Academic journal article IUP Journal of Business Strategy

Assessing Corporate Performance with Measures of Value Added as Key Drivers of Shareholder Wealth: An Empirical Study

Academic journal article IUP Journal of Business Strategy

Assessing Corporate Performance with Measures of Value Added as Key Drivers of Shareholder Wealth: An Empirical Study

Article excerpt

Introduction

With globalization and well-evolved capital markets in India, corporations have understood that in order to perform well and sustain in the booming economy, they need to create wealth to their shareholders. In order to create wealth, the company has to maximize its total value and enhance its performance through various operations and activities it undertakes. If a company is giving more returns to its shareholders, not only is it judged as a good performing company but also its shareholder base increases and vice versa. To achieve this objective, financial performance measures are needed to assess the firms' endurance in the longer run. In measuring a company's performance and its efficiency, many traditional accounting measures were used earlier. With inception of Economic Value Added (EVA) and Market Value Added (MVA) by Stern Stewart in the early 1990s companies started using these measures to assess their financial performance in terms of value creation. Stern Stewart claimed that MVA is a wealth metric which is positively related to EVA and EVA is a performance metric.

EVA, being a financial performance measure, measures economic profit created by the business and is rightly compared to accounting profit which companies announce annually. In India, the cost of procuring capital is very high, hence the management of the companies should make humongous effort to get maximum profit from every penny they invest in business. Till EVA concept was introduced, cost of capital is considered free and was never calculated when deriving profits. Thus this gap was identified and was addressed aptly through EVA concept. EVA is the difference between a company's profit and the full cost of its capital.

EVA, in general, does not take into account if a company is making profit or loss. It takes into account only the earnings that remain after all costs from all resources are taken into account, including opportunity cost of capital. After meeting this obligation if the company is still left with earnings, then it means that it created a positive EVA, meaning that it created wealth to its shareholders, else it created a negative EVA, meaning that it destroyed the wealth of shareholders. Hence, if the company is having negative EVA continuously, then there is a chance that shareholders shift their funds elsewhere. This is because the company is failing to generate adequate returns on their investment either in the short term or in the long term to its shareholders. This certainly reflects on shareholders' decision while or during their plan to invest or retract an investment/financial decision in that company.

MVA is another measure developed by Stern Stewart. MVA is a wealth metric and is directly related to EVA. From the investors' point of view, MVA is the best external measure of company's performance. Stewart states that MVA is a cumulative measure of corporate performance and that it represents stock market's assessment of firm's performance and its ability to sustain in the market in the long run, closely observing if value has been created or destroyed by the firm over a period of time. A company's total market value is equal to the sum of the market value of its equity and the market value of debt. MVA is the difference between total market value of the company and invested capital.

Literature Review

Stewart (1991) was the first person who studied the relationship between EVA and shareholder wealth with market data of 618 US companies and presented the results in his book The Quest for Value. The study found that MVA and EVA correspond to each other best when changes in EVA and MVA were studied and not the absolute levels. Moreover, changes in EVA and MVA were not affected so much by accounting distortions and inflation than the absolute values. Further, Stern et al. (1995) concluded that changes in EVA over a five-year period explained 50% of the change in MVA over the same period. …

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