What Is Economic Value Added (EVA)?
Economic value added (EVA) is a measure of a company’s financial performance. It is based on the residual wealth calculated by deducting its cost of capital from its operating profit. The measure is adjusted for taxes on a cash basis. EVA can also be referred to as economic profit. This is because it attempts to capture the true economic profit of a company. The measure was devised by management consulting firm Stern Value Management. The company was originally incorporated as Stern Stewart & Co.
EVA is used to measure the value a company generates from funds invested in it. However, EVA relies heavily on invested capital and is best used for asset-rich companies. Companies with intangible assets, such as technology businesses, may not be good candidates.
Economic Profit is a measure based on the Residual Income technique. It also serves as an indicator of the profitability of projects undertaken. The underlying premise is that real profitability occurs when additional wealth is created for shareholders. Also, individual projects should create returns above their cost of capital.
Understanding Economic Value Added (EVA)
EVA is the incremental difference in the rate of return (RoR) over a company’s cost of capital. It is used to measure the value a company generates from funds invested in it. A positive EVA shows a company is producing value from the funds invested in it. A negative EVA means the company is not generating value from the funds invested in the business.
Economic Value Added Calculation – Formula #1
- NOPAT = Net operating profit after taxes
- Invested capital = Debt + capital leases + sharholders’ equity
- WACC = Weighted average cost of capital
Economic Value Added Calculation – Formula #2
If you can’t find the Invested capital, you can modify the formula as follows:
EVA = NOPAT – WACC x (TA – CL)
- TA = Total Assets from the balance sheet;
- CL = Current Liabilities from the balance sheet.
Economic Value Added Calculation Example
Assume that Company XYZ has the following components to use in the EVA formula:
NOPAT = $3,380,000
Capital Investment = $1,300,000
WACC = .056 or 5.60%
EVA = $3,380,000 – ($1,300,000 x .056) = $3,307,200
The positive number tells us that Company XYZ more than covered its cost of capital. A negative number indicates that the project did not make enough profit to cover the cost of doing business.
There are three key components to a company’s EVA. These are NOPAT, the amount of capital invested, and the WACC. NOPAT can be calculated manually but is normally listed in a public company’s financials. The goal of EVA is to quantify the cost of investing capital into a certain project or firm. You can then assess whether it generates enough cash to be considered a good investment. A positive EVA shows a project is generating returns in excess of the required minimum return.
Capital invested is the amount of money used to fund a company or 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. The equation used for invested capital in EVA is usually total assets minus current liabilities—two figures easily found on a firm’s balance sheet. In this case, the modified formula for EVA is NOPAT – (total assets – current liabilities) * WACC. As noted by Stern Value Management, “In 1983 we developed the Economic Value Added metric to measure the value that companies generate.” (Source:investopedia)
Economic Value Added – Advantages and Disadvantages
EVA aims to quantify the cost of investing capital into a business or project. It also aims to assess whether the business or project generates enough cash returns to be considered a good investment. A positive EVA means that the project is making profits above the required minimum return. The EVA looks at businesses from a profitability perspective. A company or project is only profitable when it creates wealth and returns for the shareholders.
EVA assesses the performance of a company and its management through the idea that a business is only profitable when it creates wealth and returns for shareholders, thus requiring performance above a company’s cost of capital. EVA as a performance indicator is very useful. The calculation shows how and where a company created wealth, through the inclusion of balance sheet items. This forces managers to be aware of assets and expenses when making managerial decisions. However, the EVA calculation relies heavily on the amount of invested capital and is best used for asset-rich companies that are stable or mature. Companies with intangible assets, such as technology businesses, may not be good candidates for an EVA evaluation. (Source: ibid)
- Undervalues intangible assets – However, the calculation relies heavily on the amount of invested capital. Therefore, it is suitable for asset-rich companies that have matured and have stable performance. Companies with substantial intangible assets, like IT businesses, are usually not good candidates for EVA.
- Can be too complex – In more complex business scenarios cash adjustments can pile-up seemingly to infinity. As a result, the EVA calculation may become too complicated and time-consuming.
- Accounting distortions – Accrual distortions can also affect the Economic Value Added, primarily depreciation and amortization differences.
- Not predictive – One of the most significant minuses for the EVA calculation is that it looks only at the measured period and is not predictive of future performance.
Why Does Economic Value Added (EVA) Matter?
Economic Value Added (EVA) is important because it indicates how profitable company projects are. Therefore, it 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. The measure of this goes beyond superficially calculating net income. Proponents assert that businesses should create returns at a rate above their cost of capital. Also, it clearly summarizes how much and from where a company created that wealth. It includes the balance sheet in the calculation. Thus, it 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. (Source:investinganswers)
The Economic Value Added (EVA) is a handy performance indicator. It is also an important metric in financial modeling and analysis. It indicates how profitable projects are and it serves as a reflector of management performance. The idea behind the EVA is that businesses are only profitable when they create wealth for their shareholders. And, the measure for this goes well beyond net income. The EVA calculation aims to make sure the business generates returns above its cost of capital. This is because the calculation shows where the business created wealth via balance sheet items. Evaluating EVA forces management to be more responsible for assets and expenses while making decisions.
Up Next: What Is a Chief Financial Officer (CFO)?
CFO Meaning: A chief financial officer (CFO) is the senior executive responsible for managing the financial actions of a company. The CFO’s duties include tracking cash flow and financial planning as well as analyzing the company’s financial strengths and weaknesses and proposing corrective actions.