What is ROI, RI, and EVA ?

ROI (Return-on-investment):

To calculate ROI, simply get profit divided by total assets of the firm

ROI = profit / assets

Disadvantages of ROI: Actions that increase divisional ROI can make the corporation worse off & conversely. ROI gave the illusion of insight and control when managers were taking actions that increased ROI but decreased the long-run value of their business units. These perverse incentives happen whenever performance is measured by a percentage or a ratio.

RI (Residual Income):

RI is calculated as net investment base multiply by risk-adjusted, then deducted by ner income before tax

To simplify:

RI= Net income (before tax) – ( net investment base x cost of capital (risk-adjusted ))

The RI measure will always increase when we add investments earning above the cost of capital or eliminate investments earning below the cost of capital.

Thus, this evaluation method can eliminate the ROI perverse incentives, and more closely align manager’s incentives with the value of the firm

Econimic Value Added (EVA)

EVA is a specific form of RI (developed by Stern Stewart) with adjustments made to the inputs (i.e. Accounting numbers, e.g. earnings and assets; Investments in intangible assets, e.g. R&D, advertising, training; Leased assets; Changes in general and specific price levels; Depreciation methods.

And adjustments with purpose of correcting distortions introduced by generally accepted accounting principles (GAAP)

EVA more closely aligns with economic income. However, cares need to be taken that ensure any adjustments made to GAAP are warranted, otherwise it would lead to manipulation.

Market participants may apply a different set of adjustments. EVA and residual income contain little news beyond earnings. Under EVA, there is little incentive for managers to seek out the top level (high yield) investments as long as their investments are just above the company’s cost of capital. Although EVA doesn’t create incentives to over or under-investment per se, it may create the perverse incentive to heavily invest in mediocre investments rather than seeking out high performing investments. Investing in too many mediocre projects, rather than high performing projects not only affects risk, but may affect liquidity. Thus, EVA should be used only as one indicator among many.