Academic journal article UTMS Journal of Economics

A Review of the Economic Value Added Literature and Application

Academic journal article UTMS Journal of Economics

A Review of the Economic Value Added Literature and Application

Article excerpt

(ProQuest: ... denotes formulae omitted.)

INTRODUCTION

Complex, turbulent and uncertain conditions of the internal and external environment of enterprises complicate the process of managing the value of a firm. The management of competitive advantages and firm value as well as their planning requires the selection of appropriate management technology. In an environment filled with strategic fractures it is extremely difficult for value analysts that create, maintain and develop competitive advantages and the value of the firm to rely on the assumption of stable environment of the firm. The development of a suitable management technology is primarily driven by practical needs and the necessity of solving developmental problems of firms. Though the intimate connection between business strategy and the search for (customer) value is well established in the field of strategy, it is somewhat surprising to find only scarce research on how firms create value in contrast to the abundant ideas on value appropriation (Becerra 2009, 91). The changes in management technology are therefore caused by the strong growth in internal and external complexity of the firm, where problems of designing and implementation of business decisions (as well as their control, including ex-post and ex-ante control) are being tackled with an ever increasing set of performance measurement tools and criteria.

Most, if not all value based management performance measures use some form of discounted cash-flow technique to estimate how much a new strategy might affect shareholder value. These financial tools for strategic decision making, including option pricing theory, are widely used by managers, and the most basic of them are usually included in strategic management textbooks. The problem lies in the fact that financial analysis is not really intended to understand where value ultimately comes from. There are important aspects of strategic management that are not facilitated by the use of these techniques, like the analysis of customers, competitors and resources. Basically, how the management of the firm handles these categories will determine financial implications for shareholder value (Becerra 2009, 90).

In order to solve this practical problem, Stern and Stewart developed the Economic Value Added (EVA)2 performance measure in 1991. It measures the dollar value of the firm's return in excess of its opportunity cost (Bodie, Kane, and Marcus 2014, 644). Indeed, Hall (Hall 2013) lists a number of studies (Stewart, 1991; Stern, 1993; O'Byrne, 1996; Chen and Dodd, 1997; Hall, 1999; Chmelikova, 2008) confirming the superiority of the valuation using economic value added compared to traditional accounting performance indicators. EVA as a measure of company's performance places the emphasis on the creation of value by the management for the owners since it takes into account the cost of capital employed. From the standpoint of an investor, EVA provides a better predictor of market value of a company than other measures of operating performance (O'Byrne 1996). Furthermore, it takes into account the social aspect of an enterprise. As Peter Drucker explained it (Drucker 1995), "until a business returns a profit that is greater than its cost of capital, it operates at a loss. Never mind that it pays taxes as if it had a genuine profit. The enterprise still returns less to the economy than it devours in resources. "

1.THE ECONOMIC VALUE ADDED CONCEPT

The concept of Economic Value Added is based on the work of professors Franco Modigliani and Merton H. Miller. In 1961 they published the seminal paper "Dividend Policy, Growth and the Valuation of Shares" in the Journal of Business. Modigliani and Miller showed that corporate investment decisions - manifested in positive NPV decisions - are the primary driver of a firm's enterprise value and stock price - as opposed to the firm's capital structure mix of debt and equity securities (Grant 2003, 3). …

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