The Indian software and consumer products sectors are world beaters. That isn't a nationalistic sentiment based on a prestidigitatorial analysis; it is one of the findings of the third BT-Stern Stewart exercise to identify India's biggest wealth creators. This being the third edition of the survey, there's the temptation to rush headlong into the analysis assuming everyone knows what EVA and MVA, those karmic twins of the financial-metrics pantheon, stand for. Still, for those who missed out, EVA, or economic value added, is the difference between a company's operating after tax profits and the cost of the capital employed in generating those profits in one financial year.

MVA, or Market Value Added, is a measure of the value added by the company's management over and above the capital invested in the company by its investors (For a more detailed definition, see The Methodology).

To return from mundane finance-speak to the exciting prospect of companies like HLL and Infosys being among the best in the world in terms of market value added (or wealth created) per unit of capital employed: the Indian infotech sector creates nearly Rs 4 for every Re 1 used; the US infotech sector does less than Rs 2.5. And the Indian FMCG (Fast Moving Consumer Goods) sector does around Rs 5 of wealth for every Re 1 of capital employed; the US FMCG sector does approximately Rs 2. That's the good news. The bad news is that 314 of India's top 500 companies did not add market value in 2001; they destroyed it. And many of India Inc's most valuable companies-like ONGC, IOC, sail, and TISCO-sit closer to the bottom of the wealth-creation list. Does that mean much? Actually, yes: the MVA-EVA framework not only provides a far more accurate report-card on corporate performance than conventional measures, but also has significant implications for companies on how to make strategic decisions and manage performance in their pursuit of shareholder value.

The Great Stockmarket Deception

The fundamental premise of capitalism is that companies are expected to take financial capital from shareholders and make it worth more. Unfortunately, in the real world-especially in the Indian economy-this principle doesn't seem to hold. "Maximising shareholder value" is a popular refrain, especially among CEOs. But few companies go about measuring their 'shareholder value added' scientifically. For, managing a business to maximise shareholder-interests isn't just about being the biggest company around. Or the most efficient one. Doing so requires a balance between size and efficiency.

Lay investors, and even most companies, tend to focus far too much on size and income-based metrics such as share price (Market Value or Market Capitalisation), earnings, earnings growth, and earnings per share. Such metrics do not take into account how much additional capital has been poured into the business to generate the additional income, so it is relatively easy to improve such measures simply by investing more. However, to add wealth, managers should focus on increasing the value added to the shareholders' investment-a perspective provided by MVA.

This isn't mere semantics. While companies such as HLL, Reliance, Wipro, Infosys, and ITC are on top in both the MV and MVA list, nearly a third of India's most valuable companies appear at the bottom of the MVA hustings. With the exception of Tata Steel, the nether regions of the MVA rankings are populated by public sector enterprises. Privatisation, of course, is the preferred long-term solution. Given the speed at which the process is going, though, India's public sector could do with a crash course in managing shareholder value. Not only will this boost their economic performance, it could help them fetch a better valuation (See Where Are Our PSU's Going?).

Together, India Inc. created around Rs 80,500 crore of wealth in 2001 (total market value of Rs 6,67,000 crore less total capital employed of Rs 5,86,500 crore).

This is far lower than the wealth created in previous years, but thanks to the global stockmarket depression of the late nineties and early zeroes the phenomenon isn't unique to India. However, things have been exacerbated in India by the fact that the capital employed by India Inc. has risen by 45 per cent over the past five years.

That said, India's track record at creating wealth continues to remain woefully poor compared to other economies. For every rupee of capital employed in 2001, India Inc. created only 16 paise of wealth. In 2000, it did 50 paise. In contrast, USA Inc. created nearly five times more.

The good news is that our wealth creators are world class. But the bad news is that relative to other economies we continue to have far too much capital tied up in wealth destroyers. This sad tale is true not only for the overall economy but also for key sectors such as banking and financial services.

The even more depressing news is that over the past five years, wealth destroyers have grown worse (they destroy 30 paise for each rupee of capital today, up from 14 paise five years ago) while the creators have improved their performance (from Rs 1.50 to Rs 1.75)

There's more: the it, pharma, and FMCG sectors create more than 175 per cent of India Inc.'s wealth (that's right, if the other sectors were to suddenly, by some sleight of hand, cease to exist, India Inc. would actually create more shareholder wealth than it does now) but consume only 7 per cent of the total capital employed.

While numbers indicate an increase in the capital allotted to these sectors, what is worrying is that the wealth destroyers are continuing to increase their capital usage at significant rates.

Thus, while the capital allocation to the it sector increased by over 400 per cent between 1997 and 2001, and that to the FMCG and pharma sectors by close to 90 per cent and 60 per cent respectively, wealth-destroying sectors like consumer durables and petrochemicals saw an increase in capital allocation too.

Ideally, shareholders would like to see some of the wealth destroyers harvest and return capital back to them so that they can re-deploy it to more productive parts of the economy. But in the Indian context, where both shareholder-orientation and corporate governance are still perceived as esoteric concepts, that hasn't happened. The result? Capital, which can otherwise productively be used in sectors that create wealth, lies in a state of near-atrophy in sectors and companies that exist, not for the lofty cause of creating wealth, but just for the sake of being.

The More Appropriate Measure

Accepted, MVA is an ideal measure of wealth creation in the long-term. But it suffers from the short-term vagaries of stockmarket sentiments. If the markets are in the midst of a bull run, companies find their MVA zooming up to stratospheric proportions; if they do a sudden flip and enter the bear-mode, companies find their MVA plummeting.

That is one reason why companies should focus on improving their fundamental economic performance, as measured by EVA. Over the long-term, it is improvement in EVA-not accounting results-that drives wealth creation.

For the mathematically inclined, the MVA of a company is the net present value (NPV) of all its future EVAs. Thus, a company that continues to improve economic value added, year after year will, sooner than latter, find favour with investors.

EVA tells us how much shareholder wealth the business has created in a given time period (this is usually a year, but companies can and do use shorter time periods to aid the decision-making process) and provides a road-map to creating wealth at a business unit level within a company.

Simply defined, EVA is the economic profit that remains after deducting the cost of all the capital employed (both debt and equity). The power of EVA comes from the fact that it marries both the income statement and the balance sheet and reflects the economic reality after eliminating accounting distortions.

The role of EVA in driving a company's ability to create wealth is evident in a comparison of Reliance Industries Ltd (RIL) and Indian Oil Corporation (IOC).

Indian Oil Corporation employs around twice as much capital as RIL, has five times the revenues, and is comparable in terms of market value (RIL ranks second, IOC, fourth). Purely from this perspective, there seems to be nothing very different between the two companies.

However, RIL, with its MVA of Rs 19,346 crore ranks fourth on the wealth-creators list while IOC, with its MVA of a negative Rs 8,153 crore, comes in at number 499. The difference in their wealth creation is driven by their fundamental economic performance. RIL has an EVA of Rs 308 crore while IOC's is a negative 1,500 crore.

EVA is superior to conventional measures because it replicates the discipline of the capital markets within the firm by explicitly measuring Return on Capital Employed (ROCE) relative to the cost of capital.

ROCE is, in turn, driven by a company's net profit margin and the efficiency of asset use. It is not a surprise to see that the wealth-creators' ROCE is nearly one-and-a-half times higher than that of wealth destroyers.

However, it is interesting to note that the profit margins earned by both the wealth creators and the destroyers are pretty much the same and it is the ability to utilise capital efficiently that differentiates these two groups. That's why investors who choose where to put their money by simply looking at net profits often go wrong. And that's why wealth destroyers would greatly benefit from the discipline of making EVA-maximising tradeoffs between margins and capital efficiency in their various strategic and operational decisions.

How to Read the Numbers

That yellow-purple-blue matrix you see (See Changes In EVA And MVA Sectorwise) isn't just there for visual relief. It is a five-year analysis of key industry sectors on changes in MVA and EVA. Diversified companies, FMCG ones, and those in the pharma sector come out winners in terms of both wealth creation and fundamental economic performance. That means they managed, over a period of five years, to add both market value and economic value. However, most sectors-this list includes automobiles, capital goods, consumer durables, and banks-fared badly in terms of both parameters.

The industry sectors appearing in one of the two yellow quadrants-they fared well on one parameter and poorly on the other-are the interesting ones. Infotech, for instance, did well on the wealth-creation front, but not so well on the fundamental performance front. This is easily explained by a huge inflow of capital (a 400-per cent increase over five years) and a build-up of cash in the balance sheets of tech companies as they scout around for acquisitions.

The increase in MVA over five years signals that investors expect software companies to continue to earn above cost of capital returns even on this additional capital in the future. In contrast, investors expect little from petrochem, metals, media, and telecom sectors. Companies in these sectors may be improving economic value added today, but the market has low expectations of what they will be able to deliver in the future. For some, the expectations implied in their valuations may not be in line with their actual potential. That could explain why contrarian stock-pickers-their breed is increasing-like nothing more than an undervalued outperformer.

Tejpavan Gandhok (centre) is Country Manager, Stern Stewart, and Sanjay Kulkarni (Right) and Anurag Dwivedi are Associates at Stern Stewart's Mumbai office.

Is there a moral to the story? Yes, to create wealth on a sustained basis, companies should focus on maximising the 'value added' to the capital employed over the long term and not merely grow in terms of size. This wealth created, or MVA, is a function of a sustainable fundamental economic performance and EVA reflects the fundamental economic performance better than traditional metrics.

However accurate the numbers may be, simply measuring and issuing annual MVA and EVA report cards is not enough. The key to sustained performance improvement lies in ensuring two key outcomes:

• Aligning interests of the management and the shareholders.
• Ensuring that a value creating culture permeates the organisation, influencing the behaviour of key decision-makers.

After all, what gets measured gets managed, but you get what you pay for.