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Striving for excellent performance

The traditional accounting model of valuation argues that particular equity share prices are set when the stock exchange capitalizes a company's earnings per share (EPS) at an appropriate price/earning (P/E) ratio

Totok Sugiharto (The Jakarta Post)
Jakarta
Wed, September 16, 2009

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Striving for excellent performance

T

he traditional accounting model of valuation argues that particular equity share prices are set when the stock exchange capitalizes a company's earnings per share (EPS) at an appropriate price/earning (P/E) ratio.

The difficulty is that the P/E ratio of a company changes all the time and this makes the EPS and P/E methods very unreliable as measurement tools for value.

As a consequence, both of the traditional models of performance measurements are inadequate in the sense that neither of them addresses the main concern of shareholders: i.e. is the management adding or subtracting value from their invested capital?

Modern finance literature offers better measurement tools for value, namely economic and market value methods.

These methods acknowledge that it is crucial to generate and measure the profit from operations. It is of equal importance to express that profit in relation to the amount of the capital used to generate it. These approaches then do have special ways to calculate the economic profit of firms.

Economic and market value model

Economists since Adam Smith have concluded that the goal of firms and their managers should be to maximize the firm's value to its owners.

In light of that concern, it can be recommended that in order for management to achieve an increase in shareholder wealth, it is necessary to concentrate on increasing a company's economic value added (EVA).

Today, EVA is widely accepted as the main objective of firms, that is, to maximize shareholder value. The financial concept underlying EVA is becoming popular and appreciated by most practitioners in modern finance.

Management's attempts and decision-making to increase shareholder value is measured by the market value of a company. The roles of management are to continuously influence, directly or indirectly, those variables that affect the shareholders' wealth.

Even though there are many advantages of the EVA management system, one of its best attributes is that the remuneration of the company's management can be tied to the EVA of that company. By doing this, a win-win situation between management and the shareholders is created and, in the case of an agency problem, can be eliminated or reduced.

EVA is an internal performance and it reflects the successes of the efforts of corporate managers to add value to the shareholders' investment.

A positive EVA implies that the rate of return on employed capital exceeds the required rate of return. To the extent that a company's EVA is greater than zero; the firm is creating economic value for its shareholders.

The key principle of EVA is that value is created when the return on an investment exceeds the total cost of capital that correctly reflects its investment risk.

One can improve EVA as long as one accepts new projects on which the rate of return exceeds the cost thereof.

In 1990, the Nobel prize winner for economics from John Hopkins University, Merton Miller, refocused this goal as the goal of maximizing Net Present Value (NPV). While the NPV is primarily a long-term capital budgeting tool, the EVA method attempts to break this concept down into annual (or even monthly) installments that can be used to evaluate the performance of corporate managers and their businesses.

Finally, Stern and Steward made the EVA method popular in determining value creation. They encountered the problems and disadvantages of accounting-based methods.

In the almost 30 years they have been working together, this method has been well accepted as a powerful tool in determining the value creation and maximizing shareholders' wealth.

Use of EVA in creating market value added

The question is how EVA as an internal performance measure of a company correlates the best with its external performance measures of the corporation?

Eva is strongly related to the changes in the external performance measure, which is called market value added (MVA). MVA is the difference between a company's fair market value as reflected primarily in its equity share prices, and the economic book value of capital employed. Therefore, the MVA can be regarded as the external or "market" measure of the performance of a company's success.

Much literature argues that EVA is the best indicator of market value that has been created or destroyed by management.

The emphasis is not only on drawing a distinction between accounting-based and EVA models of determining shareholder value, but also on the fact that EVA in particular has distinct advantages in determining value created (or destroyed) by the management of a company.

It is logical then to deploy EVA in terms of its variables or components in order to determine and quantify the value drivers within a company.

In theory, the link between a company's EVA and MVA can be expressed mathematically. Many researchers in financial management insist there is a relationship between them. This can be seen in they way that MVA is equal to the sum of discounted future EVA. The MVA at any point in time is equal to the discounted present value of all EVA the company is expected to generate in the future.

The close relationship between them originated from the fact that these measures are based on the same underlying principles and concepts.

MVA, which is forward-looking, is closely associated with the historical data of EVA. While EVA is used for the internal measure of shareholder value creation, MVA is the external method of determining shareholders' wealth.

Wise advice for the value-based company is to adopt the EVA-MVA model in determining value creation and discard the traditional accounting-based approach.

The writer is a lecturer at Pelita Harapan Graduate School. Website: www.totoksugiharto.com.

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