Accumulated economic value added

What Is Economic Value Added (EVA)?

Economic Value Added (EVA) is a financial performance metric that assesses a company's true economic profit by measuring the value generated from its investments after accounting for the cost of capital. It falls under the broader category of corporate finance and performance measurement, aiming to provide a more accurate picture of a firm's profitability beyond traditional accounting metrics. EVA essentially calculates the residual income that remains after deducting the capital costs, including both debt and equity, from the net operating profit after tax (NOPAT). By doing so, Economic Value Added helps stakeholders understand whether a company's operations are truly creating wealth for its shareholders. It moves beyond simple accounting profit to consider the opportunity cost of the capital employed in the business, offering a more comprehensive view of financial performance.

History and Origin

The concept of Economic Value Added was popularized and trademarked in the early 1990s by the New York-based consulting firm Stern Stewart & Co.¹⁰, ¹¹. While the underlying principles of economic profit have historical roots, G. Bennett Stewart III, a founding partner of Stern Stewart, is largely credited with bringing EVA into the mainstream with his 1991 book, The Quest for Value⁸, ⁹. The firm aggressively marketed EVA as a superior financial management system, aiming to revolutionize how corporate performance was measured and how companies focused on shareholder value⁶, ⁷. Many large corporations, including Coca-Cola and General Motors, adopted EVA as a key metric to drive their financial and operational decisions during its rise in popularity⁵.

Key Takeaways

• EVA measures a company's true economic profit by considering the cost of all capital, both debt and equity.
• It highlights whether a company is creating value above and beyond what investors could earn elsewhere.
• EVA is calculated by subtracting the cost of capital from net operating profit after tax (NOPAT).
• It encourages management to make investment decisions that maximize wealth for shareholders.
• Primarily used in performance measurement and capital allocation by larger companies.

Formula and Calculation

The formula for Economic Value Added (EVA) is expressed as:

Where:

• NOPAT (Net Operating Profit After Tax): Represents the profit a company makes from its operations after taxes but before financing costs. This can be derived from the income statement.
• Invested Capital: The total capital employed by the business to generate its NOPAT. This includes both debt and equity, often derived from the balance sheet.
• WACC (Weighted Average Cost of Capital): The average rate of return a company expects to pay to all its capital providers (debt holders and equity holders). It reflects the firm's overall cost of capital.

The component (Invested Capital \times WACC) is also known as the capital charge, which is the minimum return required to compensate all capital providers for their investment.

Interpreting the Economic Value Added

Interpreting Economic Value Added involves understanding its implications for profitability and value creation. A positive EVA indicates that a company is generating a return that exceeds its cost of capital, meaning it is creating value for its shareholders. This is a desirable outcome, suggesting efficient use of capital and effective management. Conversely, a negative EVA implies that the company is not earning enough to cover its cost of capital, thereby destroying shareholder value.

A zero EVA suggests that the company is merely covering its costs, including the opportunity cost of capital, but not creating additional wealth. Companies strive for a consistently positive and growing EVA, as it signals strong financial health and effective capital allocation. This metric provides a more insightful view than traditional accounting profits, which do not explicitly account for the cost of equity capital.

Hypothetical Example

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

• Net Operating Profit After Tax (NOPAT): $5,000,000
• Invested Capital: $30,000,000
• Weighted Average Cost of Capital (WACC): 12%

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

1. Calculate the Capital Charge:
   Capital Charge = Invested Capital (\times) WACC
   Capital Charge = $30,000,000 (\times) 0.12 = $3,600,000

2. Calculate EVA:
   EVA = NOPAT - Capital Charge
   EVA = $5,000,000 - $3,600,000 = $1,400,000

In this example, Alpha Manufacturing Inc. has an EVA of $1,400,000. This positive EVA indicates that the company generated $1.4 million in value above and beyond what was required to compensate its capital providers, signifying successful value creation. This positive financial performance suggests that Alpha Manufacturing is efficiently utilizing its invested capital.

Practical Applications

Economic Value Added is a powerful tool with several practical applications across various aspects of corporate finance. It is frequently used by companies as an internal performance measurement metric to evaluate the efficiency of their operations and individual business units. By focusing on EVA, companies can better align management decisions with the goal of maximizing shareholder value.

For instance, EVA can influence capital allocation decisions, guiding management to invest in projects that are expected to generate a positive EVA, thereby contributing to overall firm value. It's also utilized in designing incentive compensation plans for executives and managers, encouraging them to make choices that genuinely add economic value rather than merely boosting accounting profits. While its popularity has fluctuated, EVA remains a relevant metric for large corporations focused on disciplined financial management. For more insights on its practical implications, the CFA Institute offers resources discussing how EVA can enhance investment decision-making processes⁴.

Limitations and Criticisms

Despite its benefits, Economic Value Added has faced certain limitations and criticisms. One primary critique centers on the complexity and subjective nature of calculating its components, particularly Net Operating Profit After Tax (NOPAT) and Invested Capital. NOPAT requires numerous adjustments to standard accounting figures, which can introduce subjectivity and make cross-company comparisons difficult³. Similarly, determining the precise amount of invested capital can be challenging, especially for companies with significant intangible assets.

Another limitation is its backward-looking nature; EVA measures past performance, which may not always be indicative of future value creation. Critics also argue that focusing solely on EVA might lead management to overlook other important strategic considerations, such as long-term growth opportunities or sustainability initiatives, if they do not immediately contribute to a positive EVA. Some scholars have also analyzed EVA from a "management fashion" perspective, noting its "rise and fall" trajectory in popularity since the mid-2000s, suggesting that other financial ratios and metrics have gained prominence¹, ².

Economic Value Added vs. Market Value Added

Economic Value Added (EVA) and Market Value Added (MVA) are two distinct but related concepts in corporate finance, both aimed at understanding value creation for shareholders, but from different perspectives.

While EVA assesses the residual income generated from a company's operations relative to its cost of capital, MVA reflects the market's expectation of a company's ability to create value in the future. A high positive EVA can contribute to a high MVA, as consistent economic value creation often leads to a higher market valuation. However, MVA also incorporates factors beyond a company's immediate operational efficiency, such as industry outlook, economic conditions, and investor sentiment, which are not directly captured by EVA. Understanding both helps paint a comprehensive picture of a company's value proposition to its shareholder value.

FAQs

Why is Economic Value Added considered different from traditional accounting profit?

Economic Value Added differs from traditional accounting profit because it explicitly accounts for the cost of capital, including the cost of equity. Traditional accounting profit (like net income) only subtracts the explicit cost of debt (interest expenses), but not the implicit cost or opportunity cost of using equity capital. EVA ensures that a company's earnings exceed the minimum return required by all its investors, providing a truer measure of economic value created.

Can small businesses use Economic Value Added?

While the principles of Economic Value Added are universal, its practical application is more common in larger companies. This is because calculating EVA requires detailed financial data, particularly for determining Invested Capital and Weighted Average Cost of Capital (WACC), which can be complex and costly to gather for smaller firms. Smaller businesses often rely on simpler financial performance metrics like growth rates or profit margins.

How does Economic Value Added relate to shareholder wealth?

Economic Value Added is directly linked to shareholder wealth because it measures the profit remaining after all capital providers, including shareholders, have been compensated for their investment. A positive EVA indicates that the company is generating returns above its capital costs, thus increasing the wealth of its shareholders. Conversely, a negative EVA suggests the company is destroying shareholder wealth. This alignment makes EVA a useful tool for promoting corporate governance focused on value creation.

What are some adjustments made to NOPAT for EVA calculation?

For EVA calculation, adjustments to Net Operating Profit After Tax (NOPAT) often include normalizing operating expenses, capitalizing certain expenses (like R&D or marketing) that have long-term benefits rather than expensing them immediately, and accounting for non-cash charges. The goal is to convert accounting profit into a truer economic profit by reversing accounting conventions that may distort a company's real underlying profitability.