Financial and Strategic Management

What is Economic Value Added?

Adam Smith, one of the fathers of classical economic thought, observed that firms and resource suppliers, seeking to further their own self-interest and operating within the framework of a highly competitive market system, will promote the interest of the public, as though guided by an “invisible hand. “ (Smith, 1776)

The market mechanism of supply and demand communicates the wants of consumers to businesses and through businesses to resource suppliers. Competition forces business and resource suppliers to make appropriate responses. The impact of an increase in consumer demand for some product will raise that goods price. The resulting economic profits signal other producers that society wants more of the product. Competition simultaneously brings an expansion of output and a lower price.

Profits cause resources to move from lower-valued to higher-valued uses. Prices and sales are dictated by the consumer. In the quest for higher profits, businesses will take resources out of areas with lower than normal returns and put them into areas in which there is an expectation of high profits.

Profits allocate resources

The primary objective of any business is to create wealth for its owners. If nothing else the organization must provide a growth dividend to those who have invested expecting a value reward for their investment. As companies generate value and grow, society also benefits. The quest for value directs scarce resources to their most promising uses and most productive uses. The more effectively resources are employed and managed, the more active economic growth and the rate of improvement in our standard of living as a society. Although there are exceptions to the rule relating to the value of economic wealth, most of the time there is a distinct harmony between creating increased share value of an organization and enhancing the quality of life of people in society.

In most companies today the search for value is being challenged by a seriously out-of-date financial management system. Often, the wrong financial focus, cash strategies, operating goals, and valuation processes are emphasized. Managers are often rewarded for the wrong achievements and in many cases, they are not rewarded for the efforts that lead to real value. Balance sheets are often just the result of accounting rules rather than the focus of value enhancement. These problems beg for approaches to financial focus that are completely different from current approaches. New approaches must start nothing less than an evolution in thinking in the process of economic evaluation. One of the focuses that have proved to be incorrect in the valuation of economic worth is earnings per share (EPS). EPS has long been the hallmark of executives that appear in meetings of the shareholders, as the measure of their accomplishments. This, along with return on equity has long been thought of as the way to attract investment. There is nothing that points to EPS as anything more than a ratio that accounting has developed for management reporting. Many executives believe that the stock market wants earnings and that the future of the organization’s stock depends on the current EPS, despite the fact that not one shred of convincing evidence to substantiate this claim has ever been produced. To satisfy the desire for reported profits, executives feel compelled to create earnings through creative accounting. Accounting tactics that could be employed to save taxes and increase value are avoided in favor of tactics that increase profit. Capital acquisitions are often not undertaken because they do not meet a hypothetical profit return. R&D and market expanding investments get only lip service. Often increased earnings growth is sustained by overzealous monetary support of businesses that are long past their value peak. We must ask then, what truly determines increased value in stock prices. Over and over again the evidence points to the cash flow of the organization, adjusted for time and risk that investors can expect to get back over the life of the business.

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Shreya Kushwaha

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