Economic Value Added as Universal Financial Metric: History
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Subjects: Business, Finance
Contributor:
Zbysław Dobrowolski

Previous research into Economic Value Added (EVA) has extensively described it as a business metric of firms. Still, no studies have confirmed or denied that EVA is a universal metric and that one may use EVA in unstable markets in the same way as in stable and developed economies. Meanwhile, the green energy revolution, ensuring carbon neutrality through green innovations, requires enormous investments, and the projects realised must be appropriately tailored. These projects are realised by different firms, including those from developing countries, and investors need solid financial metrics.

  • energy policy
  • energy management
  • energy
  • economic value added

1. Introduction

Most scholars and practitioners do not question that businesses exist to create profit for their owners, e.g., [1][2][3]. Young and O’Byrne [4] aptly note that every useful performance metric attempts to measure changes in shareholder value. They argue that economic value added (EVA) is the best metric available. EVA measures residual income, which means that it measures the difference between a firm’s return and cost on capital. The other metrics have significant drawbacks, because one can easily manipulate traditional income measures. Market-based measures such as market value added, excess return and future growth value make sense in publicly traded entities. Cash flow from operations and cash flow return on investment do not account for the cost of equity or debt.
Increasingly, economists believe that maximising profit for shareholders should not be companies’ primary goal, given the complex environment in which they operate and the interactions that exist with various stakeholders. Maximising the positive impact companies have on stakeholders is a new approach that contributes to the metamorphosis of companies’ business strategies in various fields, especially those that generate negative social and environmental expansions, such as companies in the energy sector [5][6][7][8]. The activity of these companies is increasingly pursued by various stakeholders such as portfolio investors, consumers and researchers, given the special economic performance they register to the detriment of protecting the environment [9][10].
Taking these arguments into account, the study follows contingency theory, e.g., [11][12][13][14], which assumes that there is no best way to show the firm’s financial results. Instead, one may identify that the optimal course of action is contingent upon the internal or external situation. Researchers recognise the research gap and decided to determine whether EVA is a universal economic metric for investors engaged in the green energy revolution, ensuring carbon neutrality through green innovations. The following hypothesis was formulated: the variable discount rate influences the EVA formula, requiring the redefinition of its assumptions. Formulating this hypothesis, it was noticed that most countries have unstable interest rates, and most of them try to follow the UN change climate assumptions presented during the Glasgow UN Climate Conference in 2021. Researchers chose energy firms because of their specific features and role in economies. Their investments are long-term and influence other sectors. One may argue that such characteristics of energy firms fit any business. However, the research underlines that energy firms do a business, but are simultaneously obliged to ensure the continuity of energy supply, and their activity is under governments’ oversight. Energy companies are important both from the point of view of energy security, a significant national objective, and from the perspective of energy poverty, because the increase in energy prices directly impacts consumers’ access to energy [15][16]. The energy transition comes with challenges for energy companies that need to adapt their business strategies and make significant investments to protect the environment and reduce their carbon footprint. Moreover, the interest of many companies is moving towards renewable energy. This is necessary in order not to lose out in the global competition to retain and attract new consumers and to improve image among stakeholders. These entities’ financial and non-financial performance intertwine to maximise value for all stakeholders and not just shareholders. Therefore, such firms are hybrid actors, linking business profit models with public tasks [17][18]. The research points out that correct financial metrics are necessary from the point of view of sustainable finance in energy sectors. In addition, energy companies are considering the interest of portfolio investors for companies that promote the principles of sustainable development and various Corporate Social Responsibility (CSR) actions. They must improve their non-financial performance in the context of intensifying divestments in sectors that pollute the environment.

2. Curent Studies

Many articles published over the last 35 years involve the theory and applications of EVA, e.g., [17][18][19][20][21][22][23][24][25][26], and one may argue that a new study about EVA is unnecessary because many have discussed how to use the EVA in unstable markets. However, including Pal and Sura’s [27] study and Worthington and West’s [28] review of the literature on EVA, and their survey of EVA’s conceptual underpinnings, one may argue that there is still a need for further analyses of EVA. It is necessary to determine whether it is a universal economic metric in the energy sector.
Stewart’s research published in The Quest for Value [29] introduces EVA to business practices. This concept is analysed mainly by many American scholars, as Sharma and Kumar noticed in 2010 [24]. One may argue that it should not surprise anybody because the EVA concept originated from the US market. However, such homogenous research may distort objective perception, as the American market is stabilised and has a different perspective than other markets. Since Sharma and Kumar presented their findings, new studies on EVA metrics have been published, involving other markets, sectors and regions, e.g., [28][29][30][31][32][33], and generally continuing the mainstream of EVA study.
The literature on EVA can be divided into several sub-themes. For example, EVA and stock returns, EVA and MVA’s relationship, managerial behaviour and performance management, implementation issues of EVA, and value-based management and EVA. Proponents of EVA state that EVA is a reasonably reliable metric to understand a firm’s value, being highly correlated with stock returns [24][34], and that it is better than other accounting-based performance indicators [24][35][36][37]. Synthetically, Machuga et al. [38] summarised these considerations and highlighted that EVA could enhance future earnings predictions. Lehn and Makhija [39] focused on the correlation between different performance measures and stock market returns. They proved that EVA is the most highly correlated measure with stock returns. Other researchers, for example, Bao and Bao [40], stated that EVA as a financial metric provides relatively more information than other measures of accounting profits. They also showed that EVA and residual income variables are highly correlated and identical to stock returns. Like those researchers mentioned above, other researchers [41][42][43][44][45] and researchers of more recent studies, e.g., [46][47][48][49][50][51][52][53][54], have also found the EVA useful in financial risk mitigation.
Researchers underline that EVA is a better alternative to traditional performance measures (profits, earnings per share or return of assets), because there is a strong connection between residual income-based incentives plans and business activity exhibiting increased income, and managers are better motivated to achieve better financial outcomes and multiply shareholder wealth creation [36][55][56][57]. Stewart [36] studied the relationship between EVA and MVA. He analysed US companies and found a stronger correlation between EVA and MVA—a calculation that shows the difference between the market value and the capital contributed by all investors. Others also found such a correlation, e.g., [56][57][58][59]. However, not all studies have generally been so enthusiastic about EVA. For example, Anastasis and Kyriazis [60] analysed Greek firms and concluded that net and operating income seem more valuable than EVA. These researchers stated that the EVA formula adds only marginal information content compared with accounting profit. Additionally, Biddle [42] stated that EVA performs relatively poorly compared with other measures such as earnings in explaining the stock returns because some estimation errors in calculating capital charge (WACC) may occur.
To demonstrate the growing interest, the Web of Science database was queried based on researchers keywords such as economic value added After querying by economic value added, 460 items were selected from WoS Core Collections.
Most of the papers were framed as expected in economics,,management, business and business finance journals. Given the importance of EVA for substantiating investment decisions in various fields of activity (especially in the industry), articles have also been published in journals framed as environmental sciences or green sustainable science and technology.
The Web of Science query based on economic value added as researchers keywords demonstrates the importance of interdisciplinary research and the integrated approach to economic and environmental issues, in consideration of financial decisions in the energy sector.
The query of the database reveals the growing interest of researchers in the topic, especially in recent years, when growing numbers of energy companies are looking for economically viable solutions for a smooth and just energy transition for all stakeholders involved. Energy companies, both in the field of fossil fuels and renewable energy, are increasingly interested in achieving a balance between their financial performance and social and environmental performance, generically called non-financial performance.
Two conclusions emerge from the analysis of the literature. First, the global interest in EVA results from convincing evidence that the metric supports business decision making. Second, the abundant evidence of the researchers’ belief that EVA is a proper performance metric. However, there are also criticisms regarding the use of EVA. There is no further need to show other published studies convincing everybody whether EVA enables economic performance measurement. However, there is a need to analyse whether EVA can be treated as a universal metric regardless of the interest rate stability, the research gap is noticeable. After more than a decade from when Sharma and Kumar published their study [24], the researchers agree with these scholars that research is needed to understand all limitations of EVA in different financial environments. It does not mean that the question of the sense of EVA was considered.
It is no coincidence that energy companies were selected. These companies conduct economic activity but also perform public tasks. They are responsible for ensuring energy security, and the requirement involves both energy producers and transmission system operators. They should ensure the correct level of security of grid operation, which means the continuous operation of the power grid. In addition, bibliometric analysis based on scientific principles [61][62] reveals an increase in interest in EVA, especially in the energy sector, which is facing multiple pressures from stakeholders to reduce negative externalities and increase the promotion of the principles of sustainable development.
Energy markets are highly regulated in many countries, and there are requirements for registration business activities with specific agencies. The regulations specify how energy enterprises transmit or distribute fuels or energy in a detailed manner. Energy companies realising public tasks may be equipped with special powers. For example, they may conduct audits of measurement and billing systems, compliance audits of clients’ activities with concluded contracts and the correctness of settlements with energy companies [17][18][63][64][65][66]. In addition, the epochal green energy revolution ensuring carbon neutrality through green innovations is realised by energy firms. All arguments presented above lead to the assumption that although EVA as a financial metric is widely presented in the literature, it is necessary to determine whether EVA in its current form can fit the investment and financial environments in any country.

This entry is adapted from the peer-reviewed paper 10.3390/su14052967

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