EVA, SVA, and the Economy

January 23, 2009  

While at Accenture, one of our analytical tools was Shareholder Value Analysis (SVA) – a tool based on Economic Value Added.  The premise is that by looking at a company’s financials, we can determine where to best target our innovation efforts.  The analysis can show us, for example, if reducing SG&A will have a greater impact on EVA than, let’s say, COGS.  It will tell us the impact on EVA if we increase sales by a certain amount.   It is a very powerful tool.  You can see the general model by clicking the image on the right.  The analysis is obviously a lot more complex.

This model works nicely in good times.  But does it work today?  What is it telling us?

I asked two of my ex-Accenture colleagues who are experts on SVA the following question:

Cost of Capital is part of the EVA equation. Given the credit crisis, how has this impacted EVA? Is cost of capital going up? If so, what does that mean in terms of where companies should invest then efforts? Or is it going down because the prime rate is so low? What does this mean that from a targeting perspective?

Here are the two responses:

Response #1: On the EVA question, theoretically the Cost of Capital is down given the prime.  But actually it’s up given the credit markets — the Libor is a good proxy (the rate at which banks lend to each other). The B2B rates are even worse, hence all the talk about the credit markets freezing up. In terms of targeting Cost of Capital, that’s a tougher question. Most of the action in EVA around the Weighted Average Cost of Capital (WACC) is related to more or less leverage. So targeting it would mean more leverage and there’s not too many companies that want to go in this direction now. In fact, we may have determined a “ceiling” on how far you can push on that lever.

Response #2: From a mathematical perspective, marginal cost of capital is fairly low these days. The availability of capital, however, is the real issue. In the current market it is difficult to raise capital. Therefore if an enterprise can generate excess cash and can identify opportunities with good returns they should certainly invest. It is no different for an individual. Assuming that a major catastrophe is not looming on the horizon and assuming that one has available cash, this is the time to invest. I should hasten to add that the “classical” capital market theories upon which WACC and EVA are based are NOT, in my opinion, quite valid in a tumultuous market where risk free rates are almost zero and people are simply keeping cash “under the mattress.”

Interesting thoughts.

My follow up question is, “Assumiung WACC is up, what is the relative impact of cost reduction versus revenue growth on EVA?”

What do you think?  I’d love to get many different perspectives on this topic.

P.S. I leave these financial calculations to the data experts (“spades”) and focus my energies on new ideas that solve problems (“diamonds”).

Leave a Reply