EVA is a much more practical concept than most imagine, and it can be explained by using a stock exchange listed company as basis. For such a company there is in fact a close practical and theoretical coherence between the well-known stock exchange key figures and concepts: ROIC, WACC, EVA, MVA, P/IV, share price and the equity capital´s market value.
If EVA is expected to be positive year after year by the market, P/IV will be higher than 1.0. As a consequence the market value of the company’s equity capital is higher than its book value. This is caused by the fact that the present value of the annual expected EVA amounts generates a positive MVA (= Market Value Added). MVA is the difference between the equity capital´s market value and its book value.
In practical terms, this means that investors realise a real annual value creation, i.e. a positive return that is higher than the minimum required yield of return, WACC, which the stock market requires in order to only receive compensation for the risks the investors run by investing in the share. Therefore, they like to invest in and hold the share that are categorised as a Value Creator.
In contrast if EVA is expected to be negative by the market, the P/IV is less than 1.0 because the present value of the annual expected negative EVA amounts generates a negative MVA. This means that the market value of the company’s equity capital is less than its book value, and that the share price is lower than its accounting intrinsic value. The investors realise a market value-related destruction of their values and the share is consequently referred to as a Value Destroyer.
In practical terms, it may also be explained as follows: the stock market investors require a “discount” on the share, allowing them to get compensation for the lack of return. Another explanation is that the share is no longer the investors’ “favourite food” because they, of course, would prefer to invest in other shares that give them value creation.
Regardless whether EVA is expected to be positive or negative, the company’s management and its owners will immediately discover this through the daily valuation on the stock exchange. Therefore, they can respond progressively and take the necessary actions to ensure value creation continuously.
The exact same EVA mechanism also applies to unlisted companies. However, the owner of the unlisted company does not know whether the market value of its equity capital for example might be only 60 % of its equity capital book value. That will be the situation unless the owner continuously undergoes a valuation of the market value of the company´s equity capital under the exact same conditions as if the company was listed.
Practical experience and many studies show that only a minority of business owners practice this. Additionally, business owners often expose themselves to a “pillow effect”, consisting of that they mistakenly perceive that relatively good accounting results and relatively high ROE´s are the same as value creation.
The result often becomes a nightmare both financially and retirement-wise for the owner, who only immediately before the company is to be sold discovers that the market value of the company’s equity capital for example is only 60% of the equity capital´s book value. For example consisting of that the market value being only one third of what the owner had imagined. Or, worst case scenario, that the company cannot be sold at all because the company for the past several years systematically and market value-wise has destroyed its equity capital.