Question

Illustrate the advantages of the economic value added (EVA) over the return on assets (ROA) as measure of financial performance. Successively, explain why, according to some scholars, the EVA measure may induce short-sightedness of managers. Finally, discuss how the EVA measure can be used in firm valuation.

Answer 1

Advantages of EVA (Economic Value add)
1. It is an excellent performance indicator which uses data from balance sheet to identify whether a project is adding value tithe firm or not.
2. EVA = Return on capital employed - Weights Average cost of capital
only when EVA is positive value is created for the shareholders. It gives a good idea about the profitability of the company.
3. It helps in identifying stocks whose EVA is negative such companies must be analysed carefully before investing.

EVA may induce short-sightedness because it might reject companies whose investment is large initially. Initially the EVA might be negative but growth in returns will kick in after certain years and in future EVA might be positive. In such cases where future growth potential is not considered EVA is a drawback.

Market valuation by EVA method can be done in following way.
The Market value add of form = Present value of all future EVA =EVA_t/ (1+ cost of capital)^t

Where EVA = NOPAT - WACC * Capital Employed

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