What Is Economic Value Added?
Economic Value Added (EVA) is a financial metric that measures a company's true economic profit after accounting for the cost of capital. It falls under the broader category of Financial Performance Measurement within corporate finance. Unlike traditional accounting measures such as Net Income, EVA provides a more accurate representation of a company's profitability and ability to create Shareholder Value by explicitly deducting the cost of financing the capital employed in the business.58, 59 A positive Economic Value Added indicates that a company is generating value by earning more than its cost of capital, while a negative EVA suggests that the company is destroying value.57
History and Origin
The concept of Economic Value Added, often abbreviated as EVA, was popularized and trademarked by the management consulting firm Stern Stewart & Co. (now Stern Value Management) in the early 1990s.56 While similar concepts of "residual income" existed earlier, Joel Stern and G. Bennett Stewart III actively developed and commercialized EVA as a practical management tool.54, 55 The firm aimed to provide a metric that aligned management incentives with maximizing shareholder wealth, moving beyond traditional accounting profits that might not capture the true cost of doing business.52, 53 Stern Value Management traces its roots back to the foundational work on value determination by professors Miller and Modigliani in the 1950s, with Joel Stern developing the Free Cash Flow concept in 1972, leading to the formal incorporation of Stern Stewart & Co. in 1982 and the subsequent development of EVA in 1983.51
Key Takeaways
- Economic Value Added (EVA) measures a company's true economic profit by deducting the cost of capital from its operating profit after tax.
- A positive EVA signifies that a company is creating value for its shareholders, as its return exceeds the cost of financing its operations.50
- EVA encourages managers to make decisions that efficiently utilize Invested Capital and generate returns above the minimum required by investors.49
- It serves as a more comprehensive performance indicator than traditional accounting profits because it accounts for the opportunity cost of capital.48
- Despite its benefits, EVA calculation can be complex due to the need for accounting adjustments and estimation of the Cost of Capital.46, 47
Formula and Calculation
The Economic Value Added (EVA) formula is calculated by subtracting a capital charge from the Net Operating Profit After Tax (NOPAT). The capital charge represents the minimum return expected by investors on the capital they have invested in the business.45
The basic formula for EVA is:
Where:
- (\text{NOPAT}) (Net Operating Profit After Tax) is the company's after-tax operating profit, adjusted to remove accounting distortions and before financing costs.43, 44
- (\text{Invested Capital}) is the total capital employed in the business, including both debt and equity.42 This can also be calculated as total assets minus non-interest-bearing current liabilities.
- (\text{Weighted Average Cost of Capital}) (WACC) is the average rate of return a company is expected to pay to its investors (both debt and equity holders) to finance its assets.40, 41 It reflects the company's blended Cost of Capital.
Alternatively, EVA can be expressed as:
This formulation highlights that EVA is generated when the Return on Invested Capital exceeds the Weighted Average Cost of Capital.39
Interpreting the Economic Value Added
Interpreting Economic Value Added involves assessing whether a company is truly creating wealth for its investors. A positive EVA indicates that the company's operations are generating profits that exceed the cost of the capital used to produce those profits, thereby adding economic value.37, 38 Conversely, a negative EVA suggests that the company is not earning enough to cover its cost of capital, effectively eroding shareholder wealth.35, 36
Managers and investors use EVA to evaluate the efficiency of a company's Capital Allocation decisions and its ability to generate returns above the required minimum.34 It prompts a focus on balancing profitability with the efficient use of assets. A sustained positive and increasing EVA over time is generally seen as a strong indicator of sound financial management and sustainable value creation.33
Hypothetical Example
Consider "Tech Innovations Inc.," a hypothetical software company.
- Last year, Tech Innovations Inc. reported a Net Operating Profit After Tax (NOPAT) of $5 million.
- The company's Invested Capital for the year was $40 million.
- Its calculated Weighted Average Cost of Capital (WACC) is 10%.
To calculate Tech Innovations Inc.'s Economic Value Added (EVA):
Capital Charge = Invested Capital × WACC
Capital Charge = $40,000,000 × 0.10 = $4,000,000
EVA = NOPAT - Capital Charge
EVA = $5,000,000 - $4,000,000 = $1,000,000
In this example, Tech Innovations Inc. has an EVA of $1 million. This positive value indicates that the company generated $1 million in economic profit above and beyond the cost of the capital invested. This suggests that Tech Innovations Inc. is efficiently using its capital to create value for its shareholders.
Practical Applications
Economic Value Added (EVA) is widely applied in various areas of finance and business management to enhance Corporate Performance and decision-making.
- Performance Measurement and Management: Companies use EVA as a key Financial Metric to evaluate overall company performance and the performance of individual business units or projects. I31, 32t helps managers understand whether their strategic decisions are genuinely creating value.
- Compensation Systems: Many corporations link executive and employee compensation directly to EVA performance. This incentivizes management to focus on long-term value creation and efficient capital utilization, aligning their interests with those of shareholders.
*29, 30 Capital Budgeting: EVA can be used in capital budgeting decisions to assess the profitability of potential investments. Projects with positive expected EVA are considered value-adding, providing a framework for Investment Appraisal.
*28 Valuation: EVA can be used as a basis for company valuation. The market value of a firm can be seen as the sum of its invested capital and the present value of all future expected EVAs. T27his connection highlights how consistent EVA generation translates into higher firm value. For instance, the United States Postal Service eliminated substantial losses by implementing a value-based management system including EVA for performance measurement and capital expenditures.
26## Limitations and Criticisms
While Economic Value Added (EVA) offers a robust measure of economic profit, it also has several limitations and criticisms that warrant consideration.
- Complexity and Subjectivity of Adjustments: Calculating EVA accurately often requires numerous adjustments to traditional Financial Statements and accounting data to reflect economic reality more precisely. T24, 25hese adjustments can be complex and subjective, leading to variations in EVA figures depending on the assumptions made. F22, 23or example, decisions regarding the treatment of research and development expenses, goodwill, or operating leases can significantly impact the calculated Invested Capital and Net Operating Profit After Tax.
*20, 21 Reliance on Accounting Data: Despite adjustments, EVA still relies on historical Accounting Practices, which may not always capture the true economic value of certain assets, particularly intangible assets like brand value or human capital.
*19 Estimation of Cost of Capital: Determining the precise Weighted Average Cost of Capital (WACC) can be challenging, as it involves estimating the cost of equity and debt, which can be influenced by market conditions and subjective judgments. I17, 18naccuracies in WACC can distort the EVA calculation.
*16 Short-Term Focus: Critics argue that EVA, when used in isolation or for short-term performance evaluation, might incentivize managers to focus on immediate results rather than long-term strategic investments that could initially reduce EVA but yield substantial future benefits.
*14, 15 Comparability Issues: Due to the various accounting adjustments and the company-specific nature of WACC, comparing EVA across different companies or industries can be difficult. A12, 13s noted by Investopedia, EVA is best suited for asset-rich companies, and may not be as effective for businesses with significant intangible assets.
Economic Value Added vs. Market Value Added
Economic Value Added (EVA) and Market Value Added (MVA) are both concepts designed to assess wealth creation, but they measure different aspects of it and serve distinct purposes within Corporate Finance.