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Economic Value Added (EVA) and Market Value Added (MVA): Reflecting on Some Policy Implications

What is economic value added (EVA)? What is Market Value Added (MVA)? How do companies choose their value creation strategies? Do higher cash flows automatically result in higher financial gain? How do companies that opt ​​for maximum economic value added compare to companies that opt ​​for maximum market value added? What does a reasonable compensation report for managers based on performance metrics? These strategic policy questions relate to a business enterprise’s profit-producing capacity and optimal cash flow improvement strategies: the right mix of cash inflows and outflows that maximizes net cash flows and thus therefore, return on investment and shareholder wealth while minimizing the cost of operations. simultaneously.

One of management’s strategic objectives is to maximize shareholder value, which is based on the future cash flows of the company. In addition, other management objectives include maximizing the company’s share price; and the value of any asset based on the cash flows it is expected to produce. Therefore, management strives to maximize the cash flows available to investors. But how does management decide which trading stocks are most likely to increase those cash flows, and how do investors estimate future cash flows? The answers to these questions can differ markedly, but are found in a careful analysis of the financial statements that publicly traded companies must provide to investors and regulators.

There are divergent cash flow improvement objectives and many factors influence effective cash flow improvement strategies. For those familiar with the relevant academic literature, the critical factors are well known and supported by contemporary research. The main objectives of effective cash flow improvement strategies and the core elements of effective cash flow improvement strategies are equally well established in the existing academic and professional literature. However, some observers and industry professionals continue to identify profit maximization as the primary goal of a business venture. As we have warned in previous review and guidance, this approach to profit maximization is a bit shortsighted and misguided.

The most common metrics used to determine the value of a business include economic value added (EVA) and market value added (MVA). In practice, there are clear differences between these two valuation strategies and investors must know how to use each one. Economic Value Added (EVA) and Market Value Added (MVA) are common ways that an investor can assess the value of a company. While EVA is useful as a way to assess a company’s economic success, or lack thereof, over a specific period of time, MVA is useful as a measure of wealth, evaluating the level of value that a company has accumulated. over a period of time.

Some practical guidelines

As we explained in the previous review, cash flows provide critical information about the performance of the company that cannot be discerned through analysis of net income. Additionally, financial accounting students and professionals know that net income data is more likely than accounting methods such as inventory and depreciation methods.

Financial statements often do not reflect the market values ​​of companies, so they are not suitable for evaluating the performance of managers. To fill this evaluation gap, financial analysts developed two additional performance measures: Economic Market Aggregate (EVA) and Market Value Added (MVA).

Economic Value Added (EVA) is a performance measure that attempts to measure the true economic profit produced by a company. EVA is often referred to as “economic benefit” and provides a measure of the economic success (or failure) of a business over a period of time. Such a benchmark is useful for investors looking to determine how well a company has produced value for its investors, and can be compared to industry benchmark company peers for a quick analysis of how well the company is operating. company in your industry.

Economic profit can be calculated by taking the after-tax net operating profit of a company and subtracting from it the product of the company’s invested capital multiplied by its percentage cost of capital. EVA provides a standardized measure of the wealth the company generated above its cost of capital during the year.

In practice, the profitability of a company can be evaluated by calculating EVA, as it focuses on the profitability of a company’s project and therefore the efficiency of the company’s management. Economic value added (EVA) weighs the opportunity cost of alternative investments, while market value added (MVA) does not. EVA as an estimate of the true economic profit of a company often differs markedly from net accounting income because it considers the cost of both debt and equity, while accounting income only considers the cost of debt equity.

Market Value Added (MVA), on the other hand, is simply the difference between the current total market value of a company and the capital contributed by investors (including both shareholders and bondholders). It is used for larger and publicly traded companies. MVA is not a performance benchmark like EVA, but rather a wealth benchmark, which measures the level of value that a company has accumulated over time.

As a business performs well over time, it will retain profits. This will improve the book value of the company’s shares, and investors are likely to increase the prices of those shares in the expectation of future earnings, causing the market value of the company to rise. As this occurs, the difference between the market value of the company and the capital contributed by the investors (its MVA) represents the price of excess or markup that the market places on the company as a result of its past operating successes or failures. , respectively.

In short, unlike EVA, MVA is a simple metric of a company’s operating capacity and, as such, it does not incorporate the opportunity cost of the alternative. A positive trending EVA will also help to ensure a positive trending MVA. Additionally, while the MVA applies to the entire company, the EVA can be determined for business units as well as the entire company, making it useful as a guide for reasonable compensation for corporate and unit managers.

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