EVA as an Indicator of Firm Performance:<br /> The Turkish Airlines Example<br /> Önder BARLAS<br /> Executive MBA Student<br /> Boğaziçi University, Istanbul<br />-7311662792400Abstract: This paper aims to give performance based view of the EVA concept. First the EVA concept will be explained based on a literature research followed by a comparison of EVA with other performance measures. Afterwards EVA for Turkish Airlines will be calculated and compared with the company’s current values.<br />305108413770500<br /><ul><li>INTRODUCTION</li></ul>Investors are currently demanding Shareholder value more strongly than ever. In the1980s, shareholder activism reached unforeseen levels with the companies in the United States. Thereafter also investors in Europe have increased the pressure on companies to maximize shareholder value. Even in Finland the so-called Shareholder value –approach has gained grounds. This is due to e.g. abolishing the restrictions on foreign stock ownership. Foreign investors emphasize and demand focus on Shareholder value –issues (1).<br /> <br />The financial theory has since long suggested that every company’s ultimate aim is to maximize the wealth of its shareholders. That should be natural since shareholders own the company and as rational investors expect good long-term yield on their investment. In the past, this ultimate aim has however been often partly ignored or at least misunderstood. This can be seen e.g. from measurement systems. Metrics like Return on investment and Earnings per share are used as the most important performance measures and even as a bonus base in a large number of companies, although they do not theoretically correlate with the Shareholder value creation very well. Against this background it is no wonder that so-called Value based measures have received a lot of attention in the recent years. These new performance metrics seek to measure the periodic performance in terms of change in value. Maximizing value means the same as maximizing long-term yield on shareholders’ investment (2). <br />Currently the most popular Value based measure is Economic Value Added (EVA). EVA figures have also been heavily promoted in the UK, Australia, Canada, Brazil, Germany, Mexico, Turkey and France, amongst others used to provide published rankings of managerial performance and several international companies have adopted EVA for performance measurement and/or incentive compensation packages (13). <br /><ul><li>THE MAIN THEORY BEHIND EVA</li></ul>Unlike traditional measures of proﬁt—such as EBIT, EBITDA, and net operating income—EVA looks at the ﬁrm’s “residual proﬁtability,” net of both the direct cost of debt capital and the <br />Indirect cost of equity capital. In this way, EVA serves as a modern-day measure of corporate success because it is closely aligned with the shareholder wealth-maximization requirement.<br />There are two popular, or operational, ways of deﬁning EVA—namely, an “accounting” way and a “ﬁnance” way. <br />30401996531400From an accounting perspective, EVA is deﬁned as the difference between the ﬁrm’s net operating proﬁt after tax (NOPAT) and its weighted-average cost of capital. As a result, EVA differs from traditional accounting measures of corporate proﬁt including, EBIT (earnings before interest and taxes), EBITDA (EBIT plus depreciation and amortization), net income, and even NOPAT because it fully accounts for the ﬁrm’s overall capital costs. This analytical difference is important to the ﬁrm’s owners because the EVA metric is net of both the direct cost of debt capital and the indirect cost of equity capital—as reﬂected in the shareholders’ required return on common stock. In this context, EVA can be expressed in more general terms as (3):<br />EVA = NOPAT – Cost of Capital<br />From a ﬁnance perspective, EVA is deﬁned in terms of how it relates to the ﬁrm’s “market value added.” In this context, MVA is equal to the present value of the ﬁrm’s expected future EVA. Additionally, since MVA is equal to the market value of the ﬁrm less the “book capital” employed in the business, it can easily be shown that EVA is related to the intrinsic value of the ﬁrm and its outstanding debt and<br />equity securities (8).<br />MVA = Firm value – Total capital<br />MVA = [Debt plus Equity value] – Total capital<br />MVA = PV of expected future EVA<br /><ul><li>ADVANTAGES AND DISADVANTAGES OF EVA</li></ul>EVA has many distinctive advantages (5):<br />-earnings per share and return on investment/assets do not reflect the true cost of capital, there is no hinge whether shareholders value have been created or destroyed,<br />-it helps managers to make better investment decisions, identify improvement opportunities and consider long –term and short-term benefits for the company;<br />-it measures the quality of managerial decisions and indicates the value growth in the future. The higher the EVA in any year, the better job managers are doing in using fund capital to create additional value,<br />-it’s very easy to compute EVA, extracting the data from both the income statement and the balance sheet and adjusting it.<br />-EVA is also really the discounted free cash flows of a business<br />Limitations of EVA are (12):<br />-EVA, on its own, is inadequate for assessing a company’s progress in achieving its strategic goals and in measuring divisional performance,<br />-in certain industries EVA alone is an inappropriate measure of financial performance,<br />-EVA is distorted by inflation; it cannot be used during inflationary times to estimate actual profitability,<br />-EVA is distorted by the fact of the upfront normal depreciation being small at the beginning of a project and big at the end of the project. Therefore companies with a lot of new investments have lower EVA than their true profitability would imply and companies with a lot of old investments have bigger EVA than their true profitability would imply. The extent of this challenge depends on the asset structure (the relative proportions of current assets, depreciable assets, un-depreciable assets) and on the length of the investment period, -another problem is how we measure relative value within the overall marketplace. A company can experience positive EVA, but have a declining share of value within the marketplace. If the competition is gaining more and more of the wealth within the marketplace, it will take a lot more than positive EVAs to sustain long-term values.<br /><ul><li>EVA AS PERFORMANCE MEASURE</li></ul>Conceptually, EVA is superior to accounting profits as a measure of value creation because it recognizes the cost of capital and, hence, the riskiness of a firm’s 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. <br />4.1 EVA and MVA<br />Both MVA and EVA are applicable to investor-owned organizations; however, EVA also is an appropriate measure for not-for-profit organizations. MVA assesses the effect of managerial actions on shareholder wealth from an organization's inception, while EVA assesses managerial effectiveness in a given year.<br />It can be concluded that there are basically only three ways in which a company can increase its MVA (8)<br /><ul><li>By making new investments in projects with a positive return spread (positive EVA);
By expanding current projects earning a positive EVA;
By scaling down or eliminating projects that have a negative EVA.</li></ul>MVA could also be calculated as follows (7):<br />MVA = current EVA / (WACC – g)<br />-7737921771004.2 EVA and ROI <br />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 these rates of return is in all cases that maximizing rate of return does not necessarily maximize the return to shareholders. Following simple example will clarify this statement: <br />Suppose a group with two subsidiaries. For both subsidiaries and so for the whole group the cost of capital is 10%. The group names maximizing ROI as target. The other subsidiary has ROI of 15% and the other ROI of 8%. Both subsidiaries begin to struggle for the common target and try to maximize their own ROI. The better daughter company rejects all the projects that produce a return below their current 15% although there would be some projects with return (IRR) 12% - 13%. The other affiliate, in turn, accepts all the projects with return above 8%. For a reason or another (e.g. overheated competition) it does not find very good projects, but the returns of its projects lie somewhere near 9% (9). <br />Let us suppose that both subsidiaries manage to increase their ROI. With the better subsidiary ROI increases from 15% to 16% and with the not-so-good subsidiary ROI increases from 8% to 8,5%. The company’s target, increasing ROI, is achieved but what about the shareholder value? It is obvious that all the projects of the not-so-good subsidiary decrease shareholder value, because the cost of capital is more than rate of return (and so the shareholders money would have been better off with alternative investments e.g. in the markets). But the actions of the better subsidiary are neither optimal for shareholders. Of course shareholders will benefit from the good (return over 15%) projects but also all 12%-13% (actually all above 10% = cost of capital) projects should have been accepted even though they decrease current ROI. These projects still create and increase shareholder value (9). <br />As the above example demonstrates 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 (4). Cost of capital is much more important hurdle rate than the company's current rate of return (9). <br />Observing rate of return and making decisions based on it alone is similar to assessing products on the "gross margin on sales" -percentage. The product with the biggest "gross margin on sales" -percentage is not necessary the most profitable product. The product profitability depends also on the product volume. In the same way bare high rate of return should not be used as a measure of a company's performance. Also the magnitude of operations i.e. the amount of capital that produces that return is important. High return is a lot easier to achieve with tiny amount of capital than with large amount of capital. Almost any highly profitable company can increase its rate of return if it decreases its size or overlooks some good projects, which produce a return under the current rate of return. <br />-773793265700In the corporate control it is worth remembering that EVA and NPV go hand in hand as also ROI and IRR. The formers tell us the impacts to shareholders wealth and the latter’s telling us the rate of return. There is no reason to abandon ROI and IRR. They are very good and illustrative measures that tell us about the rate of returns. IRR can always be used along with NPV in investment calculations and ROI can always be used along with EVA in company performance. However, we should never aim to maximize IRR and ROI and we should never base decisions on these two metrics. IRR and ROI provide us additional information, although all decisions could be done without them. Maximizing rate of returns does not matter, when the goal is to maximize the returns to shareholders. EVA should be in the commanding role in corporate control and ROI should have the role of giving additional information (9).<br />4.3 Return on equity (ROE) <br />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 simply increasing leverage can increase ROE. As we all know, decreasing solvency does not always make shareholders’ position better because of the increased (financial) risk. Therefore return on equity (ROE) is also an informative measure but it should not guide the operations (11).<br /> <br />4.4 EVA and EPS <br />There is currently a heated debate among practitioners about whether EVA has a higher correlation with stock values and their returns than traditional accounting measures. Many studies undertaken on the importance of EVA and its relationships with the share price led to opposing conclusions. <br />Anderson and Bey (1998) state that EVA varies over time and it is significantly correlated with accounting variables. Contracting this is O’Byrne’s (1997) study which shows that changes in EVA explain more of the variation in ten-year stock returns than changes in earnings, and significantly more of the variation in five-year returns. Appleby (1997) states that EVA is a lagging indicator that looks into a company’s past performance; it provides no indication of the company’s performance in the future. In contrast, Chamberlain and Campbell (1995) indicate that EVA allows management to quickly see in which way a company is heading and that EVA serves as a good predictor of future performance.<br />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 (11).<br /><ul><li>IMPROVING EVA</li></ul>3094627-614435100First, like any financial measure, the trend may be more valuable than the absolute value of EVA. Even if EVA is positive, a declining EVA suggests that financial performance is deteriorating over time, and if this trend continues EVA will become negative and financial performance unacceptable. A negative EVA indicates that the firm is not compensating its capital resources adequately, and corrective action should be considered if this negative EVA persists over time. These corrective measures can be (4):<br /><ul><li>Operating performance with respect to operating profit margins or asset turnover ratios could be improved to generate more revenue without using more capital.
Capital invested in the business might be reduced by selling under-utilized assets; this strategy will simultaneously improve operating performance through a higher asset turnover ratio, as well as a reduced capital charge against those earnings because of a reduced debt or equity capital investment.
Redeploying the capital invested to projects and activities that have higher operating performance than the current projects or investments are exhibiting. And fourth, if the business is not highly leveraged, change the capital structure by substituting lower cost debt for higher cost equity. Although this last strategy will decrease net income because of the higher interest cost, it will improve the EVA of the business because the total cost of debt and equity is reduced, and EVA measures the value created after all costs of capital (debt and equity) have been taken into account.
INTERPRETING TURKISH AIRLINES EVA</li></ul>Appendix 1 shows the EVA value for Turkish Airlines for Q1-Q3. First of all, the reason for this negative EVA’s should be investigated.<br /><ul><li>Turkish Airlines has paid an excessive sum as predelivery payment (PDP) for the new aircrafts. The calculation defines that sum as other receivables. As with arriving aircraft the sum will be paid back. Besides Turkish Airlines used its cash to finance the PDP so the debt structure did only have a slight change. If the PDP’s were long term receivables, EVA would improve around 45 Million TL but still negative.
Net Fixed Assets of Turkish Airlines are quiet high. 3.733.114.960 out of 4.730.079.226 is the value of aircrafts acquired by leasing. Actually this value is the key reason, why Turkish Airlines’ has a EVA negative value. In the airline industry, although you long term lease an aircraft, it will be count as a fixed asset. Actually, this value should be subtracted by calculating EVA, when we consider companies with high net fixed assets especially airline companies. If doing so EVA will increase to a positive 101 Million TL.
Due to the increase in fuel prices EBIT for 2010 Q1-Q3 was lower than expected. Therefore airline financial analyst exclude fuel costs, when comparing similar network sized airlines. To show the effect of fuel costs on EVA, EBIT will be recalculated by adding the Fuel Cost proportion back. By calculating EVA with the new EBIT shows around 676 Million TL. Therefore it could be said that EVA could not be properly used a performance indicator for an airline as increase in fuel prices is the airlines primary expenditure and managers do not have an influence on the fuel prices. This approach is only valid if the airline does not hedge fuel. Succesful hedge agreements would increase EVA if the relative cost in the “hedged year” is lower than hedging price.
As Appendix 4 shows EVA correlates with MVA. Therefore the formula</li></ul>MVA = current EVA / (WACC – g)<br />53249-3265600should deliver a positive value. With the first EVA calculation, this seems rather unlikely. First of all Turkish Airlines MVA is 895.410.600 TL, which is a positive value. The only way to deliver a positive MVA with a negative EVA is when g>WACC. According to the <br />MVA = PV of expected future EVA<br />formula it can be said that Turkish Airlines EVA will turn to positive in the future.<br /><ul><li>Turkish Airlines ROE is 19,4%. This is a healthy value for airline analyst. As ROE= Net Income/Common Equity we expect to increase ROE with increasing income. Although Turkish Airlines ROE has increased compared to the previous year, EVA has increased in a negative direction. As there shouldn’t be a negative correlation due to the research in Appendix 2, it can be said that EVA should be calculated stated in number 2 (11).
The same approach should also be used for EPS. Turkish Airlines EPS value have not changed compared due to the previous year (0,70 vs. 074). Therefore the decrease in EVA cannot be explained with EPS in Turkish Airlines case, which contradicts with Appendix 2 results.</li></ul>References:<br /><ul><li>Anderson, A. M., Bey, R. P., & Weaver, S. C. (2005). Economic Value Added Adjustments: Much to Do About Nothing? HYPERLINK "http://www.lehigh.edu/~incbeug/Attachments/Anderson%20EVA%204-7-05.pdf" http://www.lehigh.edu/~incbeug/Attachments/Anderson%20EVA%204-7-05.pdf
Appleby, C. (1997) The new lingo of value added. Hospitals & Health Networks, pp.50-52
Biddle,G.C., Bowen, R.M. & Wallace, J.S. 1999. Evidence on EVA. Journal of Applied Corporate Finance, 12(2);
Chamberlain, K. and Campbell, R. (1995) Creating shareholder value. New Zealand Manufacturer, Vol.100, p.15
Deutsche Bank Turkish Airlines Analyst Report, Quarter 3, 2010
Finegan, P.T. 1991. Maximizing shareholder value at the private company. Journal of Applied Corporate Finance, 4;
Keef, S. & Roush, M. 2002. Does MVA measure up? Financial Management, January: 20- 21;
Kramer, J.K. & Pushner, G. 1997. An empirical analysis of Economic Value Added as a proxy for Market Value Added. Financial Practice and Education;
Mäkeläinen E., 1998, Economic Value Added as a Management Tool, www.evanomics.com,