: The total annual profits earned by the firm has to be divided by the total number of equity shares outstanding in order to determine profit per equity share.
 
Utility:
a.      The ratio indicates whether over a given period there has been change in the wealth per (each) shareholder.
b.      Higher ratio increases the possibility for higher dividends and increase in the market price of the share due to increase in the intrinsic value of the share.
c.       The ratio calculated for 5 to 6 years showing the trend line for a given company indicates that whether the future of the company is bright or not.
 
Applicability: It is used to calculate annual profits earned by the firm per equity share in absolute terms (rupees).
 
Caution Points:
Care should be taken to exclude earnings from unusual or casual events like heavy profit on sale of assets/ property. In such cases TWO EPS should be computed; One for the earnings from Normal Operations and Second for the earnings from extra-ordinary events to eliminate the distorting effects of abnormal events.

Parameter – IV: Economic Value Added (EVA)
Formulae:
Economic Value Added (EVA) = NOPAT – COCE
Where,
NOPAT = Net Operating Profit After Taxes
COCE = Cost of Capital Employed
Rationale: The returns earned have to be related to the Cost of Capital Employed while taking investment decisions by the firm.
 Utility:
a.      The ratio indicates whether over a given period there has been an excess of earnings over the Cost of Capital Employed.
b.      Higher ratio increases the possibility for higher dividends and increase in the market price of the share due to increase in the intrinsic value of the share.
c.       The ratio calculated for 5 to 6 years showing the trend line for a given company indicates that whether the future of the company is bright or not.
Applicability: It is used to calculate excess of the annual Net Operating Profit After Taxes over the annual Cost of Capital Employed by the firm in absolute terms (rupees). The concept of Economic Value Added (EVA) has revolutionized the ways in which companies are evaluated.
To make the data comparable absolute EVA figures are converted into relative figures by applying the following formula:

Formulae:
EVACE = EVA × 100
CE
Where,
EVACE = Economic Value Added as a % of Capital Employed.
EVA = Economic Value Added.
CE = Capital Employed (Debt + Equity).
There exists a significant relationship between:
  i.      Economic Value Added and Earning Per Share, and
ii.      Economic Value Added and Market Price of share in stock exchange/markets.
There exists a relationship between two traditional parameters of shareholders wealth creation, viz. Earning Per Share and Share Price in stock exchange/ market and the modern parameter ‘Economic Value Added’.
Shareholders wealth creation is the ultimate objective of corporate financial management and problem of the shareholders is to understand that among the various tools available in order to measure the performance of company’s management, which tool has more relationship with shareholders wealth creation. There is a need to assess the extent of and change in shareholders wealth creation. Has there any change in the shareholders wealth creation and the extent of change in it, if any. Shareholders need some tools, which would enable them to assess and forecast the performance of company’s management. Shareholders expect to achieve the required return from their investments. In order to measure the performance of company’s management, various users use several tools available in order to measure the performance of company’s management, which tool has more relationship with shareholders wealth creation. Among the modern tools, Economic Value Added (EVA) has received attention and recognition in accounting and financial literature as a vital tool to measure corporate performance. Investors, who want to buy stocks, need to know the relationship between returns on their investments and financial information. They have to know measurement tools that help them to buy the stock with higher return; and Economic Value Added (EVA) concept is a correct criterion in performance management, because it includes all the cost of capital employed. There is also a need to study and examine the relationship between Economic Value Added with two parts of shareholders wealth, viz. Earning Per Share and Share Price in stock exchange/ market. There is a need to understand the relationship between two traditional parameters of shareholders wealth creation, viz. Earning Per Share and Share Price in stock exchange/ market and the modern parameter ‘Economic Value Added’ and finally to compare the performance of the companies applying traditional parameters such as Earning Per Share and Share Price in stock exchange/ market with that of ‘Economic Value Added’ and assessing and evaluating that whether there is any significant change in the performance of the companies applying traditional parameters such as Earning Per Share and Share Price in stock exchange/ market with that of Economic Value Added. It is believed that, the companies are expected to generate higher wealth for their shareholders over a period of time since generation of higher wealth for their shareholders over a period of time since generation of higher wealth year after year for their shareholders is the ultimate goal of
corporate financial management. In recent years it is believed that, measuring shareholders wealth on the basis of Economic Value Added concept is more meaningful than traditional concept. Economic Value Added being the modern parameter for measuring shareholders wealth is termed better than traditional parameters of shareholders wealth creation viz. Earning Per Share and Share Price in stock exchange market.

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0 Comments
  1. exooo 3 months ago

    Shareholders Wealth Creation through Economic Value Added (EVA) are just
    great and very helpful.
    I found a video that help me a lot and i share it with you:
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