Eva Better Than Roi

Topics: Profit, Rate of return, Investment Pages: 5 (1267 words) Published: July 15, 2013
Why EVA is better than ROI (ROCE, ROIC, RONA, ROA) and earnings, operating profit etc. Equity investors should earn on their capital a return far over risk-free interest rate in order to induce and maintain capital in the company Therefore earnings should always be judged against the capital used to produce these earnings Earnings can be easily increased simultaneously worsening the position of shareholders e.g. if more capital is poured into a company although the return on capital is 5% or less (even lower than long-term government bond) Thus it is clear for most people that any earnings figure can not alone be a reliable performance measure (still some companies use EPS !?) !

Following slides focus on explaining why also return on capital alone is often an unreliable performance measure 1

© Esa Mäkeläinen 12.3.1998

E-mail: Esa.Makelainen@iki.fi

EVA is a registered trademark of Stern Stewart & Co.

EVA vs. rate of return
There are two very good reasons why EVA is much better than ROI (RONA, ROCE, ROIC) as a controlling tool and as a performance measure 1. Steering failure in ROI Increase in ROI is not necessarily good for shareholders i.e. maximizing ROI can not be set as a target. (Increase in ROI would be unambiguously good only in the companies where capital can be neither increased nor decreased -> however we leave in a world where both operations are easily executed in almost all companies) 2. EVA is more practical and understandable than ROI As an absolute and income statement -based measure EVA is quite easily explained to non-financial employees and furthermore the impacts of different day-to-day actions can be easily turned into EVA-figures since an additional $100 cost decreases EVA with $100. (ROI is neither easy to explain to employees nor can day-to-day actions easily be expressed in terms of ROI) This latter benefit if often totally forgotten in academic discussion since it can not, of course, be visible in desk studies or empirical studies which try to trace the correlation of EVA and share prices Both points are explained in detail in the following slides © Esa Mäkeläinen 12.3.1998 E-mail: Esa.Makelainen@iki.fi

2

EVA is a registered trademark of Stern Stewart & Co.

Reason 1: Steering failure in ROI
Suppose of a SBU earning currently a return (ROI, ROIC, ROCE) of 30% and suppose that this SBU faces an investment opportunity producing a return of 20% What happens to the ROI of the SBU if the investment is executed? ³ ³

Before investment: Capital 100, Operating profit 30, Capital cost 10% ROI = 30/100 = 30% , EVA = 30 - (10% x 100) = 20 Investment´s capital requirement 20, return 20%/year: Thus increase in yearly operating profit is 20% x 20 = 4 After investment: Capital 120, Operating profit 34, Capital cost 10% ROI = 34/120 = 28% , EVA = 34 - (10% x 120) = 22

³

³ ³

In this case decreasing ROI is good for the shareholders, thus ROI should not be maximised and therefore it is problematic controlling tool. Usually large corporations have at least some very profitable units and particularly these units are steered wrongly with ROI E-mail: Esa.Makelainen@iki.fi 3 © Esa Mäkeläinen 12.3.1998 EVA is a registered trademark of Stern Stewart & Co.

Reason 2: EVA is more practical and understandable than rate of return (ROI...) (1/4) Usually the rate of return is not used and totally understood at the lower levels of organizations in the companies using ROI as the prime performance measure. I.e. operating people like sales people, production engineers and supervisors etc. do not use ROI while making day-to-day operating actions (they use operating profit and perhaps also some turnover times instead) This kind of behaviour is obvious since cost reductions, revenue increases, capital increases and reductions etc. are too difficult to convert into change of ROI with day-to-day activities ³

Furthermore those persentages would not be so informative or illustrative to operating...
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