keymodels
Economic value added (Stern Stewart)
How can economic value added (stern stewart) support strategic choice or positioning?
Contents
When an investor backs your firm, he expects a return equivalent to your WACC. If the return is higher, it is because of economic profit or residual.
Investors expect a return that compensates them for time and risk. Economic Value Added, developed and branded by Stern Stewart & Co., is the residual income left after a company’s operating profit covers its weighted average cost of capital.
When to use it
- Use EVA when comparing economic performance across businesses with different risk and financing, or when setting a demanding objective above investors’ required return.
Origins
Economic profit and residual income are long-established ideas. Joel Stern and G. Bennett Stewart turned them into a defined consulting methodology, management measure and trademark. Their version links NOPAT, economic capital and WACC so that an apparently profitable business is charged for the opportunity cost of all funding.
What it is
A 12 per cent return on capital can be good or poor depending on:
The business and market risk borne by investors.
The company’s debt level and financing cost.
WACC combines the after-tax cost of long-term debt multiplied by debt’s share of capital with the required return on equity multiplied by equity’s share. The debt cost can be observed from borrowing rates. The equity cost is estimated because shareholders do not receive a contractual rate.
Under CAPM, the cost of equity equals a risk-free government-bond yield plus the market risk premium multiplied by beta. The market premium might be 6–7 per cent, while beta may range from about 0.5 in steadier sectors to 1.5 in more volatile ones. These are illustrative, not universal values; use current market inputs and a beta appropriate to the firm.
How to use it
Calculate NOPAT, economic capital and WACC consistently. EVA equals NOPAT minus the capital charge. EVA return—EVA divided by capital employed—can make comparison across different-sized firms easier.
A ranking based only on ROCE may place a leveraged company in a volatile sector above a more resilient peer. EVA tests each company against the return required for its own operating and financial risk; the same logic can compare a portfolio such as the FTSE 100. Positive EVA indicates performance above investor expectations; negative EVA indicates value destruction under the assumptions.
Economic value added
Value creation!
WACC
Value destruction!
Your ROCE
WACC
Your ROCE
Set an EVA target only after managers understand the drivers and the cost-of-capital estimate. A 5 per cent spread should translate into explicit margin, asset-use and capital-allocation choices rather than remain a finance slogan.
Top pitfall
Do not introduce EVA when its complexity outweighs the decision benefit. Document estimation uncertainty and avoid ranking businesses with incompatible accounting boundaries or WACC assumptions.
Further reading
- Stewart, G.B. (nineteen ninety-one). The Quest for Value: The EVA Management Guide. HarperBusiness.
- Stern, J.M., Shiely, J.S. and Ross, I. (two thousand and one). The EVA Challenge: Implementing Value-Added Change in an Organization. Wiley.