EVA: Lessons from the best

It is a linear mathematical relationship: to ensure that both its MVA and EVA increase, a company has to invest in growth, keep the cost of capital down, and squeeze optimal returns from its investments. This is what the company that topped both the EVA and the MVA rankings, HLL, did. Although the company's capital mushroomed by 33 per cent from Rs 2,043.15 crore in 1997-98 to Rs 2,716.83 crore in 1998-99, its ROCE increased marginally from 29.02 per cent in 1997-98 to 30.65 per cent in 1998-99-attributable, largely, to a 40 per cent increase in HLL's Net Operating Profits, from Rs 592.94 crore in 1997-98 to Rs 832.69 crore in 1998-99-and its cost of capital declined from 20.27 per cent in 1997-98 to 19.95 per cent in 1998-99.

Cutting through the clutter of numbers, what this means is that HLL managed to increase its returns on a larger capital-base even while lowering its cost. The result? The company's EVA increased by 62.50 per cent from Rs 178.86 crore in 1997-98 to Rs 290.64 crore in 1998-99; its MVA, by 52.60 per cent from Rs 29,714 crore to Rs 45,344.60 crore; and its average market-cap from Rs 26,636.24 crore to Rs 34,210.15 crore. Evidently, the markets reward a focus on EVA variables.

Indeed, this line of reasoning also serves to explain why Castrol is the company with the second-highest EVA in the BT - Stern Stewart value listing, ahead of companies like Punjab Tractors, NIIT, and SmithKline Beecham. Between 1997-98 and 1998-99, Castrol's sales revenues grew by a measly 8 per cent from Rs 1,011.06 crore to Rs 1,089.43 crore, and its Net Operating Profits by only a slightly better 12 per cent, from Rs 160.11 crore to Rs 179.90 crore. Neither was a performance that could boost the company's EVA. However, Castrol managed to increase its already-high ROCE from 38.74 to 40.18 per cent in the same period, and lower its cost of capital from 23.43 to 21.24 per cent. Explains Devina Mehra, 35, Director (Research), First Global Finance: ''Castrol has built a great brand out of a commodity. This enables it to command a brand premium from even fleet operators. That has helped the company earn a higher return on its capital.'' But, although Castrol's capital grew by a mere 8 per cent between 1997-98 and 1998-99, limiting capital-growth isn't part of the EVA-recipe.

Thus, in the period between 1997-98 and 1998-99, the capital employed by Hero Honda Motors (EVA Rank: 6) grew by 39 per cent; Punjab Tractors (EVA Rank: 3) by 37 per cent; and Smithkline Beecham Consumer Healthcare (EVA Rank: 5) by 33 per cent. Hero Honda had no option but to pump more capital into its business to counter the threat of competition: the only way 2-wheeler manufacturers can conform to the Euro norms that come into effect from April 1, 2000, is by manufacturing 4-stroke motorcycles, until not-too long back the domain of companies like Hero Honda and Bajaj. Not surprisingly, Hero Honda's capital employed grew from Rs 304.41 crore in 1997-98 to Rs 423.99 crore in 1998-99.

But the company managed to offset the impact of this by delivering even better returns: its sales increased by 34 per cent in the same period; Net Operating Profits by 54 per cent, and its ROCE rose from 26.91 to 29.79 per cent. And, despite the substantial growth in its capital employed, Hero Honda Motors' cost of capital increased only marginally, from 21.44 per cent in 1997-98 to 21.94 per cent in 1998-99. The result: the company's EVA and MVA doubled in that period.

Companies can use these examples of how their counterparts managed to improve their EVAs without sacrificing growth to derive a thumb-rule: the right time, or context, for a firm to make a capital investment that is mandatory for its future success is either when the returns from this investment are immediate, or when the returns from its other investments-made earlier-can be increased so as to ensure that the magnitude of the difference between the company's ROCE and cost of capital remains at least the same as it was the previous year.

Rare, indeed, is the investment that generates immediate returns. The typical company, then, tries to offset the increase in its capital in 2 ways: in a buyer's market, by launching a marketing thrust that results in an increase in its sales, Net Operating Profits, and ROCE; and, in a seller's market, by increasing the capacity-utilisation of its manufacturing facilities.

Explains Shantanu Rudra, 42, General Manager (Finance), NIIT, the first Indian company to implement EVA across its functions: ''EVA brings about a discipline that ensures that, instead of looking at top-line growth, each employee of the company seeks to justify the investment by proving that its potential to generate incremental NOPAT is higher than the cost of capital at all times.'' And by knowing when to invest, and how much, such companies get the most out of their potential-investments.

Sectorals: Beyond EVA

A sectoral analysis of the 27 sectors that companies in the BT-500 listing belong to throws up dismal results: not one sector boasts of a positive EVA. The writing between the lines: none of the sectors has strong fundamentals. The worst offender was the steel sector (represented by 28 companies in the BT-500) which reported an aggregate EVA of -Rs 6,769.14 crore. The petrochemical sector (26 companies), and an aggregate EVA of -Rs 4,575.62 crore; and the auto sector (55 companies), and an aggregate EVA of -Rs 3,919.23 crore were not far behind.

That isn't totally surprising: the steel, petrochemical, and automobile sector are among the most capital-intensive in India Inc.. In 1998-99, the aggregate capital employed by the steel sector was Rs 43,089.97 crore; by the petrochemical sector, Rs 42,219 crore; and the auto sector, Rs 35,699.38 crore. Employing vast amounts of capital isn't a crime; but delivering poor returns on this capital is. The aggregate ROCE of the steel sector in 1998-99 was 5.62 per cent; the petrochemical sector, 7.37 per cent, and the automobile sector, 10 per cent.

Says Ashwani Puri, 45, Managing Partner (Financial Advisory Services), PricewaterhouseCoopers: ''Companies operating in capital-intensive industries have to ensure that every rupee of capital they use generates at least enough returns to cover the cost of capital.'' Companies that lose sight of this axiom end up being obsessed with growth for growth's sake; not sustainable growth.

But if the 27 sectors came with weak fundamentals, they also came with high investor expectations. Sixteen of the 27 sectors boasted a positive MVA and, together, the 500 companies had a MVA of Rs 171,655 crore. This, though, can be attributed to investor-perceptions about the future-performance of companies in certain sectors. In mature markets, intra-industry analysis indicates that there is at least a 0.60 or 0.70 correlation between EVA and MVA. This is not the case in India. For instance, in the infotech sector, the correlation between MVA and EVA is an insignificant 0.03, which is no correlation at all. And the pharmaceutical sector exhibits a correlation even closer to zero.

What could explain this comprehensive lack of correlation between EVA and MVA when theory indicates that there should be a high level of correlation? The most obvious reason is the growth-potential of sectors like infotech and pharmaceuticals. In India, both are sunrise sectors. Typically, companies operating in these industries invest huge amounts of capital which cascade not into immediate returns, but into long-term returns that start kicking in 3 or 4 years later. EVA does account for such investments by capitalising expense-heads such as R&D expenditure, but being a point-of-time measure, it does not account for future returns. MVA does, although markets do have a proclivity to exaggerate the value of a company.

Indeed, this theory is borne out by an analysis of the correlation between EVA and MVA in mature industries like steel. In the case of the steel sector, there is a 0.88 correlation between MVA and EVA. In such sectors, empirical studies prove that the EVA of a company is an accurate indicator of not just its present, but also its future MVA.

So what should CEOs, managers, and investors look at? Should their decisions be based on a company's EVA, or its MVA? What if there is little correlation between the 2, as there is in several sectors in India? Across sectors, and contexts, companies cannot go wrong if they use EVA. True, EVA does not have the ability to factor in returns from new technologies or new products into its point-of-time calculations. But a company that is keen to raise its EVA from year to year is certain to adopt an extremely cautious approach to capital investments. Not just in terms of the quantum, but also the timing: EVA-companies are likely to make a substantial capital investment only when they are sure that they can raise their ROCE by upping the utilisation of their existing assets, or by stimulating demand for their products or services.

EVA is also an ideal technique for companies operating in new-age sectors. The typical knowledge industry is not capital-intensive, and the companies operating in these industries are not faced with too many decisions involving huge amounts of capital; and returns on the capital that they do invest are immediate. As a result, EVA is almost a made-to-order performance metric for the knowledge industries.

The lack of correlation between EVA and MVA in sunrise sectors, then, can be attributed to improper market valuation techniques. The market-price of a scrip is not a function of its fundamental strengths, but of investor perceptions that, often, have no quantitative basis. Consider a pharmaceutical company that has a track-record of coming up with block-buster drug after block-buster drug. Obviously, this company will have a sizeable R&D expenditure. The EVA process ensures that this expense is capitalised. But only the markets can quantify the expectation that the company will come up with another block-buster drug. Consequently, the company could have a negative EVA and a large positive MVA. This is a global phenomenon-no amount of retro-fitting, for instance, can explain the market-prices of Net stocks-and is evident in several sectors in India too.

The 3 sectors that form what investors call the golden triangle-FMCGs, software, and pharmaceuticals-contributed most to the growth in MVA: the aggregate MVA of the FMCG sector (16 companies), for instance, increased from Rs 44,742.80 crore to Rs 65,690.43 crore. And that of the 46-company pharmaceutical sector from Rs 11,174 crore to Rs 28,881 crore. The basis? Investor-expectations that companies in these sectors have the potential to generate larger revenue-streams with time. Does this mean India Inc.'s negative EVA can be attributed to the fact that it is in the growth phase? And that today's capital-investments will generate returns tomorrow? Maybe, for only high positive EVAs down the line can explain an inflated MVA.

However, unless companies focus on their EVAs as a metric that can facilitate the creation of wealth, they may find it difficult to survive in the long term. Agrees Raghunathan of IIM-A: ''Most Indian companies, barring a few exceptions, will not show any surplus in excess of the cost of capital. The paucity of positive EVA in our country only means that it is a rare company that generates genuine economic wealth.'' So, how can companies improve their EVA?

In the short term, this can be easily done: a reduction in a company's cost of capital, an increase in its ROCE, and a rise in its NOPAT will all contribute to an upswing in its EVA. Thus, the short-term solution to a higher EVA could be the choice of projects and products that are not capital-intensive.

However, to achieve a positive EVA, and then increase it consistently from year to year-only this will result in an increase in the organisation's MVA-companies need to focus on growth and financial jurisprudence simultaneously. What does this involve?

One, companies have to acquire the expertise to manage their cost of capital. They need to explore emerging sources of finance that can lower their overall cost of capital. Two, they need to develop a relentless focus on ROCE. This year's ROCE should never be lower than the previous year's. Especially if there has been an increase in the capital employed. And three, they need to understand that there's more to value-addition than mere post-tax profits.

Reality, as companies that adopt these 3 tenets will realise, lies beyond their financial reports. It lies in the intricacies of an integrated management philosophy called EVA..

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