Economic Value Added (EVA)
What is Economic Value Added (EVA)?
In corporate finance, Economic Value Added (EVA) is an estimate of a firm's economic profit or the value created in excess of the required return of the company's shareholders. Quite simply, EVA is the net profit less the opportunity cost of the firm's capital. The idea is that value is created when the return on the firm's economic capital employed exceeds the cost of that capital. This amount can be determined by making adjustments to GAAP accounting. There are potentially over 160 adjustments but in practice, only several key ones are made, depending on the company and its industry. EVA is a service mark of Stern Value Management.[1]
Economic Value Added Formula[2]
The formula for calculating EVA is: Net Operating Profit After Taxes (NOPAT) - Invested Capital * Weighted Average Cost of Capital (WACC)
The equation above shows there are three key components to a company's EVA: NOPAT, the amount of capital invested, and the WACC. NOPAT can be calculated manually but is normally listed in a public company's financials. Capital invested is the amount of money used to fund a specific project. WACC is the average rate of return a company expects to pay its investors; the weights are derived as a fraction of each financial source in a company's capital structure. WACC can also be calculated but is normally provided as a public record.
The goal of EVA is to quantify the charge, or cost, for investing capital into a certain project, and then assess whether it is generating enough cash to be considered a good investment. The charge represents the minimum return that investors require to make their investment worthwhile. A positive EVA shows a project is generating returns in excess of the required minimum return.
source: Investopedia
Significance of Economic Value Added (EVA)[3]
The concept of Economic Value Added (EVA) that is gaining popularity globally was founded by the Stern & Stewart Company. EVA can be used by corporate to measure financial performance. Many companies globally seem to have destroyed shareholders’ wealth over a period of time and only a few have positively contributed to their wealth. With the help of Economic Value Added (EVA) which tells what the institution is doing with investors’ hard-earned money and it also finds out whether companies have been able to create (or destroy) shareholders' wealth. The overriding message is that corporate must always strive to maximize shareholders' value without which their stocks (shares) can never be fancied by the market. The EVA analysis helps us to dig below the surface numbers to tell us more about the underlying business and whether there is another case for using EVA as one of the ranges of performance measurement tools. EVA is a mirror reflection of an organization's true performance. EVA is the invention of Stern Stewart & Co., a global consulting firm, which launched EVA in 1989. EVA is Economic Value Added, a measure of economic profit. EVA is the most misunderstood term among the practitioners of corporate finance. The proponents of EVA are presenting it as the wonder drug of the millennium in overcoming all corporate ills in one stroke and ultimately helping in increasing the wealth of the shareholder, which is synonymous with the maximization of the firm value. EVA is nothing but a new version of the age-old residual income concept recognized by economists since the 1770s. Both EVA and ‘residual income’ concepts are based on the principle that a firm creates wealth for its owners only if it generates a surplus over the cost of the total invested capital. Perhaps EVA could bring back the lost focus on ‘economic surplus’ from the current emphasis on accounting profit.
Economic Value Added Example
Economic Value Added or EVA is a tool for gauging the real economic performance of a business and its ability to create shareholder value. EVA provides a means for coupling the two fundamental drivers of economic or shareholder value– operating earnings and capital efficiency. The EVA Example worksheet details the calculation of EVA over five years for a middle-market manufacturing company operating in a capital-intensive industry.
Economic Value Added Template
The EVA Template worksheet provides a simple template for the calculation of EVA from annual financial statement inputs provided by the user.
Advantages and Disadvantages of Economic Value Added[4]
- The main advantage of using EVA as a metric for performance appraisal is that it takes into consideration all the costs including the cost of equity capital which is ignored in normal accounting. With this EVA Model, economic profit can be determined.
- The disadvantage is the practicability of the calculations. The first difficulty is in finding a correct cost of equity. It is not suitable for all kinds of companies. It may not correctly understand efficiency as the EVA of a bigger plant will always be more than a smaller plant even when they are more efficient and maintain a better ROI comparatively.
The Importance of Economic Value Added[5]
Economic Value Added (EVA) is important because it is used as an indicator of how profitable company projects are and it, therefore, serves as a reflection of management performance. The idea behind EVA is that businesses are only truly profitable when they create wealth for their shareholders, and the measure of this goes beyond calculating net income. Economic value added asserts that businesses should create returns at a rate above their cost of capital. The economic value calculation has many advantages. It succinctly summarizes how much and from where a company created wealth. It includes the balance sheet in the calculation and encourages managers to think about assets as well as expenses in their decisions. However, the seemingly infinite cash adjustments associated with calculating economic value can be time-consuming. And accrual distortions can still affect the measure, particularly when it comes to depreciation and amortization differences. Also, economic value added only applies to the period measured; it is not predictive of future performance, especially for companies in the midst of reorganization and/or about to make large capital investments. The EVA calculation depends heavily on invested capital, and it is therefore most applicable to asset-intensive companies that are generally stable. Thus, EVA is more useful for auto manufacturers, for example, than software companies or service companies with a lot of intangible assets.
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