Staying on top

Staying on top

Stern Stewart & Co popularised the concept of Economic Value Added (EVA) to ascertain whether companies meet their shareholder’s expectations or not.Nandini Patwardhan examines the concept and its relevance to the Indian pharma industry in today’s day and age

Maximising shareholder value has always been high on the agenda of companies from various sectors, and pharma is no exception. While the industry is poised to take a giant leap, EVA is one mileage tracker that will help them to understand if they are progressing in the right direction towards increased performance or whether they are going off track. EVA provides a snapshot of performance for managers, who can discover for themselves, the performance of their business unit, plant or the entire company over time and see whether they are creating or destroying value. It also enables smart allocation of capital. If a company’s EVA is negative, it means that the company’s returns do not cover the cost of capital and hence it would be wise to borrow from some other source or change strategy.

Not compulsory

Vasudevan Chief finance Officer

Dr Reddy’s Laboratories Ltd.

EVA calculation is not mandatory for companies. Yet many pharmacos undertake the process of calculating it to come up with an absolute figure, year after year. For instance, JB Chemicals and Pharmaceuticals reported an EVA of Rs 1,143.41 lakh in its annual report for the year 2004-05.

“If you look at the way the EVA model is structured, what you are really doing is that you are taking your Netoperating Profit after Tax (NOPAT) and deducting your Cost of Capital (COC) and you are also taking your capital charge. Many companies like Nicholas Piramal, Dr. Reddy’s, and JB Chemicals have adopted EVA models and all of them are hugely EVA positive,” says Alok Gupta, Head, Life Sciences, Yes Bank. (See box for details of EVA calculation)

Meeting expectations

EVA enables the company to understand what the shareholder expectations are in terms of returns they expect on their investment in the company and how well it is meeting those expectations. It also helps the investor (shareholder) to justify his own investment in the company. For instance, let us assume that a person has Rs 100, which can be invested in any option ranging from bank deposits (safest) to equity (risky). He will be happy to come out with Rs 110 at the end of one year if he invests in some safer option. However if he takes the same amount to a casino in Goa, he will be okay if he loses Rs 100, but will only be happy if the amount doubles. Then, Rs 110 does not make sense to him because he is taking a higher risk and thus expects a return over and above the risk-free return (Rs 110).

Sanjay Kulkarni Managing Director

Stern Stewart & Co. India

Sanjay Kulkarni, Managing Director, Stern Stewart & Co, emphasises this point by saying, “When you invest in a new technology that may or may not take off, you are taking a higher risk. So for that higher risk, you will expect a higher return as opposed to the returns that you will get from investing in any other industry.” With pharma, since the risks are high, the returns expected are also high.

Fundamentally speaking…

EVA framework became popular because of diverging interests between the owner and the manager. As businesses grow bigger, they require more managers to run the show

The EVA framework became popular because of diverging interests between the owner and the manager. As businesses grow bigger, they require more managers to run the show. “As rational human beings the managers work towards their self interest also, which might be shortchanging the shareholders’ interests. So there is a need to align the management’s interests to that of their shareholders and that is where the EVA framework comes into picture,” elaborates Kulkarni.

Most of the pharma majors calculate the value generated by their companies based on the Capital Asset Pricing Model says a report released by the Organisation of Pharmaceutical Producers of India. This concept, because of its simplicity, is applicable to the Indian pharma industry.

“That’s pretty fundamental because the EVA model is dependent on the kind of capital structure the companies are following; most of them are essentially low debt in nature. The stock volatility is also not that great and so their betas are also in line with the market,” explains Gupta.

Value-based management

It is important to understand that EVA can be deployed at various levels in a pharma company (to various processes) to ascertain if it is profitable to invest in them. One should not forget that shareholder wealth is not EVA. Shareholder wealth is the net present value of the business. The capital value invested in the business and any further value addition reflects shareholder value and that definition is consistent across companies, and across sectors and businesses. EVA as a standalone figure for a particular year seldom means much. Only over a period of EVA calculation can it be ascertained whether a particular company is generating value or not. In order to generate shareholder value, pharma companies need to weave the concept of EVA into their management framework as under:

1. Setting up strategic long-term financial goals: A company needs to know its long-term strategic goals and the performance destination that it aspires to reach. Once the strategic goal is established, the company should question whether it is good enough. For instance if a company expects to reach attain 25 percent revenue growth, the key question here would be, “is 25 percent good enough in comparison to industry growth and to shareholder expectations? The term strategic goals can be understood from the stock (destination) perspective and the flow perspective.

a. Stock perspective: The focus in this case is on milestones. For instance a company is at ‘X’ performance level and would like to reach a level ‘2X’.

b. Flow perspective: This aspect determines the path or the route undertaken by the company to reach its goals or destinations.

2. Identifying the source of contribution: The management needs to figure out the contributions from various products in the product line. It also needs to understand the organisation’s structure and dynamics and the changes necessary

3. Sharing the wealth between managers and shareholders: This means giving them an ownership stake in it. The moment managers realise that there is something in there for them, their motivation levels rise. After having agreed with the shareholders on certain goals and performance levels, the management should take decision on ‘over per-formance’ and ‘under-performance’. For instance if managers over perform shareholders expectations, they get a share of it and in case of under-performance, they (managers) bear the brunt.

4. Decision-making: Currently management use these value based principles to refine their decision-making to strike a balance between the strategic (decisions that affect a company’s net present value) as well as operational decisions.

5. Guiding the organisation through the process: Implementation of these management elements involves considerable training, communication and handholding to take the organisation through the entire change management programme, from setting strategic goals to decision-making.

Benefits derived

Companies who have implemented EVA in their management frameworks have benefited immensely. According to Kulkarni, they have derived following three advantages from this implementation:

  • Substantial improvement in their fundamental per-formance as compared to the peers. Vasudevan, the Chief Financial Officer at the Hyderabad-based Dr Reddy’s Laboratories, reveals that EVA links the compensation of managers with the movement in shareholder value. “This ensures a greater accountability for managerial actions while handing a greater stake in the company’s performance,” he states.

  • In India on an average, companies that have adopted the value-based framework have delivered almost 50 percent excess wealth as compared to the broad market index over time. “At Dr Reddy’s we develop performance metrics and incentives that produce behavioral changes, which cause employees to take decisions as if they were owners. For Indian pharma companies which stand on the inflection point of significant growth, EVA will help improve the alignment of performance with shareholder expe-ctations,” explains Vasudevan.

  • As a part of this programme, companies reap a host of intangible process benefits in performance measurement, performance reporting, incentive compensation, capital planning. The processes are refined and motivation levels of employees hit a high note. All of these form a fairly potent combination or a reason for people to adopt value based management framework.

Industry significance

The Indian pharmaceutical industry is at a very precarious juncture right now. The stage is set for this industry to perform and soar high. However, there is also a fear of failure given the high costs in research and development and the absence of blockbuster molecules. In addition, the environment is highly volatile with litigations being the order of the day. Calculating EVA thus makes more sense for pharma companies as investment here is a little more risky.

EVA = NOPAT – Cost of Capital

NOPAT = Profit Before Tax + Interest – Tax + Tax shield on interest.

Cost of Capital: It is the weighted average cost of borrowings and equity as on the balance sheet date.

Cost of borrowings: The cost of borrowing depends on the rate of interest.

Cost of equity: Risk free cost of bank lending rate + Market premium on the risk free equity investment * Beta variant
(R + B * M).Where Beta is the relative price movement of the stock vis-Ă -vis the market.