Why EVA And MVA Are Better Metrics

EVA is superior to traditional measures such as PAT, PBT, and rates of return because it replicates the discipline of the capital markets within the firm, by explicitly measuring returns relative to the cost of capital. It also provides a roadmap to the ultimate goal of improving MVA.

There are basically two parts to EVA, efficiency and growth. EVA is the difference between the per cent rate of return and the per cent cost of capital, or what we call the return spread (that's a measure of efficiency) times the capital (that's the measure of size). To up EVA, a company can improve its efficiency, reduce its cost of capital, or increase its capital. It's an issue of both quality and quantity. EVA, as a measure, points out that growth without efficiency is bad, and also that efficiency without growth isn't really much better (See 4 Key Strategies To Increase Value). For unless a company manages to increase its Return on Capital Employed, no amount of reduction in the Cost of Capital can widen the spread between the two. In addition to being an efficient measure of wealth creation, the EVA/MVA framework is also the basis of an effective management philosophy that can guide a company's strategic decisions.

Our study indicates that India's biggest wealth creators grew and at the same time, improved their efficiency, while its biggest wealth destroyers continued to invest in projects expected to earn below the cost of capital.

Our MVA rankings provide a useful snapshot point in time comparison across Indian companies. However, for a given company, what matters most is its ability to increase MVA over the long-term. We analysed the top 10 and the bottom 10 wealth creators/destroyers using a value-based lens, examining their efforts to improve efficiency and their growth strategies.

Most of the leading wealth creators (highest positive change in MVA) showed an increase in their invested capital as well as their efficiency over a four-year period (1996-97 to 1999-2000). While the majority of the companies that destroyed the most MVA over the same period grew invested capital significantly, their efficiency continued to be low.

Another interesting point is that a company's ability to create or destroy wealth is not just a matter of what industry it is in; it is also influenced by what investment and efficiency improvement strategies it follows. People often say, ''Oh sure, it's easy if you're an IT company'' or ''It's easy if you're a consumer products company with strong brands''.

Take the case of the FMCG sector. Our analysis shows that HLL is a true winner. The reason is simple: the company grew and improved returns. Companies such as SmithKline Beecham, P&G, and Nestle also created MVA, but not as much as HLL because they mainly followed efficiency improvement strategies. The moral of the story is that mere efficiency improvement isn't going to make you a winner; you need to grow as well. Similarly, mere growth without earning a return over the cost of capital is value destroying. You really need to have both the drivers of wealth creation. That logic runs through several other instances: of Hero Honda's growing dominance over Bajaj in the two-wheeler market; and of M&M's fall from grace in terms of MVA (the company destroyed over Rs 3,000 crore of wealth).

Now that the gameplan is pretty clear, how does one ensure that the game is played in its true sense? The answer, as we reiterate, lies in creating a framework that ensures internal corporate governance. One needs to ensure that a culture of value creation pervades within the company and align the interests of the managers and the shareholders. Shareholder wealth creation performance improves only if the behaviour of managers-at least the key senior managers who make decisions that impact the economics of the business- changes.

From Theory To Practice

We believe, that adopting the EVA framework achieves this and more. The backbone of the EVA framework is the incentive compensation plan. Simply measuring EVA is not enough-although unfortunately that is what most people think EVA involves. It must become the basis of key management decisions and be linked to the variable compensation of the senior