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Agrekon, Vol 42, No 2 (June 2003) Geyser & Liebenberg

CREATING A NEW VALUATION TOOL FOR SOUTH

AFRICAN AGRICULTURAL CO-OPERATIVES

M Geyser & IE Liebenberg1

Abstract

Long-term shareholder wealth is equally important for all profit seeking organizations,
regardless of their size. This paper examines introducing Economic Value Added
(EVA) as a performance measure for agribusinesses and co-ops in South Africa. EVA
is an effective measure of the quality of managerial decisions as well as a reliable
indicator of an enterprise’s value growth in future. The question posed is whether
South African agribusinesses and cooperatives are capable of creating shareholder and
member value after the deregulation of the agricultural markets.

1. INTRODUCTION

Every asset, financial as well as real, has a value. The key to successfully
investing in and managing these assets lies in understanding not only what
the value is but also the sources of the value. Any asset can be valued, but
some assets are easier to value than others and the details of valuation will
vary from case to case. Thus, the valuation of a share of a real estate property
will require different information and follow a different format than the
valuation of a publicly traded share and the valuation of an agricultural co-
operative. What is surprising, however, is not the differences in valuation
techniques across assets, but the degree of similarity in basic principles.

The traditional discounted cash flow model provides for a rich and thorough
analysis of all the different ways in which a firm can increase value, but it can
become complex, as the number of inputs increases. It is also difficult to tie
management compensation systems to a discounted cash flow model, since
many of the inputs need to be estimated and can be manipulated to yield the
results management wants.

If market efficiency is assumed, the unobservable value from the discounted

cash flow model is replaced with the observed market price, and valuation of
the business and/or reward for managers is based upon the performance of

1 Department of Agricultural Economics, Extension and Rural Development, University of

Pretoria.
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Agrekon, Vol 42, No 2 (June 2003) Geyser & Liebenberg

the share. Thus, a firm whose share price has gone up is viewed as having
created value, whereas one whose share price has fallen has destroyed value.
However, while market prices have the advantage of being up to date and
observable, they are also ‘noisy’. Even if markets are efficient, share prices
tend to fluctuate around the true value. Thus, a firm may see its share price go
up and its top management rewarded even as it destroys value. Conversely,
the managers of a firm may be penalized as its share prices drops, even
though the management may have taken actions to increase firm value. The
other problem with using share prices as the basis for compensation is that the
price only reflects the value of the entire firm. Share prices cannot be used to
analyse the managers of individual divisions of a firm or for their relative
performance. Furthermore, the discounted cash flow model is only usable for
firms with traded share prices.

In the past decade, while firms have become more focused on value creation,
new mechanisms for measuring value have been created. The two
mechanisms that seem to have made the most impact are:

• economic value added (EVA), which measures the surplus value created
by a firm in its existing environment, and
• cash flow return on investment (CFROI), which measures the percentage
return made by a firm on its existing investments.

These mechanisms enable all types of firms to determine their value creation.
In this article, we look at how the calculation of EVA can be adapted for usage
by agricultural co-operatives.

2. WHAT IS EVA?

EVA is a value based financial performance measure, an investment decision

tool and a performance measure reflecting the absolute amount of shareholder
value created. It is computed as the product of the “excess return” made on an
investment or investments and the capital invested in that investment or
investments. EVA is the net operating profit minus an appropriate charge for
the opportunity cost of all capital invested in an enterprise or project. It is an
estimate of true economic profit, or the amount by which earnings exceed or
fall short of the required minimum rate of return investors could get by
investing in other securities of comparable risk (Stewart, 1990).

EVA is not new. Residual income, an accounting performance measure, is

defined to be operating profit with a capital charge subtracted. Thus, EVA is a

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Agrekon, Vol 42, No 2 (June 2003) Geyser & Liebenberg

variant of residual income, with adjustments to how one calculates income

and capital. Stern Stewart & Co, a consulting firm based in New York,
introduced the concept of EVA as a measurement tool in 1989, and
trademarked it. The EVA concept is often called Economic Profit (EP) to avoid
problems caused by the trade marking. EVA is so popular and well known
that all residual income concepts are often called EVA even though they do
not include the main elements defined by Stern Stewart & Co (Pinto, 2001).

Up to 1970 residual income did not get wide publicity and it was not the
prime performance measure for companies (Mäkeläinen, 1998). However, in
the 1990’s, the creation of shareholder value has become recognised as the
ultimate economic purpose of a corporation. Firms focus on building,
operating and harvesting new businesses and/or products that will provide a
greater return than the firm’s cost of capital, thus ensuring maximisation of
shareholder value. EVA is a strategy formulation and a financial performance
management tool that help companies make a return greater than the firm’s
cost of capital. Firms adopt this concept to track their financial position and to
guide management decisions regarding resource allocation, capital budgeting
and acquisition analysis.

2.1 Advantages of EVA

EVA is frequently regarded as a single, simple measure that provides a real

picture of shareholder wealth creation. In addition to motivating managers to
create shareholder value and to serving as a basis for the calculation of
management compensation, there are further practical advantages that value
based measurement systems can offer. An EVA system helps managers to
(Roztoci & Needy, 1998):

• make better investment decisions;

• identify improvement opportunities; and
• consider long-term and short-term benefits for the company.

EVA is an effective measure of the quality of managerial decisions and a

reliable indicator of a company’s value growth in the future. Constant positive
EVA values over time will increase company values, while negative EVA
values might decrease company values.

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2.2 Limitations of EVA

Like other financial performance measures, such as return on investment

(ROI), EVA, on its own, is inadequate for assessing a company’s progress in
achieving its strategic goals and in measuring divisional performance. Other
more forward-looking measures, often non-financial in nature, should be
included in regular performance reports to provide early warning signs of
problem areas (Wood, 2000). In certain industries EVA alone is an
inappropriate measure of financial performance. For new high growth
companies, such as those in the new technology-intensive industries, year-on-
year changes in EVA, which may be negative at times, are unlikely to explain
changes in a firm’s value, given that the value is dependent on future
expected cash flows (Wood, 2000).

Another problem of EVA is that it is distorted by inflation, with the result that
it cannot be used during inflationary times to estimate actual profitability. A
superior measure, the adjusted EVA, corrects for inflationary distortions.

3. EVA RESEARCH IN SOUTH AFRICA

Several research studies have focused on the use and measurement of EVA in
South Africa, although no research has been conducted into the development
of EVA as a measurement tool for agricultural co-operatives. Several studies
have examined the relationship between EVA and shareholder value
maximisation. Bottger (1999), for example, found that basic corporate finance
and microeconomic theory indicates that the primary financial directive of
any firm ought to be to maximize the wealth of the shareholders. The EVA
concept is considered from a financial management perspective. He found
that one of the major challenges facing EVA implementation is changing
traditional methods of financial reporting. You Lee (1995) researched the use
of EVA as a corporate performance measurement tool. His main research
finding was that, within the context of the JSE, EVA is at best marginally
better than measures such as ROA and ROE.

Lloyd (1996) examined the use of four traditional share valuation techniques
that are based on different versions of economic value added, while Pearson
(1998) compared the explanatory power of EVA to that of Refined Economic
Value Added (REVA) for share returns on the mining sector of the JSE. He
found that, while EVA partially explains share returns, REVA does not appear
to explain these returns at all. Manipulating the EVA information to obtain the
annual change in EVA leads to the finding that the annual change explains a
significant portion of share returns in the mining sector. This suggests that

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positive changes in EVA from one year to the next could be a reliable measure
of management performance. Pretorius (1997) and Jansen (1998) both
researched EVA as an investment decision-making measure.

4. CALCULATING EVA

The definition of EVA highlights the three basic inputs needed for its
computation — the return on capital earned on investments, the cost of capital
for those investments and the capital invested in them. The formula for
determining EVA is:

 NOPAT 
EVA =  − Cost of Capital  x Capital invested
 Capital invested 

How much capital is invested in existing assets? While an obvious solution is to

use the market value of the firm, market value includes capital invested not
just in assets in place, but also in expected future growth. Since the quality of
assets needs to be evaluated, the market value of only those assets needs to be
estimated. The book value of capital as a proxy for the market value of capital
invested in assets can be used (Kramer & Pushner, 1997). The book value,
however, is a number that reflects not just the accounting choices made in the
current period, but also accounting decisions made over time on how to
depreciate assets, value inventory and deal with acquisitions. At the
minimum, three adjustments need to be made to capital invested when
computing EVA — converting operating leases into debt, capitalizing R&D
expenses and eliminating the effect of one-time or cosmetic charges (O’Byrne,
1996).

To evaluate the return on this invested capital, the after-tax operating income
(NOPAT) earned by a firm on these investments needs to be estimated. Again,
the accounting measure of operating income has to be adjusted for operating
leases, R&D expenses and one-time charges to compute the return on capital.

The third and final component needed to estimate EVA is the cost of capital. The
cost of capital should be estimated based upon the market value of debt and
equity in the firm, rather than book values (Kramer & Pushner, 1997). There is
no contradiction between using book value for purposes of estimating capital
invested and using market value for estimating cost of capital, since a firm has
to earn more than its market value cost of capital to generate value. From a
practical standpoint, using the book value cost of capital will tend to understate
the cost of capital for most firms and will understate it more for more highly

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leveraged firms than for lightly leveraged firms. Understating the cost of
capital will lead to overstating the economic value added. The capital asset
pricing model (CAPM) is used to determine the cost of capital.

The formula of CAPM is:

Rj = Rf + b(Rm − Rf )

where: Rj = cost of capital

Rf = risk-free rate
b = beta
Rm = market return

5. APPLYING EVA TO AGRICULTURAL CO-OPERATRIVES

The concept of EVA has been adjusted and applied to four agricultural co-
operatives in South Africa. The selection of the co-operatives was random2
and EVA was only determined for 2000. Table 1 indicates NOPAT, the capital
invested and the cost of that capital for three agricultural co-operatives.

Table 1: NOPAT, capital, the cost of capital and EVA of three agricultural
co-operatives for 2000

Co-operative A Co-operative B Co-operative C

NOPAT 3,719,598.50 9,926,734.00 24,292,500.32
Capital 41,442,518.00 65,113,060.00 209,807,000.00
Cost of capital 16.38 10.07 16.22
EVA (3,067,389.47) 3,372,559.00 (9,730,231.68)

In determining the cost of capital, the following assumptions were made:

• the average of the R150 government stock during 2000 was used as the
risk-free rate;
• the average beta of three listed companies in the food and related sector
was used as the beta; and
• a market risk premium of 6%3 was used.

2 This is research in progress and the main objective of the research is to determine the EVA
of all trading co-operatives in South Africa for the period 1997 to 2001.
3 Stern Steward & Co in South Africa uses 6% in all their valuations.

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The financial statements of the three selected co-operatives are given in

appendixes A and B. The financial statements were obtained from the
Registrar of Co-operatives. It is clear from the table that only Co-op B
succeeded in creating value for its members for the financial year ending 2000.

6. CONCLUSION

The value of a co-operative has three components. The first is its capacity to
generate cash flows from existing assets, with higher cash flows translating
into higher value. The second is its willingness to reinvest to create future
growth and the quality of these reinvestments. The final component of value
is the cost of capital. To create value then a co-operative has to:

• generate higher cash flows from existing assets, without affecting its
growth prospects or its risk profile;
• reinvest more and with higher excess returns, without increasing the
riskiness of its assets; and
• reduce the cost of financing its assets in place or future growth, without
lowering the returns made on these investments.

In this study, we consider EVA as a value enhancement measure for

agricultural co-operatives. EVA measures the excess return on existing assets.
It is important to remember when using EVA as a value enhancement
measure that it will not work unless there is a commitment on the part of
managers to make value maximization their primary objective. Finally, there
are no magic bullets that create value. Value creation is hard work in
competitive markets and almost always involves a trade off between costs and
benefits. Everyone has a role in value creation and it certainly is not the sole
domain of financial analysts. In fact, the value created by financial engineers is
smaller and less significant than the value created by good strategic
marketing, production and personnel decisions.

REFERENCES

BOTTGER R (1999). Economic value added (EVA): The essence to creating real
wealth? Unpublished Mimeo, Department of Economics, University of
Stellenbosch.

JANSEN C (1998). South African Marine Corporation Limited: Using economic

value added (EVAtm) for capital project evaluation. University of Cape Town,
Graduate School of Business, South Africa.

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KRAMER JR & PUSHNER G (1997). An empirical analysis of economic value

added as proxy of market value added. Financial Practice and Education 7:41–49.

LLOYD P (1996). A study of the relationship between changes in share price and
contemporaneous changes in economic value added and other corporate performance
measures. University of Cape Town, Graduate School of Business, South
Africa.

MÄKELÄINEN E (1998). Economic value added. http//:www.evanomics.com

(access 2002/06/03).

O’BYRNE SF (1996). EVA and market value. Journal of Applied Corporate

Finance 9(1):116–125.

PEARSON GD (1998). An analysis of the explanatory power of economic value

added and refined economic value added for share returns in the mining sector.
University of Cape Town, Graduate School of Business, South Africa.

PINTO F (2001). Economic value added. http//:www.evanomics.com (access

2002/06/03).

PRETORIUS JL (1997). Ekonomiese waarde toegevoeg as alternatiewe

waarderingsmetode. (Economic value added as an alternative method of valuation).
Randse Afrikaanse Universiteit (RAU), Johannesburg.

ROZTOCKI N & NEEDY KL (1998). EVA for small manufacturing companies.

Working Paper, University of Pittsburgh, Department of Industrial
Engineering, USA.

STEWART ML (1990). The quest for value. Harper: New York.

WOOD N (2000). Economic value added (EVA): Uses, benefits and limitations
– A South African perspective. Southern African Business Review 4(1):46–53.

YOU LEE DF (1995). EVA as a measure of corporate performance. University of

the Witwatersrand, Graduate School of Business Administration, South
Africa.

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Appendix A: Balance sheets of three selected co-operatives for the

financial years 1999 and 2000 (R’000)

CO-OP A CO-OP B CO-OP C

1999 2000 1999 2000 1999 2000
Reserves & undistributed income
Reserve 18,108,608 4,475,572 17,842,080 21,228,265 60,096,000 63,699,676
Undistributed income - - - - - -
Total own resources 18,108,608 4,475,572 17,842,080 21,228,265 60,096,000 63,699,676
Sources from members
Paid-up share capital 2,552,084 196,323 1,729,103 1,729,183 20,915,000 21,251,374
Members funds 17,437,462 2,903,520 - - 108,560,000 111,582,036
Total members' sources 19,989,546 3,099,843 1,729,103 1,729,183 129,475,000 132,833,410
Total members interest 38,098,154 7,575,415 19,571,183 22,957,448 189,571,000 196,533,086
External LT liabilities
Land Bank loans 2,902,208 14,595,623 3,432,159 3,364,241 - -
Other loans - - 2,494,414 2,770,932 - 39,818
Total interest-bearings external 2,902,208 14,595,623 5,926,573 6,135,173 - 39,818
Deferred tax - 2,065,075 - - - -
Total LT liabilities 41,000,362 24,236,113 25,497,756 29,092,621 189,571,000 196,572,904
Current liabilities
Land bank loans - - 34,337,549 40,248,770 - -
Total Land Bank loans - - 34,337,549 40,248,770 - -
Bank overdraft and acceptances - - 4,755,311 1,405,721 - -
ST portion of LT liabilities 442,156 - 522,444 301,123 20,236,000 -
Total interest bearing current 442,156 - 39,615,304 41,955,614 20,236,000 -
Creditors 24,145,110 9,888,810 9,860,771 17,276,335 47,824,000 50,876,697
Total current liabilities 24,587,266 9,888,810 49,476,075 59,231,949 68,060,000 50,876,697
Total external liabilities 27,489,474 26,549,508 55,402,648 65,367,122 68,060,000 50,916,515
Total members interest & liab 65,587,628 34,124,923 74,973,831 88,324,570 257,631,000 247,449,601
Fixed assets
Fixed assets 20,422,908 14,069,499 16,044,353 19,972,911 22,816,000 32,538,265
Investments and loans 1,565,815 12,069,706 6,040,784 5,856,883 2,740,000 186,212
Total LT assets 21,988,723 26,139,205 22,085,137 25,829,794 25,556,000 32,724,477
Current assets
Members debtors 1,283,092 1,545,072 27,367,994 31,138,301 118,452,000 118,668,523
Other debtors 6,280,500 19,955 4,703,772 6,071,615 - 6,354,379
Total debtors 7,563,592 1,565,027 32,071,766 37,209,916 118,452,000 125,022,902
Prepaid expenses 8,538 - - - - -
Total debtors 7,572,130 1,565,027 32,071,766 37,209,916 118,452,000 125,022,902
Net agents' stock & pool accounts 20,709,166 6,362,723 - - 75,979,000 35,781,297
Stock 2,131,417 57,968 19,129,821 23,414,487 20,536,000 26,921,071
Cash on hand & in bank 13,186,192 - 1,687,107 1,870,373 17,108,000 26,999,854
Total current assets 43,598,905 7,985,718 52,888,694 62,494,776 232,075,000 214,725,124
Total assets 65,587,628 34,124,923 74,973,831 88,324,570 257,631,000 247,449,601

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Appendix B: Income statements of three selected co-operatives for the

financial year ending 2000

CO-OP A CO-OP B CO-OP C

(R'000) (R'000) (R'000)
Net income/(Loss) for the year (after tax) 671,111 3,386,185 16,906,363
Extraordinary items - - -
Tax (287,619) - (2,893,456)
Net income/(Loss) before taxation and other items 958,730 3,386,185 19,799,819
Other income/(Expenditure) - - (84)
Net income/(Loss) 958,730 3,386,185 19,799,735
Lease monies - - -
Depreciation of fixed assets 1,810,400 954,627 8,562,946
Directors renumeration - 384,000 396,460
Auditors renumeration 35,726 200,200 392,440
Provisions - - 705,949
Irrecoverable debts written off - 3,071,631 40,206
Interest paid 1,404,875 6,540,549 8,650,245
Capital profit/(loss) on the disposal of fixed assets - 53,840 148,959
Income from investments - 186,234 277,004
Adjusted net income 4,209,731 14,297,118 38,122,018
Plus all interest received 721,848 5,694,739 13,050,154
Net operating income 3,487,883 8,602,379 25,071,864
Distributable income 671,111 3,386,185 7,809,432

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