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The rationale behind EVA

The EVA approach defines value as that which is left from profit once the capital charge has been deducted. Capital charge amounts to what providers of capital expect to get as return on their investment. The advantage of this method is that value creation (or destruction) can be measured year-by-year based on the financial statements and linked to management compensation. Once the EVA calculation has been made for each year, the annual EVA values are then discounted and summed, using the WACC as the cost of capital to reflect the time value of money and risk. Finally, the value of net assets taken from the balance sheet at the date of valuation is added to the present value of the EVA stream, and this provides an entity valuation for the business.

The EVA method is based on accounting money i.e. it is P&L and Balance Sheet-based, and not cash-based. However, it can be shown that an EVA valuation leads to the same result as an NPV valuation if the accounting rules remain the same over time.

NPV and EVA valuations are equivalent

The EVA method looks more complex than the NPV method, and indeed it is: it requires estimating the net invested capital over time, so producing a balance sheet. The depreciation of assets becomes necessary and not only a cashflow calculation. When a business plan is prepared for a new project and not an existing business, an NPV approach is more straightforward, and FCF is more appropriate due to the emphasis on cash and cashflow break-even in new ventures. For an existing business or when looking at a multi-business company, the EVA approach is usually a more appropriate method as it shows value creation year after year, which an NPV approach does not.

The NPV approach has some disadvantages though, in its calculation as well as its interpretation. In the NPV approach, a high portion of the value will usually be captured in the Terminal Value, so that results become very sensitive to a correct estimate of the Terminal Value. Also, this creates an illusion that in the early year of the business, value is destroyed because cashflows are negative, and value is only created in the long term. This is a wrong interpretation, and based on a confusion between cashflow and value, which are not the same. The misunderstanding would be like believing that “negative Free Cashflow is value destroying, positive Free Cashflow is value creating”. This is not quite right. A negative FCF due a high investment can be value creating when the profit generated in the same year from that investment is higher than the capital charge of the investment. Also, later positive Free Cashflows are only possible because invested capital has been built up in the first place, including intangible capital such as brands and patents.

EVA is very good at showing the timing of value creation in the short to medium term, and the EVA Terminal value term should be lower than the NPV terminal value, especially for existing businesses.

It is also an illusion that the NPV method is simpler to apply on the base that a cashflow statement is enough and no balance sheet is necessary. A correct cashflow forecast has to include change in working capital, so working capital has to be estimated in any case. Cashflow is also more volatile than NOPAT. Although in principle a cashflow estimate does not need asset depreciation to be calculated, it requires a good estimation of annual capital investment including replacement of past depreciated assets, so calculating depreciation will be helpful in any case. A good capital investment estimate will be a very important cost item in all capital-intensive high-tech businesses.

Whether you go for the NPV or EVA valuation approach, you should always estimate the ROIC and compare it with the WACC as a cross-check. It is worth asking yourself whether the ROIC should be decreasing over time. If the capital turnover remains stable or increases due to new processes and lower technology costs, then ROIC might be maintained at a high level above WACC, unless the competition puts pressure on Sales and EBITDA margins that more than compensate for the gains in capital turnover.

In all cases, do prepare a bottom-up forecast including the year n+1. Don’t derive FCFn+1, NOPATn+1 or ROICn+1 values from year n values and the growth rate g, as this is usually incorrect.