Form a company with equity of BDT 100 mn. Put that amount in a bank deposit account that yields 10% per year. This company will continue to see a 10% growth in earnings along with a 10% return on investment (pre-tax). Is this a very good company from a shareholder perspective?
The concept of Economic Value Added (EVA) was introduced to answer this question (along with certain other things like accounting inconsistencies between companies but that is outside the scope of this article). The logic of EVA is simple. When we invest in a company with equity and/or debt there is a minimum required return we should get. This is known as the Weighted Average Cost of Capital (WACC). For the company to make economic sense the return on investment has to be at least equal to or preferably greater than the WACC. Otherwise the company is destroying value. It would be better to not have that company at all.
Let me give an example. Assume a company in Bangladesh is only financed by equity. This company would have a WACC of at least *15-16% (WACC=Cost of equity in this case). If this company does not generate a Return on Invested Capital (ROIC) then it is surely destroying shareholder’s value.
Now that the theory part is over let me go into the real problem in the case of Bangladesh. Most companies have a segment showing the Economic Value Added. The problem starts with their version of WACC. Most of them are using the government bond yield as the WACC. This is funny and infuriating because its like saying that this is a risk-free business. By the result of using very low cost of capital these companies are showing that they are generating economic profit when in reality they are not. In fact, I have a big doubt whether even 50 of the 250+ companies listed on the Dhaka Stock Exchange are generating ROIC>WACC in the truest sense.
Secondly, the calculation of invested capital is also a tricky subject. I have a lot of reservations on whether companies are calculating Invested Capital properly. By showing lower invested capital it is possible to jack up ROIC (ROIC=NOPAT/Invested Capital).
It is very important that shareholders understand whether a company is creating or destroying value. Also from the company management perspective as well EVA is a very important metric. Unfortunately it seems that neither the sponsors, the management or the minority shareholders understand the correct application of EVA.
*The 15-16% comes from Risk Free Rate plus a Risk Premium.