eva and wealth creation in the indian context
TRANSCRIPT
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EVA and Wealth Creation in the Indian Context
M.P.Birla Institute of Management 1
RESEARCH PROJECT
On
EVA and Wealth Creation in the Indian Context
Submitted in partial fulfillment of the requirement for MBA
Degree of Bangalore University
BY
Deepika Pandya
Registration Number
04XQCM6024
Under the guidance of
Dr. T. V. N. Rao
M.P. Birla Institute of Management
Associate Bharatiya Vidya BhavanBangalore-560001
2004-2006
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DECLARATION
I hereby declare that the research project titled EVA and Wealth
Creation in the Indian Context is prepared under the guidance of Dr. T.V.N. Rao in partial
fulfillment of MBA degree of Bangalore University, and is my original work.
This project does not form a part of any report submitted for degree or diploma
under Bangalore University or any other university.
Place: Bangalore Deepika Pandya
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GUIDES CERTIFICATE
I hereby declare that the research work embodied in this dissertation entitled EVA
and Wealth Creation in the Indian Context has been undertaken and completed
by Ms Deepika Pandya under my guidance and supervision.
I also certify that she has fulfilled all the requirements under the
covenant governing the submission of dissertation to the Bangalore University for
the award of MBA Degree.
Place: Bangalore Dr. T.V.N Rao
Date: Research Guide
MPBIM, Bangalore
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ACKNOWLEDGEMENT
The successful accomplishment of any task is incomplete without
acknowledging the contributing personalities who both assisted and inspired and
lead us to visualize the things that turn them into successful stories for our
successors.
First of all we thank the Almighty God for his grace bestowed on us
throughout this project.
My special thanks to my project Guide Dr. T.V.N Rao, who guided me
with the timely advice and expertise and has helped remarkably to complete the
project.
Last, but not the least, I would like to thank my parents and all my
friends for their wholehearted support and encouragement.
DEEPIKA PANDYA
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TABLE OF CONTENTS
CHAPTERS PARTICULARS PAGE NO.
ABSTRACT 1
1. INTRODUCTION 2
1.1 Introduction 3
1.2 Background of the study 4
1.3 Purpose of the study 7
1.4 Problem statement 7
1.5 Objectives of the study 7
1.6 Research Questions 7
1.7 Theoretical Framework 8
2. REVIEW OF LITERATURE 15
2.1 The Wealth Creation Framework 16
2.2 Examination of EVA as a performance metrics 18
2.3 The quest for value 20
2.4 The five forces of Wealth creation 21
3. METHODOLOGY 23
3.1 The Sample Size 24
3.2 Data gathering procedure and Instrumentation 27
3.3 Research Calculations 28
3.4 Data Analysis 29
4. RESEARCH FINDINGS & ANALYSIS 30
5. CONCLUSIONS & RECOMMENDATION 41
6. ANNEXURES 44
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LIST OF TABLES
S. No Particulars P.No
1 Table 4.1 The Largest Wealth Creators for
(2000-2005)
31
2 Table 4. The Toppers in terms of Economic
Value Added (2000-2005)
32
3 Table 4.3 The Largest Wealth Creators for
(2004-2005)
33
4 Table 4.4 The Toppers in terms of
Economic Value Added (2004-2005)
34
5 Table 4.5 The Largest Wealth Creators for
(2003-2004)
35
6 Table 4.6 The Toppers in terms of
Economic Value Added (2003-2004)
36
7 Table 4.7 The Largest Wealth Creators for
(2002-2003)
37
8 Table 4.8 The Toppers in terms of
Economic Value Added (2002-2003)
38
9 Table 4.9 The Largest Wealth Creators for
2001-2002
39
10 Table 4.10 The Toppers in terms of
Economic Value Added (2001-2002)
40
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Abstract
Wealth Creation is the process by which a company enhances the market value of the
capital entrusted to it by its shareholders. It is a basic measure of success for any
commercial venture. Wealth Creation is achieved by the rational actions of a company in a
sustained manner.
Many organizations devote a significant proportion of management resource thinking on
competitive strategy; however their strategic planning processes often lack the discipline or
analytical rigor of thinking through alternative strategies and their long-term financial risk-
reward implications. The EVA analysis provides the company with profits in real sense and
measures the actual value creation by the organization which benefits its stakeholders.
The research provides a fundamental platform to investors to analyze the companies in
terms of its present position; earning capabilities and the growth potential unleashed which
leads to value addition and subsequently wealth creation.
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Chapter 1
Introduction
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1. Introduction
Creation of shareholders value is the core of every business. This is natural since shareholders
own the company and as rational investors they expect good long-term yield on their investment.Commonly used accounting measures are EPS (Earnings per Share), ROE (Return on Equity),
NPR (Net Profit Ratio) etc. But these metrics may not show a clear picture with respect to the
value created by the company.
Therefore, value based metrics of performance evaluation like EVA (Economic Value Added),
MVA (Market Value Added), CVA (Cash Value Added) and CFROI (Cash Flow Return on
Investment) have come into existence. These new performance metrics seek to measure the
periodic performance in terms of change in value. Maximizing value means maximizing long-term
yield on shareholders investment.
Economic Value Added defined by Stern Stewart & Co. is the financial performance measure that
comes closer than any other to capturing the true economic profit of a company. EVA also is the
performance measure most directly linked to the creation of shareholder wealth over time.
EVA = Net Operating Profit after tax (NOPAT) [Capital * the Cost of Capital]
Put most simply, EVA is net operating profit minus an appropriate charge for the opportunity cost
of all capital invested in an enterprise. As such, EVA is an estimate of true "economic" profit, or
the amount by which earnings exceed or fall short of the required minimum rate of return that
shareholder and lenders could get by investing in other securities of comparable risk.
The consulting firm of Stern Stewart published The Real Key to Creating Wealth (John Wiley &
Sons, New York, 1998), which "celebrates a revolution in management known as economic value
added (EVA)." Stern Stewart claims that:
EVA is the only true indicator of business and management performance;
EVA is "today's hottest financial idea and getting hotter;
EVA "allows all financial decisions to be modeled, monitored, evaluated, communicated, and
compensated in terms of a single measure";
"EVA is the only reliable and unambiguous continuous-improvement metric"
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1.2 Background of the study
Wealth Creation is the process by which a company enhances the market value of capital entrusted
to it by its shareholders. It is a basic measure of success for any commercial venture. Wealth
Creation is achieved by rational actions of a company in a sustained manner. The foundation of
Wealth Creation is in buying businesses at a price substantially lower than their intrinsic value.
Lower the market value than the intrinsic value; higher is the margin of safety.
Investors are currently demanding Share value more strongly than ever. So the wealth created by
the company is more linked to the market price of the shares. This study is undertaken to show the
relationship that exists between the various value metrics and wealth creation as the performance
of the company is reflected in the wealth created.
Value investing starts with having a better understanding of the intrinsic value of the company than
rest of the market. A companys intrinsic value can be divided into three parts:
I Asset Replacement Value
II Earning Power Value
III Growth Value
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Asset Replacement Value
o Basic value of a business with no competitive advantage is the replacement cost of assets.
Any new entrant can get these assets by paying the current price.
o Typically found in industries like cement, steel, aluminum, refining and petrochemical.
Earning Power Value
o Competition keeps eroding profitability till it falls below the cost of capital.
o Competitive advantage or some kind of entry barrier allows companies to earn higher
returns than the cost of capital.
o Higher the entry barriers and the longer they last, higher and larger w ill be the profits
above the cost of capital.
o Solidity of the barrier or competitive advantage is the starting point of Wealth Creation. If
it is missing, any amount of growth will be meaningless in the long run.
Growth Value
o Growth is the most difficult to estimate. Especially, to project growth for a long period into
the future is not an easy task.
o All growth is not rewarding. Growth has to be in the same franchise of business.
o Free competition allows all the firms to enter new businesses.
o
New lines of business without competitive advantage are unlikely to earn attractive returns
(> cost of capital) on additional capital for a meaningful period.
o Hence, only 'valuable grow th ' is the grow th in businesses w here the firm enjoys a
competitive advantage.
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Not All Growth Creates Value
We quested further to probe the process of Wealth Creation of Growing companies. Value of a
share is the Present Value of all future free cash flows. Th e formula:
Present Value of Future Cash Flow s = C x (RoC G)/(R -G)
C: Capital Employed
RoC: Return on Incremental Capital Employed / Equity
G: Growth in Capital Employed
R: Cost of Capital
Value created by growth depends on
o Profitability of incremental capital employed. Greater the amount by which incremental
returns (RoC) exceed the cost of capital (R), greater will be the value created.
o Amount of capital that can be deployed in the business. In the long run, growth (G) has to
be a fraction of cost of capital.
o An investor should substitute cost of capital with the return that he/she expects on the
investment to decide on the extent of Margin of Safety.
The academic approach to calculate shareholder value ignores the market price altogether.
According to this approach, value creating companies are those that have positive free cash flows
after applying the cost of capital. Many companies use this yardstick themselves to find out
whether each of their action and divisions are creating free cash flow, the technique is called
Economic Value Added.
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1.3 Purpose of the study
The purpose of the study is to show that EVA has relationship with wealth creation and this
relationship is significant. This shows that value addition by the company is also a dependantfactor for the movement in the share prices.
1.4 Problem Statement
There are various views with respect to whether traditional measures or value-based measures
influence wealth creation. Considering this, it is interesting to examine which of the performance
measures have significant impact on wealth creation.
Question to be addressed is whether there is relationship between EVA and Wealth creation andwhether this relationship is significant.
1.5 Research Question
Is there a significant relationship between EVA and wealth creation? The research question tests
the importance to measure EVA in terms of real profit which in adds wealth to the company.
1.6 Objectives of the study
o To measure wealth creation for the sample companies.
o To judge the relation between EVA and change in market capitalization.
o To analyze the relationship between EVA and wealth.
o To establish that EVA is a better measure of performance.
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1.7 Theoretical framework
Investors analyze and interpret the financial statements so that they can get an insight into the
firms performance. Ratio analysis is one of the tools of financial analysis. It shows the
relationship between two figures in the financial statements. There are various types of ratios used.
Investors of more interested in profitability ratios like Net profit ratio, Return on capital employed,
Return on Equity, etc., and valuation ratios like Price-Earnings ratio, Earnings per share, Yield,
etc.
Net profit ratio
NPR shows the earnings left for the shareholders as a percentage of net sales. It measures the
overall efficiency of production, administration, selling, financing, pricing and provides a valuable
understanding of the cost profit structure of the company. It enables the analysts to identify the
sources of business efficiency/inefficiency.
NPR= Net Profit * 100
Sales
Return on Net worth/Equity
RONW measures the profitability for the shareholders funds invested in the firm. It is an important
measure as it reflects the productivity of the ownership capital in the firm. This measure is of great
interest to the shareholders.
RONW= Earnings for Equity shareholders * 100
Average equity capital
Earnings per share
EPS is also a measure of the profitability of the firm. It indicates the profitability on a per-share
basis.
EPS = Earnings for Equity shareholders * 100
No. of equity shares
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Economic Value Added
The consulting firm Stern Stewart originally proposed it. It is the most popular value-based measure. It is
the surplus left after making an appropriate charge for the capital employed in the business.
EVA = NOPAT WACC (Capital Invested)
NOPAT: Net Operating Profit after Taxes
WACC: Weighted Average Cost of Capital
Market Value Added
MVA is the difference between the companys market value and the capital invested. It is the premium
the market awards a company over and above the amount the investors have invested in it. This helps
in the assessment of how the markets view EVA generating ability of the firm. So, MVA is the market
expectations of future EVAs generated by a firm.
MVA= EVA1 + EVA2 +(1+WACC)1 (1+WACC)2
Cash Flow Return on Investment
The CFROI model avoids the use of accounting book capital in valuing the firms existing assets and
thus provides an accurate estimate in determining shareholder value.
CFROI = Cash flow - Economic depreciation
Cash Invested
Economic depreciation is the amount of annual sinking fund payment earning the cost
of capital required to replace the assets.
Cash Value Added
CVA is based on cash flows and not on earnings. It is the spread between CFROI and the real cost
of capital, multiplied with the investment in fixed assets and working capital.
CVA= Cash flows- Economic Depreciation-(Cash invested* WACC)
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Background of Economic Value Added
EVA is not a new discovery. An accounting performance measure called residual income is
defined to be operating profit subtracted with capital charge. EVA is thus one variation of residual
income with adjustments to how one calculates income and capital. According to Wallace (1997,p.1) one of the earliest to mention the residual income concept was Alfred Marshall in 1890.
Marshall defined economic profit as total net gains less the interest on
invested capital at the current rate. According to Dodd & Chen (1996, p.27) the idea of residual
income appeared first in accounting theory literature early in this century by e.g. Church in 1917
and by Scovell in 1924 and appeared in management accounting literature in the 1960s. Also
Finnish academics and financial press discussed the concept as early as in the 1970s. It was
defined as a good way to complement ROI-control (Virtanen 1975, p.111). Knowing this
background many academics have been wondering about the big publicity and praise that has
surrounded EVA in the recent years. The EVA concept is often called Economic Profit (EP) in
order to avoid problems caused by the trade marking. On the other hand the name "EVA" is so
popular and well known that often all residual income concepts are often called EVA although
they do not include even the main elements defined by Stern Stewart & Co. For example, hardly
any of those Finnish companies that have adopted EVA calculate rate of return based on the
beginning capital as Stewart has defined it, because average capital is in practice a better estimate
of the capital employed. So they do not actually use EVA but other residual income measure. This
insignificance detail is ignored later on in order to avoid more serious misconceptions. It is
justified to say that the EVA concept Finnish companies are using corresponds virtually the EVA
defined by Stern Stewart & Co.
In the 1970s or earlier residual income did not got wide publicity and it did not end up to be the
prime performance measure in great deal of companies. However EVA, practically the same
concept with a different name, has done it in the recent years. Furthermore the spreading of EVA
and other residual income measures does not look to be on a weakening trend. On the contrary the
number of companies adopting EVA is increasing rapidly (Nuelle 1996, p.39, Wallace 1997, p.24
and Economist 1997/2). We can only guess why residual income did never gain a popularity of this
scale. One of the possible reasons is that Economic value added (EVA) was marketed with a
concept of Market value added (MVA) and it did offer a theoretically sound link to market
valuations. In the times when investors demand focus on Shareholder value issues this was a good
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bite. Perhaps also pertinent marketing by Stern Stewart & Co. had and has its contribution. EVA is
one measure that is used to monitor the overall value creation in a business. It is a value based
framework that provides unique insight into the value creation. The idea behind EVA is that
shareholders must earn a return that compensates the risk taken. In other words equity capital has
to earn at least same return as similarly risky investments at equity markets. If that is not the case,
then there is no real profit made and actually the company operates at a loss from the viewpoint of
shareholders. On the other hand if EVA is zero, this should be treated as a sufficient achievement
because the shareholders have earned a return that compensates the risk. This approach - using
average risk-adjusted market return as a minimum requirement - is justified since that average
return is easily obtained from diversified long-term investments on stock markets. Average long-
term stock market return reflects the average return that the public companies generate from their
operations.
What is EVA and how it is calculated?
EVA is the difference between the companys net operating profits aftertaxes and the cost of
capital employed in generating those profits in one financial year. If EVA is positive, the company
creates shareholder wealth. If EVA is negative, the shareholder wealth is destroyed. The concept of
EVA is based on the principle of residual income, which states that the real income generated by a
company is the residue that remains after a companys shareholders and debtors have been paid
their annual required return. The technique of EVA has acquired acceptance as a tool for assessing
the existing financial status and predicting the future performance of the company. The most
important reason to adopt EVA as the main corporate financial goal is that it is directly correlated
to the intrinsic market value. Maximizing EVA consistently would lead to maximization of the
market capitalization.
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EVA has two distinct applications
To measure how much shareholder value the firm has created in the past and to determine investor
expectations as they relate to the stock price. A firm/s present value should equal its invested
capital plus the present value of future EVA. Basically EVA examines the three fundamentalprinciples of value creation: Cash flow, Risk, and Sustainability of Returns.
Uses of EVA
In stock selection the EVA tool can be used in four distinct ways.
1. Analyzing historical trends - EVA can measure a companys historical success in creating
shareholder wealth.
2. Using EVA to forecast a target stock price - EVA can be used to determine whether a stock is
fairly valued based on a forecast of economic profits. Such a forecast converts discounted EVA
into a share price.
3. To quantify Competitive Advantage Period (CAP) - Stock prices in many cases may reflect a
long competitive advantage period. Analysts can use the value driver model to look at their
assumptions regarding risk and CAP.
4. To examine excess returns and its impact on valuation of a stock- Another way of exploring the
explanatory power of the value drivers in an EVA model is to perform a regression analysis of
invested capital (ROIC) minus the weighted average cost of capital (WACC) spread as the
independent variable and enterprise value to invest capital as the dependant variable. The
correlation between return spreads and valuation is quite strong.
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Superiority of EVA can be known from the following comparisons
Conceptually, EVA is superior to accounting profits as a measure of value creation because it
recognizes the cost of capital and, hence, the risk of a firms operations. Furthermore EVA is
constructed so that maximizing it can be set as a target. Traditional measures do not work that way.
Maximizing any accounting profit or accounting rate of return leads to an undesired outcome.
EVA vs. ROE
ROE suffers from the same shortcomings as ROI. Risk component is not included and hence there is no
comparison. The level of ROE does not tell the owners if company is creating shareholders wealth or
destroying it. With ROE this shortcoming is however much more severe than with ROI, because simpl
increasing leverage can increase ROE. As we all know, decreasing solvency does not always make
shareholders position better because of the increased (financial) risk. As ROI, return n equity (ROE) i
also an informative measure but it should not guide the operations.
EVA vs. ROCE
1. Return on capital is very common and relatively good performance measure. Different
companies calculate this return with different formulas and call it also with different names like
Return on investment (ROI), Return on invested capital (ROIC), Return on capital employed
(ROCE), Return on net assets (RONA), Return on assets (ROA) etc. The main shortcoming with
all this rate of return is that maximizing rate of return does not necessarily maximize the return to
shareholders.
2. Also operations should not be guided with the goal to maximize the rate of return. As a relative
measure and without the risk component ROI fails to steer operations correctly. Therefore capital
can be misallocated on the basis of ROI. First of all ROI ignores the definite requirement that the
rate of return should be at least as high as the cost of capital. Secondly ROI does not recognize that
shareholders wealth is not maximized when the rate of return is maximized. Shareholders want
the firm to maximize the absolute return above the cost of capital and not to maximize percentages.
Companies should not ignore projects yielding more than the cost of capital just because the return
happens to be less than their current return. Cost of capital is much more important hurdle rate than
the company's current rate of return.
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EVA vs. EPS
EPS is raised simply by investing more capital in business. If the additional capital is equity (cash flow
then the EPS will rise if the rate of return of the invested capital is just positive. If the additional capital
is debt then the EPS will rise if the rate of return of the invested capital is just above the cost of debt. In
reality the invested capital is a mix of debt and equity and the EPS will rise if the rate of return of that
additional capital invested is somewhere between cost of debt and zero. Therefore EPS is completely
inappropriate measure of corporate performance and still it is very common yardstick and even a
common bonus base. EPS and earnings can be increased simply by pouring more money into business
even though the return on that money would be entirely unacceptable from the viewpoint of owners.
EPS, earnings and earnings/EPS growth should therefore be abandoned as performance measures.
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Chapter 2
Literature Review
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2.1 The Wealth Creation Framework
The Indian Rope TrickThe destruction of wealth (PPAF Services)
The wealth creation framework is the application of the EVA concept to the Indian corporate
world. The model has been tested on the BSE 100 stocks. This universe has been divided into
four sections based on two factors:
- Average EVA per share
- Compounded Average Rate of Growth of capital employed
On these two factors the Indian corporate diaspora can be classified into four types of companies.
These four sections are shown in the "Wealth Creation Matrix" shown below.
The four sections in order of decreasing value are.
TYPE A- This is the best type of company in the matrix as it creates wealth year after year on a
regular basis and also maintains a positive EVA with an increasing amount of capital employed
TYPE B- The companies falling under type B of the matrix are the next preferred companies as
these corporate segments are creating wealth but on a decreasing capital employed.
TYPE C- The corporates associated with this segment are known as destroyers of wealth. The
only remarkable behaviour of theirs is that they are reducing their capital employed; therefore they
are destroying capital on a reducing base.
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TYPE D- The worst type of company in the matrix lies under Type D as it not only destroys
wealth but also taking an increasing amount of capital into operation which are leading to wealth
destruction.
The wealth creation framework brings some amount meaning to an otherwise static EVA
analysis. This concept (EVA) in conjunction with the 'Wealth Creation Matrix' (WCM) can be
used to plot and understand the profitability movement of various economic entities over time.
The two measures used in the model indicates that the growth rate of capital employed reflects
the rate at which the company is growing and the average EVA is then compared to the change
in the capital base. The study of the matrix indicates that if a wealth destroyer is bringing in more
capital it is worse, similarly the logic flows for other segments of wealth creators.
The framework would be an ideal tool to allocate capital in a socialist economy. If the entire
economic capital needs are consolidated and then segmented among different companies, this
framework would help in making decisions.
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2.2 Examination of EVA as a performance measure
CCS.PGP P1-63
Shubra Pandit,IIM Bangalore
The EVA reflects the excess of returns over the opportunity cost of capital for the company. It is
an analysis of the historical performance using a measure that is considered to convey more
information than the traditional accounting measures. EVA competes with other measures in
predicting the true value of a firm and consequently it surrogates the stock price.
MULTIPLE GOALS TO THE COMMON INTEGRATED MEASURE EVA
EVA belongs to the class of metrics that attempt to measure an underlying concept called Residual
income, its based on the premise that in order for a firm to create wealth for its shareholders it
must earn more on its invested capital than the cost of that capital. whereas traditional accounting
net income measures profits net of interest expenses on debt capital, residual income measures
profits net of the full cost of debt and equity capital.
The idea behind EVA is that shareholder must earn a return that compensates the risk. In other
words equity capital has to earn at least same return as similarly risky investments at equity
markets. If that is not the case, then there is no real profit made and actually the company operates
at a loss from the viewpoint of shareholders.
EVATreasury
Management
Cost
Accounting
Human
Resource
Capital
Budgeting
Investors
Relations
Strategic
Planning
Valuation
Annual
Budgeting
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If EVA is zero, this should be treated as a sufficient achievement because the shareholders have
earned a return that compensates the risk. This approach using average risk adjusted market return
as a minimum requirement is justified since the average return is easily obtained from diversified
long term investments on stock markets. Average long term stock market return reflects the
average return that the public companies generate from their operations.
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2.3. The quest for value
Brian Carvalho
Business today, March 2001The EVA is a basis for effective decision making, corporate governance and employee motivation
framework. EVA is superior to traditional measures such as PAT, PBT and rates of return because
it replicates the discipline of the capital market within the firm by explicitly measuring returns
relative to the cost of capital.
EVA as measure states that growth without efficiency is bad and also that efficiency without
growth isnt really much better. Unless a company manages to increase its return on capital
employed, no amount of reduction in the cost of capital can widen the spread.
EVA = {NOPAT/ Capital Cost of capital}* capital
The Key strategies to increase Value are:
OPERATE: Improve the return earned on existing capital.
BUILD: Invest as long as returns exceed the cost of capital
HARVEST: Divest capital when returns fail to achieve the cost of capital.
OPTIMISE: Reduce cost of capital by optimizing capital structure.
The implementation of EVA is done in three phases.
1st
PHASES- Analyses businesses on EVA parameters like ROCE and MVA benchmark them
against peers understand shareholders expectations and work out historical EVAs as well as
projections for next three years.
2nd
PHASE- Train managers in methodologies to optimize EVA how to go about the task of
becoming efficient on the capital and operation fronts, and how to make the decisions to achieve
these efficiency with growth, be it through an investment, an acquisition or a divestiture.
3
rd
PHASE- The implementation of a variable compensation system for all employees. Incentives toteams will be worked out on the basis of how they manage to improve EVA on an incremental basis.
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2.4 Five Forces of Wealth Creations
Force I: High RoE
RoE substantially higher than the cost of capital signifies that the company possesses some edge
over its competitors. Continuation of this competitive advantage imparts longevity to the Wealth
Creation Process.
Force II: High RoE coupled with Increasing Capital Employed
W hen ever the RoE is high, there will be wealth creation. But, size of the wealth created is
dependent on the amount of capital employed. High capital employed is a function of the size of
the opportunity. Businesses which can consume substantial amounts of capital at high incremental
returns only can create Big Wealth because profitable growth through increasing RoE is generally
difficult and limited.
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Force III: Growth
High RoE starts the wealth creation process. Large capital deployment gives it size. But, most
investors are interested in SPEED. This comes from growth in free cash flow,
That is, C * (RoC G).
Growths in free cash flows can come by an increasing RoE or increasing the capital employed.
Generally, under normal circumstances one of the factors is increasing.
But, when a company finds itself in a situation when both the RoC as w ell as capital is growing,
the combination is exponential. This is what has happened in recent years in the Indian technology
stocks. This happens when:
a. Size of the opportunity is huge
b. Competitive advantage is wide and long
c. Managements are capable of seizing the opportunity
Force IV: Cost of Capital
The level of interest rates prevailing in the economy will determine the discount rate (cost of
capital) by which future free cash flows of the companies will be discounted to arrive at the present
value.
Higher the discount rate, lower will be the present value of future cash flows. Thus, the cost of
capital will be a key determinant of valuation of businesses.
Force V: Margin of Safety
Intrinsic value of a company is determined by the interplay of sum of free cash flows and cost of
capital. But, an investor will make money only if he buys at an attractive price. Eventually,
purchase price w ill determine the rate of return.
Never count on making a good sale. Have the purchase price be so attractive, that even a
mediocre sale gives an attractive return"
Warren Buffett
An investor has to understand what the price implied is in terms of free cash flow, growth andlongevity. To adjudge market expectations and a company's inherent capability to deliver free cash
flows in future, we have used our time-tested "Pay back ratio" barometer.
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Chapter 3
METHODOLOGY
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The study type is analytical as facts and existing information is used for the analysis based on
historical data for the period of 2000-2005 with the help of Quantitative toolsas EVA is calculated
and the variables are expressed in measurable terms.
3.1 Sample Profile
The sample undertaken for the research includes 100 companies of BSE100 Index of the Bombay
Stock Exchange (for which relevant data was available), for a period of 5 years starting from FY
2000-2001 to FY 2004-05.
The following are the sample 100 companies:
1) A B B Ltd.
2) Aditya Birla Nuvo Ltd.
3) Allahabad Bank
4) Andhra Bank
5) Arvind Mills Ltd.
6) Ashok Leyland Ltd.
7) Asian Paints Ltd.
8) Associated Cement Cos. Ltd
9) Bajaj Auto Ltd
10)Bank Of Baroda
11)Bank Of India
12)Bharat Electronics Ltd.
13)Bharat Forge Ltd.
14)Bharat Heavy Electricals Ltd
15)Bharat Petroleum Corpn. Ltd
16)Bharti Airtel Ltd.
17)Biocon Ltd.
18)Canara Bank
19)Century Textiles & Inds. Ltd.
20)Chennai Petroleum Corpn. Ltd.
21)Cipla Ltd.
22)Colgate-Palmolive (India) Ltd.
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23)Cummins India Ltd.
24)Dr. Reddy'S Laboratories Ltd.
25)G A I L (India) Ltd.
26)Glaxosmithkline Pharmaceuticals Ltd.
27)Glenmark Pharmaceuticals Ltd.
28)Grasim Industries Ltd.
29)Great Eastern Shipping Co. Ltd.
30)Gujarat Ambuja Cements Ltd.
31)H C L Technologies Ltd.
32)H D F C Bank Ltd.
33)Hero Honda Motors Ltd.
34)Hindalco Industries Ltd
35)Hindustan Lever Ltd.
36)Hindustan Petroleum Corpn. Ltd.
37)Housing Development Finance Corpn. Ltd.
38)I C I C I Bank Ltd.
39)I T C Ltd.
40)I-Flex Solutions Ltd.
41)Indian Hotels Co. Ltd.
42)Indian Oil Corpn. Ltd.
43)Indian Overseas Bank
44)Indian Petrochemicals Corpn. Ltd
45)Industrial Development Bank Of India Ltd
46)Infosys Technologies Ltd.
47)J S W Steel Ltd.
48)Jaiprakash Associates Ltd.
49)Jindal Steel & Power Ltd.
50)Kochi Refineries Ltd.
51)Kotak Mahindra Bank Ltd.
52)Larsen & Toubro Ltd.
53)Lupin Ltd.
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54)Mahanagar Telephone Nigam Ltd.
55)Mahindra & Mahindra Ltd.
56)Mangalore Refinery & Petrochemicals Ltd.
57)Maruti Udyog Ltd.
58)Matrix Laboratories Ltd.
59)Moser Baer India Ltd.
60)Motor Industries Co. Ltd.
61)N T P C Ltd.
62)National Aluminium Co. Ltd.
63)Nestle India Ltd.
64)Neyveli Lignite Corpn. Ltd.
65)Nicholas Piramal India Ltd.
66)Oil & Natural Gas Corpn. Ltd.
67)Oriental Bank Of Commerce
68)Patni Computer Systems Ltd.
69)Petronet L N G Ltd.
70)Pfizer Ltd.
71)Punjab National Bank
72)Ranbaxy Laboratories Ltd.
73)Raymond Ltd.
74)Reliance Capital Ltd.
75)Reliance Energy Ltd.
76)Reliance Industries Ltd.
77)Satyam Computer Services Ltd.
78)Sesa Goa Ltd.
79)Shipping Corpn. Of India Ltd.
80)Siemens Ltd.
81)State Bank Of India
82)Steel Authority of India Ltd.
83)Sterlite Industries (India) Ltd.
84)Sun Pharmaceutical Inds. Ltd.
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85)Tata Chemicals Ltd.
86)Tata Consultancy Services Ltd.
87)Tata Motors Ltd.
88)Tata Power Co. Ltd.
89)Tata Steel Ltd.
90)Tata Tea Ltd.
91)Tata Teleservices (Maharashtra) Ltd.
92)U T I Bank Ltd.
93)Ultratech Cement Ltd.
94)Union Bank Of India
95)United Phosphorus Ltd.
96)Videsh Sanchar Nigam Ltd.
97)Vijaya Bank
98)Wipro Ltd.
99)Wockhardt Ltd.
100) Zee Telefilms Ltd.
3.2 Data gathering procedure and Instrumentation
Data typeThe data required for the research has been collected from secondary resources Prowess and the
database of Capital Market Publishers (India) Ltd., Capitaline 2000 Capitaline Database, historical
earnings and financial Information such as dividend and new equity issue of the sample companies for
the specified time period.
Valuation Parameters
The following parameters are used for valuing the companies:-
1. Net operating profit less adjusted taxes(NOPLAT)
2. Return on capital employed(ROCE)
3. Weighted average cost of capital (WACC)
4. Wealth Added Index
5. Economic Value Added
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3.3 Research Calculations
The specified companies are evaluated for various performance metrics to analyze its impact on
wealth creation or wealth added.Wealth Added =
Change in Market Capitalization
LESS: Required return
ADD: Dividends
LESS New Equity Issues
Wealth Added measures the extent of capital appreciation in the market value of the equity of the
firm netted for new equity issuances plus the extent of cash return to shareowners in the form of
dividend of equity buybacks, less an opportunity cost charge equal to investors cost of equity
expectations.
WAI can help management being more disciplined in creating wealth to shareholders as suggested
by the Nobel Laureates Merton Miller and Franco Modigliani.
o Increase net operating profit after taxes through enhancing operating efficiency
o Rationalize capital expenditure by improving capital efficiency
o Ensure adequate rates of return on new investment by putting in place a world class capital
investment analysis framework
o Managing sources of fund toward optimal capital structure
o WAI is a practical way to measure the ultimate performances of management.
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3.4 Data Analysis
The data considered for the research on wealth creation of the sample companies studies the
amount of wealth added on a year to year basis and its impact on the time period considered for the
research. The study also determines the real economic profit measured in terms of EVA which
benefits the company and its stakeholders in real terms. The research also states that the forces
which drive a company are performance, potential for growth and the position it holds in the
mindset of its shareholders and the market.
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Chapter 4Research
Findings & Analysis
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Table 4.1 The Largest Wealth Creators for 2000-2005
S.NO Company Name
Market
Cap
Required
Return Dividend
New Equity
Issue
WEALTH
ADDED
1Oil & Natural Gas Corpn.Ltd. 89759.61 7819.07 5703.74 10694.4975 76949.78
2 Indian Oil Corpn. Ltd. 39931.19 3306.77 1693.62 0 38318.04
3 Reliance Industries Ltd. 35515.43 5894.53 1045.13 0 30666.03
4 I C I C I Bank Ltd. 19915.07 607.82 626.21 334.9019604 19598.56
5
Steel Authority Of India
Ltd. 16704.44 531.27 1363.03 0 17536.20
6 Tata Motors Ltd. 13729.7 384.33 452.19 0 13797.56
7 Tata Steel Ltd. 12287.95 1139.62 719.51 0 11867.84
8
Bharat Heavy Electricals
Ltd. 11652.41 661.26 195.81 0 11186.96
9 Ranbaxy Laboratories Ltd. 12484.73 1939.48 316.17 0 10861.42
10 State Bank Of India 17523.86 8254.55 657.87 0 9927.18
Interpretation
The research study shows that Oil & Natural Gas Corporation Ltd which is better known as
ONGC has added maximum wealth for the specified time period and provided high returns to itsshareholders in terms of dividend.
Taking an overview of the arrived results, we observe that the major sectors creating wealth are
the industrial-oil & gas, transportation and financial services. The reason behind such behaviour is
that market values are forward looking and include an expectation premium, market prices over the
medium-term are driven more by differences in actual performance and expectations, by the
strength of the actual fundamental performance.
Exceeding the investors expectation alone does not enhance absolute wealth flows; it requires
outperforming expectations by converting currently embedded expectations into observable
profitability.
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The companies should develop growth prospects that can create value and eventually deliver
returns above the cost of capital. This can be achieved by setting a target intrinsic value for the
business and explicit wealth flow goals on the intrinsic value, Use of alternate strategies for
maximizing wealth added and managing medium term performance and design equity linked
rewards.
Table 4.2 The Toppers in terms of Economic Value Added (2000-2005)
S.NoCompany Name EVA
1Oil & Natural Gas Corpn. Ltd. 9436.315
2
Steel Authority Of India Ltd. 6326.803
3I C I C I Bank Ltd. 5623.73
4Reliance Industries Ltd. 4571.595
5Tata Steel Ltd. 3172.197
6Bharti Airtel Ltd. 1401.365
7Tata Motors Ltd. 1325.009
8Indian Oil Corpn. Ltd. 1287.517
9Mangalore Refinery & Petrochemicals Ltd. 1148.371
10Infosys Technologies Ltd. 1093.932
Interpretation
The enterprise value of a firm is equal to the market value of the equity and the market value
of the debt or the present value of all future free cash flows. EVA analysis can be applied to
disaggregate a given enterprise value at any time to explicitly derive investor expectations for
future growth.
The analysis from the EVA outcome states that the investors should focus on cheaply priced
but fundamentally strong companies rather than harping over the irrationally priced stocks in the
market.
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The EVA calculation facilitates the investors in realizing the difference between capital gain
and net earning in terms of returns; also it educates the investors to invest in relatively small
capitalization companies having high potential to create value for the shareholders on a consistent
basis.
Table 4.3 The Largest Wealth Creators for 2004-2005
S.NO Company Name
MarketCap
Required
Return Dividend
New
Equity
Issue
WEALTH
ADDED
1
Oil & Natural Gas Corpn.
Ltd. 1288.27 41454.10 400 0 39765.83
2 Indian Oil Corpn. Ltd. -350.01 14769.99 145 0 14975.00
3 Infosys Technologies Ltd. 5245.98 18708.15 230 0 13232.17
4 Reliance Industries Ltd. -766.89 11947.14 75 0 12639.03
5 Bharti Airtel Ltd. 3404.62 1412.18 0 0 1992.44
6
Glenmark Pharmaceuticals
Ltd. 554.74 234.22 35 0 355.52
7 Petronet L N G Ltd. 360.09 21.48 0 0 338.61
8 Jindal Steel & Power Ltd. 345.24 391.78 300 0 253.46
9 Sterlite Industries (India) Ltd. 681.85 503.47 60 0 238.38
10 Arvind Mills Ltd. 327.13 153.64 10 0 183.49
Interpretation
The Research study for wealth creation undertaken for the time period 2000-01 to 2004-05 has
been further been analysed to identify the consistent wealth creators. This has been done by
studying the changes in wealth creation from year to year basis, which also reflects the wealth
destroyers.
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The Oil & Natural Gas corporation has a zenith positioned followed by Indian Oil corporation Ltd
and Infosys Technologies Ltd. The analysis reflects that ONGC has the top position also
maintaining an accountable margin with its successive wealth creator.
The top list for wealth creators is mainly formed by stocks of Petroleum, Power and heavy
industries.
Table 4.4 The Toppers in terms of Economic Value Added (2004-2005)
S. No Company Name EVA
1 Oil & Natural Gas Corpn. Ltd. 4995.844
2 Steel Authority Of India Ltd. 4532.724
3 Reliance Industries Ltd. 1984.297
4 Tata Steel Ltd. 1836.282
5 Bharti Airtel Ltd. 1406.937
6 National Aluminium Co. Ltd. 558.537
7 Shipping Corpn. Of India Ltd. 530.46
8 Infosys Technologies Ltd. 528.087
9 Mangalore Refinery & Petrochemicals Ltd. 521.787
10 Indian Petrochemicals Corpn. Ltd. 391.391
Interpretation
The top companies in terms of Economic Value addition are ONGC, Steel Authority of India and
Reliance Industries Ltd. On the basis of EVA these companies can be termed as Consistent value
creators. Bharti Airtel Ltd and the National Aluminums Co. Ltd are a new entrant to the list of top
economic value added companies, where as Mangalore Refinery & Petrochemicals Ltd has moved
to a lower position from its last ranking.
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Table 4.5 The Largest Wealth Creators for 2003-2004
S.NO Company Name
Market
Cap
Required
Return Dividend
New
Equity
Issue
WEALTH
ADDED
1 Bharti Airtel Ltd. 18870.27 470.9285524 0 18399.34
2 Reliance Industries Ltd. 21257.2 8401.0185 52.5 0 12908.68
3 Indian Oil Corpn. Ltd. 20344.1 8980.465448 210 0 11573.63
4
Oil & Natural Gas Corpn.
Ltd.38604.37 26777.49547 240 1069.44975 10997.42
5 I C I C I Bank Ltd. 9754.79 2342.919152 75 0 7486.87
6 Tata Motors Ltd. 7924.36 1450.491462 80 0 6553.87
7 Reliance Energy Ltd. 6741.97 395.089748 45 0 6391.88
8
Bharat Heavy Electricals
Ltd. 6703.46 1310.100322 60 0 5453.36
9 Infosys Technologies Ltd. 14472.47 12112.17294 2590 0 4950.30
10
Steel Authority Of India
Ltd. 7111.25 2279.951149 0 0 4831.30
Interpretation
The research study for the financial period 2002-03 and 2003-04 has shown an interesting
highlight. Bharti Airtel Ltd had been positioned on the top most level, which the traditional players
of wealth creation making their presence in the wealth creation list. ICICI Bank is the only
financial entity which has made its presence in the top wealth creator list.
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Table 4.6 The Toppers in terms of Economic Value Added (2003-2004)
S. No Company Name EVA1 Steel Authority Of India Ltd. 1755.964
2 Tata Steel Ltd. 900.599
3 Reliance Industries Ltd. 824.138
4 Indian Oil Corpn. Ltd. 691.131
5 Mangalore Refinery & Petrochemicals Ltd. 554.862
6 Tata Motors Ltd. 481.285
7 Hindustan Petroleum Corpn. Ltd. 329.581
8 Shipping Corpn. Of India Ltd. 299.159
9 Bharat Heavy Electricals Ltd. 221.858
10 Infosys Technologies Ltd. 217.364
Interpretation
The financial years 2002-03 and 2003-04 compared for the evaluation of highest Economic Value
addition reflects Steel Authority Of India Ltd, Tata Steel Ltd and Reliance Industries Ltd as the top
three players in terms of economic value added.ICICI Bank which had been declared the top EVA
company of 2002-03 has shown complete absence in the top ten list this year.
The Gaining Company of the study is Mangalore Refinery & Petrochemicals Ltd. The company
has been a new entrant in the List of top EVA companies.
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Table 4.7 The Largest Wealth Creators for 2002-2003
S. NO Company Name Market Cap
Required
Return Dividend
NewEquity
Issue
WEALTH
ADDED
1 Reliance Industries Ltd. 19187.62 5200.14 50 0 14037.48
2 Indian Oil Corpn. Ltd. 15930.68 4446.91 210 0 11693.77
3
Oil & Natural Gas Corpn.
Ltd. 26033.38 16880.13 300 0 9453.25
4
Steel Authority Of India
Ltd. 6905.73 696.61 160 0 6209.12
5 I C I C I Bank Ltd. 4849.19 1281.92 75 0 3642.27
6
Mangalore Refinery &
Petrochemicals Ltd. 3476.49 81.91 0 0 3394.58
7 Bharti Airtel Ltd. 3419.97 300.34 0 0 3119.63
8 Tata Motors Ltd. 3626.02 779.82 40 0 2886.20
9 Tata Steel Ltd. 3800.42 1215.64 80 0 2664.78
10
Bharat Heavy Electricals
Ltd. 3343.18 721.30 40 0 2661.88
Interpretation
The wealth creation research study based on the time period 2001-02 and 2002-03 reflects that the
petroleum companies are the top wealth creators. They are reliance Industries Ltd, Indian Oil
Corporation Ltd and Oil & Natural gas Corporation Ltd.
The Bharti Airtel which has the top position in the last research study has moved to quite a lower
position. ICICI bank maintains a monopoly in the wealth creators list. The investors should
identify the wealth creating stocks and buy them on a lower intrinsic to gain profits.
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Table 4.8 The Toppers in terms of Economic Value Added (2002-2003)
S. No Company Name EVA (03-02)
1 I C I C I Bank Ltd. 5199.544
2 Oil & Natural Gas Corpn. Ltd. 4841.333
3 Indian Oil Corpn. Ltd. 2123.205
4 Steel Authority Of India Ltd. 837.27
5 Hindustan Petroleum Corpn. Ltd. 733.684
6 Neyveli Lignite Corpn. Ltd. 349.314
7 Tata Motors Ltd. 320.348
8 Ranbaxy Laboratories Ltd. 262.927
9 Indian Petrochemicals Corpn. Ltd. 203.091
10 National Aluminium Co. Ltd. 174.069
Interpretation
The Economic Value Addition has been a measure of efficiency. The competitive list for highest
EVA shows that ICICI Bank had topped the list, also stating that the bank is the only entity that
has marked a presence in the top ten list of economic value addition. The other players preceding
are the traditional players representing Power, Petroleum and Natural gas sector.
The commendable highlight of the EVA study shows that ICICI Bank which was on 4 th position in
the last evaluation had gained EVA to top the list.
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Table 4.9 The Largest Wealth Creators for 2001-2002
S. NO Company Name
MarketCap
RequiredReturn Dividend
New
EquityIssue
WEALTHADDED
1
Oil & Natural Gas Corpn.
Ltd. 23833.59 7819.07 140 0 16154.52
2 I C I C I Bank Ltd. 3080.86 607.82 20 0 2493.04
3
Hindustan Petroleum
Corpn. Ltd. 3295.05 1395.11 100 0 1999.94
4 Neyveli Lignite Corpn. Ltd. 2169.01 323.26 13.5 0 1859.25
5 Tata Motors Ltd. 2138.25 384.33 0 0 1753.92
6
National Aluminium Co.
Ltd. 2364.29 867.46 40 0 1536.83
7 Bajaj Auto Ltd. 1798.12 521.07 140 0 1417.05
8 Ranbaxy Laboratories Ltd. 2915.99 1939.48 150 0 1126.51
9
Shipping Corpn. Of India
Ltd. 1118.28 175.38 35 0 977.90
10
Indian PetrochemicalsCorpn. Ltd. 1102.63 230.25 20 0 892.38
Interpretation
The research study indicates that Oil & Natural Gas Corporation has been positioned the top most
wealth creator for the time period Financial year 2000-01 and 2001-02.The successive to ONGC in
the list are the ICICI Bank which is the only financial entity in the list and Hindustan Petroleum
Corporation.
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Table 4.10 The Toppers in terms of Economic Value Added (2001-2002)
S. No Company Name EVA (02-01)1 Reliance Industries Ltd. 1592.738
2 Indian Oil Corpn. Ltd. 1057.868
3 Oil & Natural Gas Corpn. Ltd. 703.059
4 I C I C I Bank Ltd. 612.409
5 Bharat Heavy Electricals Ltd. 317.842
6 Bajaj Auto Ltd. 294.609
7 Tata Motors Ltd. 265.846
8 Ranbaxy Laboratories Ltd. 180.726
9 Infosys Technologies Ltd. 174.734
10 Neyveli Lignite Corpn. Ltd. 126.413
Interpretation
The Comparison between the financial years 2000-01 and 2001-02 on the basis of EVA reflects
that the petroleum and natural industry had shown a remarkable addition in terms of Economic
Value Added. The top companies in the list are Reliance Industries Ltd, Indian Oil Corporation.
Ltd and Oil & Natural Gas Corporation which has shown an incredible value creation. These
stocks are positioned as hot cakes in the stock market. The only IT player making its presence in
the top Economic Value added list is Infosys Technologies Ltd.
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Chapter 5
Conclusions&
Recommendations
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Consistency in Wealth Creation
New leaders are created and several leaders of the yesteryears face demise
Yet, there are the resilient few that weather all storms and remain in the reckoning
The research provides a fundamental platform to investors to analyze the companies in terms of its
present position; earning capabilities and the growth potential unleashed which leads to value
addition and subsequently wealth creation.
The Investors in the market need identify companies that are strong and posses a future growth
potential. The selection of stocks in an individuals portfolio depends on each individual investors
investment objective and should be clearly defined at the beginning of the investment cycle.
Consistent wealth creators can help meet these investment objectives.
Investors often like to be associated with fast wealth creators; but its difficult to identify such
stocks in their early stages. In fact, several consistent wealth creators have been fast wealth
creators at some point of time such as ONGC, Reliance Industries.
Consistent wealth creators are known for their demonstrated earnings power over a long period of
time.
The first benefit of investing in consistent wealth creators is that the investors are looking at a very
small number of companies, at a given point of time. Secondly, these are established large
companies and leaders in their own fields. Safety of capital invested in them would be very high.
The EVA analysis draws attention towards economic profit and Market value added, but while
economic value added is a more scientific approach, it has been hyped too much. Not all corporate
actions may meet the EVA criteria but otherwise may be strategically right. EVA contributes to
wealth creation but high EVA may not lead to higher market value. EVA recognizes that in
capital-intensive industries returns cannot be expected in a short time. The initial EVA-negativeyears will be built into the EVA capital budgeting framework, as is the year in which the company
is scheduled to go EVA-positive. If company fails to achieve the desired level of performance as
forecasted in the capital approval process it will be an accounting issue.
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Many have argued that EVA has its most appropriate use in asset rich companies and less useful in
companies with a large price to book ratio. (Value Enhancement Strategies: Damodaran) however,
this does not account for the successful EVA implementation in Coca Cola.
Studies reflect that the success of EVA is more dependent on whether the company is in a growth
or a more stagnant stage of its life cycle.
Critics claim that EVA is too short sighted a measure in order to capture value creation. By cutting
down on investments a company can boost its EVA; however this might not be the right move in
the long run. Stern Stewart argues that this is a mistaken notion; EVA does not penalize large
investments-as long as the new projects are able to earn more than their opportunity cost of capital.
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Annexures
Websites:
www.motilaloswal.com
www.EVA.com
www.icfai.org
www.valuebasedmanagement.com
Journals:
Business Today- stem steward survey (April 2004)
Motilal Oswals 10th Wealth Creating Study
Brian Carvalho, Business today, March 2001
CCS.PGP P1-63, Shubra Pandit,IIM Bangalore
The Indian Rope TrickThe destruction of wealth (PPAF Services)
http://www.valuebasedmanagement.com/http://www.icfai.org/http://www.eva.com/http://www.motilaloswal.com/