During the first years of the eighties, a topic that revolutionized companies worldwide began to be known, the topic I refer to is none other than the famous (EVA) Economic Value Added that translated into Spanish is Economic Value In addition, this indicator that has been used by world-class companies such as IBM, AT&T, and TEXAS INSTRUMENTS, among others, is nothing more than a comprehensive financial management system and its incentive-based remuneration, which consists of finding the performance of a company after deducting taxes and subtracting the cost of all the invested capital, to generate that return (Cost of Debt plus Cost of Capital Stock.) But how is it possible to add value in companies? Although it seems incredible the only thing to do,is to carry out a Management Based on Value.
KEYWORDS
- EVA - Economic Value Added - Economic Added Value NOPAT - Net Operating Profit After Taxes - Net Income Before Interest and After Tax NOPBT - Net Operating Profit Before Taxes - Operating Income After Tax WACC - Weighted Average Cost of Capital - Capital Weighted Average Cost - Markett Value Adedd - Aggregate Market Value GBV - Value Based Management
Administrative, accounting and financial effects of value-based management
Wealth creation is an obligation and is an economic reality; the distribution of wealth is a political decision, but everyone who is entrusted with resources must answer for its use. Salmmón Fabricant
Today's companies must be at the forefront of administrative processes that provide them with technical, analytical and operational bases where they can effectively verify the generation of value, this in turn contributes to organizations that implement Management Based on value increase your investments and improve your financial functions.
Over the last decades, those interested in improving the vital part of organizations more and more, have designed a series of processes which have been successful in many cases, but have failed in others. Now what is being imposed is Value Based Management (GBV), this is a tool that prioritizes continuous improvement at all levels, since proper decision-making in companies depends on it.
Value-Based Management breaks with all paradigms such as that business management is measured solely on the basis of net profit. Many organizations consistently present high levels of profit in their income statements, but this does not mean that they are adding value. The same happens when a company shows in its statement of lost results, this does not mean that the company is destroying value. The theory of Value-Based Management (GBV), is based on the commitment of all members of the organization (Shareholders, Managers, Employees) to act in the participation of value generation, but to achieve this, a genuine change of mentality, that although it generates negative reactions at the beginning of the implementation of the system, the results will be seen soon.
It can be said that the Generation of Value is a whole philosophy that is changing the way of seeing finances in companies. This philosophy has become the most important challenge for all those organizations that wish to remain in a market where investors are increasingly demanding and where the conditions of the stock system do not admit failed attempts, because they would risk disappearing. Although it is very important to keep in mind that adaptation to a new system is not easy, especially when the changes to be made are not only structural, but we must also change our ways of thinking, from introduction to new measurement systems of results and compensation schemes that monitor and incentivize employees to achieve the objectives set,the development and fulfillment of a strategic plan that the organizational communities forget to fulfill.
The Management of the company must be very clear that in order for this philosophy not to be left alone in that, it is necessary to link all the actors involved in an organization and who must work in favor of continuous improvement, we can define such actors as follows; The Clients, since if they are not satisfied with our service and the quality of our products, they will withdraw and take with them at least 11 new clients, but for the client to be motivated to continue buying from me, it is necessary to have a committed human talent (Personnel), who not only fulfills the assigned tasks, but goes further, adds value to their work, additionally, in order for this process to take place in the proposed direction, it is necessary to count on the permanent competition of shareholders,since they are the ones who must offer the mechanisms so that the employee feels satisfied with the organization. This philosophy can be seen much better in the following graph.
Therefore, if the company starts with the continuous improvement process, it is highly feasible that it will begin to generate added economic value, because the company will have had the necessary elements that contribute to achieving the basic financial objective of any company, which it is to generate more wealth for the shareholder, and this in turn will redistribute said wealth to those who have contributed to generating it. In this order of ideas, it is necessary to delve a little into the issue of value creation and how companies can measure and accumulate it, since it is not only about adding value in a single year, but that this practice becomes in a straitjacket for all actors in the process, because their success or failure depends on them.
Value creation is the goal of all good management. If the objective was to maximize accounting profit before, now this profit objective has been supplanted by value creation. But how is value added measured? This very simple question in its approach when putting it into practice is not so much. In summary, the value created in the company can be measured considering not only the benefit but also the cost of generating that benefit. In conclusion, if the benefit obtained exceeds the cost of the resources involved, it can be said that value has been created. If we transfer this to investment decision-making, it means that in order to create value in the company, the Net Present Value (NPV) -In the words of Professor Faus:"The NPV precisely measures the value that the investment under consideration is expected to create" - the investment should be positive and, therefore, it would be investing in assets that generate additional value for the company.
In the foreground, and from the accounting and financial point of view, it is very important to mention the actors that drive the creation of value in the company from a double perspective. "ROIC, WACC, NOPAT, and CAPITAL". On the one hand, considering the discount of free cash flows and, on the other, by discounting free cash flows for shareholders.
But before going into details, the first thing we should know is that it is the Markett Value Added (MVA), which in Spanish indicates Added Market Value. The (MVA) is a financial tool, whose main task is to measure the capacity of an organization to create value and accumulate it over time. Taking for this the management capacity of the management and the commitment of all the actors involved with said organization. In the following diagram we can clearly see what the MVA is.
What is the MVA Aggregate Market Value?
Value-Based Management (GBV) can be defined as a work of art, since it is each company that makes it a unique piece because each organization is different from the others even though they belong to the same productive sector; Companies adapt the GBV to their needs, which is why it has been so successful so far, however, as any new technique or process causes a little uncertainty for managers, they fear implementing this tool for the financial growth of the organizations they manage.
But experience shows us that companies that generate value increase their investments, since their shares are listed at incredible prices on the Stock Exchanges, due to the fact that it is less risky to invest money in a company that generates value and is capable of responding for the accumulation of value that they realize.
Due to the aforementioned, the culture of Value-Based Management (GBV) is necessary, so that companies are aware of the magnitude of their commitment, as this novel system forces them to monitor stockbrokers. and that of market agents, since it is this management system that breaks with all the paradigms that business management is measured taking into account net profit, since many organizations that record high profits in their income statements do not generate value and the opposite case also usually presents that companies with low profits add value.One of the hypotheses that supports the GBV theory is that both owners and managers must act in the participation of value generation and the remuneration system must be in accordance with the addition of value, but to achieve this, a genuine change of mentality, although it generates negative reactions at the beginning of the implementation of this system.
It is clear that we must bear in mind that continuous improvement processes lead to value creation. To generate greater value in the company, an organizational structure that has a reduction in hierarchical levels is necessary, and this structure must be oriented to the company's processes, that is, a team-based organization that carries synergies and the power to decision, to create a culture of value creation that can be measured through financial performance; This entire structure must be focused on the generation of Added Economic Value (EVA) that meets the expectations of the shareholder.
As can be seen in all this theory, to add value, you must know the tools; and one of them is the one just mentioned by the famous EVA. That is nothing more than the number one indicator of the value that a company adds, as a result of its management. In order to start a continuous improvement process, the organization must ask itself three strategic questions:
- What value has the company created / destroyed? What will be the value to create / destroy in the future? What is our current measurement system?
In order to answer all these questions, it is necessary that we know a little about EVA. Therefore, I will start by defining what it is and what its main characteristics are.
EVA is the estimate of economic profit after subtracting the cost for the net assets used to produce. In other words, the EVA is created in an organization when its net operating profits (ONE) are greater than the cost of capital it uses.
For this reason, we can affirm that the EVA is the clearest instrument for communicating business results to staff and shareholders.
The main characteristics of the EVA are:
- It is a single financial measure It calculates the average cost of the entire investment It is an ideal tool for decision making, it is more understandable Performance is linked to compensation.
The EVA is also a set of management tools that take into account the amount of profit that must be obtained to recover the cost of capital employed. For example, if the EVA is projected at zero, that means that the company is earning hardly what is necessary, and if it is projected more because it will earn more, the company that adopts the EVA rethinks its capital budgets and evaluation procedures, until achieving the desired goal.
Regarding motivation, the philosophy is that the progress brought by the EVA be shared, if shared with the employees. That a policy of sharing wealth be used, which Stern Stewart & Co calls, "The most socialist form of capitalism." Here you have to make the employees truly believe in the EVA, and for this they need to be paid and made to feel like owners of the company.
Finally, the change in mentality means that there is a common language in decision-making and clear identification of the organization's goals. That all company employees understand what is being done and what the new priorities are. This produces a real change in business behavior, which is reflected in the company's net profits.
Economic Added Value, EVA, a total integrated management system
The EVA represents a total integrated administration system, which in turn measures the true profitability of companies and remunerates their managers according to the real growth obtained.
To best describe it, it can be understood through four primary elements that Stern Stewart & Co has defined as the Big Four (4M) Measurement, Management, Motivation, and Midset. (Measurement, Administration, Motivation and Mentality).
The measurement looks at the economic process in position to the accounting process. Firms typically place a burden on capital use and eliminate accounting distortion, such as subtracting excess research and development. In contrast, the EVA capitalizes those excesses over a period of time and the behavior of the current share price can be more clearly explained.
Economic Added Value, EVA, Vs. Profits
Conclusions
In conclusion, what is adding value ?
The creation of value according to many entrepreneurs, is an action that motivates human consumption by an increase in the benefit provided by a good or service, that is, it is the action that attracts people to those objects and services that in some way increasingly meet their needs more efficiently.
Value according to popular belief increases if performance improves or costs decrease, other ideas about value creation focus on improving performance within the organization, since competitiveness is synonymous with efficient economy, to achieve it, The adequate combination of three basic factors is required: optimal resource allocation, high productivity and dynamic response to technological and market changes. Efficiency in the allocation of productive resources refers to the fact that they are distributed in such a way that they reach those who can add the most value to them. A company is considered to generate value with the resources it uses, when it makes profits after having paid the price for the capital used.
The administration of a company must take care of all the links of the value chain, finances, clients, efficient operation and innovation. This process is cyclical and its constant modification guarantees continuous improvement of the business. As we can see, accounting and financial effects are presented which are the result of the company's management and the support they are receiving from the actors in the process, which is why a prior evaluation and during the process is so important, in order to adjust the variables that are limiting the normal development of the company's operations.
To conclude, let's look at how the correct use of EVA and its method of calculation should be graphically.
Correct use of the Economic Added Value, EVA, and its calculation graphically
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