7. The relationship between the book value of shareholders' equity and the firm's Market Value Added (MVA) and Economic Value Added (EVA)

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Yesterday, Water and Power Co. released its 2015 annual report on the companys website. While reading the report for her boss, Claire came across several terms about which she was unsure. She leaned around the wall of her cubicle and asked her colleague, Alexis, for help.

CLAIRE: Alexis, do you have a second to help me with my reading of Water & Powers annual report? Ive come across several unfamiliar terms, and I want to make sure that Im interpreting the data and managements comments correctly.

For example, one of the footnotes to the financial statements uses the book value of Water & Powers shares, and then in another place, it uses Market Value Added. Ive never encountered those terms before. Do you know what theyre talking about?

ALEXIS: Yes, I do. Lets see if we can make these terms make sense by talking through their meaning and their significance to investors.

The term book value has several uses. It can refer to a single asset or the company as a whole. When referring to an individual asset, such as a piece of equipment, book value refers to the assets selector 1

• market value or replacement cost
• historical value or original purchase price

, adjusted for any accumulated depreciation or amortization expense. The selector 2

• net
• gross

value, or difference between these two values, is called the assets book value.In contrast, when the term refers to the entire company, it means the total value of the companys selector 3

• shareholders equity
• total liabilities

as reported in the firms selector 4

• statement of cash flows
• balance sheet

.CLAIRE: That makes sense. So, what makes this value important to investors is that it is selector 5

• a historical
• an expected future

value that can changebut only due to a couple of events, including the selector 6

• repurchase
• sale

of Treasury stock, the sale of new common or preferred shares, and the payment of selector 7

• interest
• dividends

. Equally important, it selector 8

• will
• will not

change in response to changes in the market prices of the firms shares.

ALEXIS: Right! So, how useful would a firms book value be for assessing the performance of Water & Powers management?

CLAIRE: Well, because Water & Powers book value selector 9

• does not change
• changes

with changes in the market price of the firms shares, the firms book value selector 10

• can
• cannot

reflect managements efforts to maximize the price of the firms common stock and therefore selector 11

• should not
• should

be used to evaluate managements performance.

Now, what about Market Value Added?

ALEXIS: During the 1990s, the consulting firm Stern, Stewart & Company developed the concept of Market Value Added, or MVA, to better assess managements performance in maximizing their shareholders wealth. To achieve this, a firms MVA is computed as the selector 12

• difference
• product

between (of) the selector 13

• book
• market

value and the selector 14

• market
• book

value of Water & Powers shareholders equity.

OK, now heres a question for you: Compared to the book value, what is the advantage of the MVA as a means of evaluating managements performance?

CLAIRE: Well, I would say that because the market value of Water & Powers shareholders equity is calculated by multiplying the shares selector 15

• par value
• market price

by the number of shares selector 16

• outstanding
• repurchased

, then it will fluctuate depending on how the market perceives managements performance. A negative assessment will result in selector 17

• an increased
• a decreased

market price and MVA.

ALEXIS: Nicely done! Does this make your reading of Water & Powers annual report easier?