Accelerated economic value added

What Is Economic Value Added (EVA)?

Economic Value Added (EVA) is a financial metric used in Corporate Finance to measure a company's true Economic Profit, representing the value generated above and beyond the cost of the capital employed to produce that profit. Unlike traditional Financial Metrics like net income, EVA explicitly accounts for the Cost of Capital for both debt and equity, providing a more comprehensive view of Shareholder Value creation. If a company's operations yield a return greater than its cost of capital, it indicates a positive EVA, signifying wealth creation for its investors. The term "Accelerated Economic Value Added" is not a recognized or distinct financial term in standard corporate finance literature; the focus is solely on Economic Value Added.

History and Origin

The concept of Economic Value Added (EVA) was popularized and trademarked by the consulting firm Stern Stewart & Co. in the early 1990s. While the underlying principles of economic profit have been present in economic thought for centuries, Joel Stern and Bennett Stewart refined and promoted EVA as a practical performance measurement tool for corporations. Stern Stewart & Co. was founded in November 1982, building upon foundational work in finance that explored the determinants of value¹². Bennett Stewart, often referred to as "the father of EVA," further articulated the methodology in his 1991 book, "The Quest for Value," advocating for EVA as a superior measure of financial performance that directly links to shareholder wealth creation¹¹. This period saw a significant shift in corporate finance towards value-based management, with EVA emerging as a leading metric to encourage managers to align their decisions with the interests of shareholders¹⁰.

Key Takeaways

• EVA measures a company's economic profit, which is the profit remaining after deducting the cost of all capital, both debt and equity.
• A positive EVA indicates that a company is creating value for its shareholders, while a negative EVA suggests value destruction.
• The calculation of EVA requires careful adjustments to conventional Accounting Principles to reflect true economic performance.
• EVA encourages efficient Capital Allocation and operational excellence by making the cost of capital explicit.
• It serves as a key performance indicator for evaluating Corporate Performance and guiding strategic decisions.

Formula and Calculation

The formula for Economic Value Added (EVA) is derived by subtracting the capital charge from the Net Operating Profit After Tax (NOPAT).

Where:

• NOPAT (Net Operating Profit After Tax): This represents the company's operating profit after taxes but before interest expenses. It is calculated to show the profit generated from core operations, available to all capital providers.
• Invested Capital: This refers to the total capital employed in the business, which can be calculated as total assets minus non-interest-bearing current liabilities, or as the sum of shareholder's equity and net debt.
• Weighted Average Cost of Capital (WACC): This is the average rate of return a company expects to pay to its investors (both debt and equity holders) to finance its assets. It serves as the minimum acceptable rate of return for projects.

The term ( (\text{Invested Capital} \times \text{WACC}) ) is often referred to as the "capital charge" or "finance charge"⁹. It represents the minimum profit a company must generate to cover the cost of all the capital tied up in the business.

Interpreting the EVA

Interpreting Economic Value Added involves assessing whether a company is truly creating wealth. A positive EVA signifies that the company is generating a return greater than its Cost of Capital, thereby adding value for its shareholders. This indicates efficient operations and effective utilization of capital. Conversely, a negative EVA suggests that the company's operating profit is insufficient to cover the cost of its capital, implying value destruction. This might signal a need for operational improvements or strategic adjustments in Capital Allocation.

EVA is a robust measure because it aligns managerial incentives with Shareholder Value maximization, promoting decisions that yield returns above the required minimum. It moves beyond traditional accounting profits, which do not deduct a charge for equity capital, offering a clearer picture of economic reality.

Hypothetical Example

Consider "Alpha Manufacturing Inc." with the following hypothetical financial data for a given year:

• Net Operating Profit After Tax (NOPAT): $5,000,000
• Invested Capital: $40,000,000
• Weighted Average Cost of Capital (WACC): 10%

To calculate Alpha Manufacturing Inc.'s Economic Value Added (EVA):

1. Calculate the Capital Charge:
   Capital Charge = Invested Capital × WACC
   Capital Charge = $40,000,000 × 10% = $4,000,000

2. Calculate EVA:
   EVA = NOPAT - Capital Charge
   EVA = $5,000,000 - $4,000,000 = $1,000,000

In this example, Alpha Manufacturing Inc. has an EVA of $1,000,000. This positive EVA indicates that the company generated $1 million in profit above and beyond the cost of the capital it employed. This suggests that Alpha Manufacturing Inc. is successfully creating wealth for its shareholders.

Practical Applications

Economic Value Added (EVA) is widely applied in various areas of finance and business management to enhance decision-making and performance evaluation. Companies use EVA to guide Capital Allocation decisions, prioritizing investments that are expected to generate a positive EVA and increase Shareholder Value. ⁸It is also integrated into performance measurement systems, providing a more accurate assessment of divisional and overall Corporate Performance than traditional accounting measures. ⁷Many firms have adopted EVA as a basis for incentive compensation plans, motivating managers to make decisions that truly add economic value.
⁶
For instance, companies like Coca-Cola have historically utilized EVA as a core performance metric, prompting managers to optimize their use of capital and identify underperforming business units. ⁵The focus on EVA encourages operational efficiency and helps ensure that projects generate returns above their required Cost of Capital. This strategic application of EVA helps businesses align their internal goals with market expectations and long-term value creation.

Limitations and Criticisms

Despite its strengths, Economic Value Added (EVA) has certain limitations and has faced criticism. One primary critique is its reliance on accounting data, which often requires numerous adjustments to convert generally accepted accounting principles (GAAP) figures into economically meaningful ones. While these adjustments aim for accuracy, they can be complex and subject to management discretion, potentially impacting the comparability of EVA across different companies or even within the same company over time. Stern Stewart identified over 160 potential accounting adjustments, though typically only a few key ones are made in practice.
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Another common criticism is that EVA can be perceived as a short-term performance measure, as it focuses on a single period's economic profit. ³This might inadvertently incentivize managers to prioritize short-term gains at the expense of long-term strategic investments, such as research and development, which may have negative near-term impacts on EVA but significant long-term benefits. ²Furthermore, EVA's sensitivity to fluctuations in the Cost of Capital, particularly in unstable economic conditions, can limit its reliability as a universal financial metric. ¹Companies with significant Intangible Assets, whose value is not fully captured on traditional Financial Statements, may also find EVA less suitable as a sole performance indicator.

EVA vs. Net Income

Economic Value Added (EVA) and Net Income are both measures of profitability, but they differ fundamentally in how they account for the use of capital.

The key distinction lies in EVA's inclusion of the capital charge, particularly for equity, which Net Income does not consider. This makes EVA a more rigorous measure of wealth creation. While a company may report positive net income, it could still have a negative EVA if the profits are not sufficient to cover the full cost of all capital invested. This is why EVA is often confused with or seen as a refinement of traditional profitability measures. Another related metric, Return on Investment (ROI), measures the efficiency of an investment but does not explicitly deduct the cost of capital in the same way EVA does.

FAQs

What is the primary purpose of EVA?

The primary purpose of EVA is to measure a company's true economic profit, reflecting whether it is creating or destroying Shareholder Value by accounting for the full Cost of Capital employed in the business.

How is EVA different from traditional accounting profits?

EVA differs from traditional accounting profits, such as Net Income, by deducting a charge for the use of all capital, including equity capital, which represents an opportunity cost. Traditional accounting profits do not account for the cost of equity, only the cost of debt (interest expense).

Can a company have positive net income but negative EVA?

Yes, a company can have a positive Net Income but a negative EVA. This occurs if the accounting profits are not high enough to cover the full Cost of Capital (both debt and equity). In such a scenario, while the company is profitable on paper, it is still destroying economic value for its shareholders.

Is EVA used for external reporting?

While some companies might mention EVA in their investor communications, it is primarily an internal Financial Metric used for performance measurement, Capital Allocation, and aligning managerial incentives. Investors often use it to assess a company's ability to create value. Another related metric, Market Value Added (MVA), is more directly observable by external stakeholders as it reflects the difference between a company's market value and the capital invested in it.

Are there any adjustments made to financial statements when calculating EVA?

Yes, calculating EVA often involves making adjustments to figures from conventional Financial Statements to arrive at a more accurate measure of Invested Capital and Net Operating Profit After Tax (NOPAT). These adjustments aim to remove accounting distortions and reflect the true economic reality of the business.