2.25 Market Value Added (MVA) and Economic Value Added (EVA)
Accounting data do not usually reflect current market values; rather, they reflect historical costs (and other distortions). This makes it difficult to make assessments of corporate performance. Market Value Added (MVA) delineates the difference between the firm’s equity’s market value and its book value as recorded in its balance sheet. This difference is intended to gauge management’s performance and address shareholder concerns.
For instance, if a firm issued equity at $10 per share and the price/market value is now $15 per share, the corporation has, presumably, performed well. The $5 increase may be multiplied by the number of shares in order to measure the increase in firm value realized over the time period during which the shares were originally issued. Put differently, this difference represents the increase, after retaining and accumulating historical earnings, to which the shareholders arguably are entitled, i.e., the difference between the shareholders’ initial contribution to the firm and its current value. While this may be useful for evaluating market performance, it is not very helpful in gauging management’s performance. Part of the increase in share value may be attributable to secular market increases rather than management performance. For example, the stock’s price may have gone up simply because interest rates have decreased. Another assessment tool is “Economic Value Added.”
Economic Value Added (EVA), a.k.a., “economic profit” is calculated as follows:
EVA = NOPAT – Annual Dollar cost of capital
Where,
NOPAT = net operating profit after taxes = EBIT (1 – T) and
Annual Dollar Cost of Capital = (total investor supplied operating capital) (After-tax percentage cost of capital)
Alternatively, EVA can be calculated in another way, i.e., a way that conveys a different meaning and perspective.
EVA = (Equity Capital) (ROE – Cost of Equity Capital)
Take note that “Equity Capital” is expressed in dollar terms while ROE and Cost of Equity Capital are expressed in percentage terms.
These formulas imply that firms can increase EVA by investing in internal projects that provide returns in excess of their cost of capital.
(Note that cost of capital, in effect, means the returns the firm would earn on alternative choices of equal risk. The management must produce a retrurn equal to the opportunit set facing shareholders.)
EVA estimates the firm’s true yearly economic profit and differs therefore markedly from accounting net income, which ignores the cost of equity. If EVA > 0, the firm’s management is thought to have contributed positively to its growth.
Given the foregoing, we may rewrite the firm’s market value as:
Equity Market Value = Book Value + PV of all future EVAs
