Acquired economic value added: Meaning, Criticisms & Real-World Uses

What Is Acquired Economic Value Added?

Acquired Economic Value Added (Acquired EVA) is a financial metric used within corporate finance to assess the true economic value created or destroyed by a company through a merger or acquisition (M&A). Unlike traditional accounting profits, Acquired EVA goes beyond simple revenue or earnings growth by explicitly accounting for the cost of capital invested in the acquired entity. It seeks to determine if the returns generated by the acquired business, post-acquisition, exceed the minimum required rate of return expected by investors, thereby genuinely increasing shareholder value. This metric provides a more holistic view of deal success by emphasizing economic profit rather than just accounting profit, making it a critical tool in performance measurement for M&A activity.

History and Origin

The concept of Economic Value Added (EVA) was popularized by the consulting firm Stern Stewart & Co. (now Stern Value Management) in the early 1990s as a measure of a company's financial performance. The academic literature notes how Stern Stewart aggressively marketed EVA during the 1990s, leading to a significant wave of adoption among corporations.⁵ While EVA itself measures economic profit for an ongoing enterprise, its principles naturally extended to evaluate strategic corporate actions, particularly mergers and acquisitions (M&A). Given that studies frequently show a high failure rate for M&A deals, often between 70% and 90%⁴, the need for a robust post-deal assessment tool became apparent. Acquired Economic Value Added emerged as an application of EVA to specifically scrutinize whether an acquisition truly generated value above and beyond the capital deployed, challenging the assumption that all growth through acquisition is inherently good for shareholders.

Key Takeaways

Acquired Economic Value Added measures the true economic profit generated by an acquired entity after accounting for the cost of capital.
It provides a more comprehensive view of M&A success than traditional accounting metrics.
A positive Acquired EVA indicates that the acquisition is creating value for shareholders, while a negative figure suggests value destruction.
This metric is crucial for post-acquisition performance evaluation and guiding future capital allocation decisions.

Formula and Calculation

The calculation of Acquired Economic Value Added adapts the core EVA formula to the specific context of an acquisition. It measures the surplus value created by the acquired business (or combined entity) after deducting the finance charge for the capital invested in the acquisition.

The formula for Acquired EVA is:

\text{Acquired EVA} = \text{NOPAT}_{\text{Acquired}} - (\text{Invested Capital}_{\text{Acquired}} \times \text{WACC}_{\text{Acquirer}})

Where:

(\text{NOPAT}_{\text{Acquired}}) represents the Net Operating Profit After Tax (NOPAT) of the acquired company or the incremental NOPAT generated by the combined entity directly attributable to the acquisition.
(\text{Invested Capital}_{\text{Acquired}}) refers to the total capital invested to acquire the target company, including the purchase price and any additional capital injections required for integration or growth initiatives. This typically includes debt and equity used in the transaction.
(\text{WACC}_{\text{Acquirer}}) is the Weighted Average Cost of Capital (WACC) of the acquiring company, representing the overall required rate of return by its investors.

This calculation helps evaluate the return on investment from the acquisition by comparing the operating profit generated by the acquired assets against the cost of financing those assets.

Interpreting the Acquired Economic Value Added

Interpreting Acquired Economic Value Added is straightforward:

Positive Acquired EVA: A positive value indicates that the acquisition is generating returns that exceed its cost of capital. This means the deal is creating economic value for the acquiring company's shareholders, justifying the capital invested. It signals that the integration is successful and that the synergies, if any, are materializing.
Negative Acquired EVA: A negative value suggests that the acquisition is not generating sufficient returns to cover its cost of capital, thereby destroying economic value for shareholders. This could be due to overpaying for the target, failure to achieve anticipated synergies, poor post-acquisition integration planning, or operational inefficiencies.
Zero Acquired EVA: A zero value implies that the acquisition is just breaking even in terms of economic profit; it covers its cost of capital but does not generate additional value.

This metric offers a clear measure of whether the acquisition contributes to or detracts from the overall enterprise value of the acquiring firm.

Hypothetical Example

Consider TechSolutions, a publicly traded software company, that acquired InnovateLabs, a smaller, innovative startup, for $500 million. TechSolutions financed the acquisition using a combination of debt and equity. Their corporate WACC is determined to be 10%.

One year after the acquisition, the incremental NOPAT generated by InnovateLabs (after accounting for all operational costs and taxes associated with its integration) is $40 million.

Let's calculate the Acquired EVA:

(\text{NOPAT}_{\text{Acquired}} = $40 \text{ million})
(\text{Invested Capital}_{\text{Acquired}} = $500 \text{ million})
(\text{WACC}_{\text{Acquirer}} = 10% = 0.10)

\text{Acquired EVA} = \$40,000,000 - (\$500,000,000 \times 0.10) \\ \text{Acquired EVA} = \$40,000,000 - \$50,000,000 \\ \text{Acquired EVA} = -\$10,000,000

In this hypothetical example, TechSolutions' Acquired EVA is -$10 million. This negative value indicates that the acquisition of InnovateLabs, after one year, is destroying economic value for TechSolutions' shareholders. The returns generated by the acquired business ($40 million NOPAT) are not sufficient to cover the cost of the capital invested in the acquisition ($50 million). This signals that TechSolutions might have overpaid, or that the expected synergies or growth haven't materialized as anticipated, requiring a re-evaluation of the acquisition strategy.

Practical Applications

Acquired Economic Value Added is a powerful tool with several practical applications in the realm of M&A and valuation:

Deal Evaluation and Target Selection: Before an acquisition, companies can project the potential Acquired EVA to determine if a target is likely to create value. This helps in rigorous due diligence and pricing decisions, guiding strategic choices.
Post-Acquisition Performance Review: After a deal closes, Acquired EVA provides a clear metric for evaluating the acquisition's actual contribution to economic profit. This helps management assess the success of the integration process and identify areas for improvement.
Incentive Compensation: Tying management compensation to Acquired EVA can align executive incentives with shareholder value creation, encouraging prudent decision-making regarding M&A activities. Many companies have begun to link management compensation directly to Economic Value Added (EVA) performance to ensure executives are rewarded based on the creation of genuine economic value.³
Strategic Planning: Consistently monitoring Acquired EVA across a portfolio of acquisitions helps a firm refine its M&A strategy, focusing on deal types and integration approaches that reliably create value. Research from McKinsey & Company emphasizes that companies employing a programmatic approach to M&A, undertaking a series of smaller deals, generally outperform those relying on large, infrequent transactions.²
Capital Allocation: By providing a clear economic return on capital invested in acquisitions, Acquired EVA informs future capital allocation decisions, ensuring resources are directed towards the most value-accretive opportunities. The Federal Reserve also examines corporate mergers and acquisitions outcomes under lender scrutiny, noting that enhanced scrutiny can lead to fewer but higher-quality deals.¹

Limitations and Criticisms

While Acquired Economic Value Added offers a robust framework for assessing M&A success, it has certain limitations and criticisms:

Complexity of Data Collection and Adjustment: Accurately calculating the NOPAT and invested capital specifically attributable to the acquired entity post-merger can be challenging. It requires careful accounting adjustments to isolate the performance of the acquired business from the broader operations of the acquiring firm.
Focus on Tangible Assets: Like its parent concept, EVA, Acquired EVA is often considered most suitable for asset-intensive companies. For acquisitions involving businesses with significant intangible assets, such as technology firms or service providers, the "invested capital" might not fully capture the true economic resources contributing to value.
Short-Term Focus Risk: While intended to measure long-term value, if used for short-term performance incentives, managers might defer necessary long-term investments that could negatively impact current Acquired EVA, potentially leading to "underinvestment."
Integration Challenges Not Fully Captured: A negative Acquired EVA signals a problem, but it doesn't diagnose the specific integration or strategic failures. Factors like cultural misalignment, loss of key talent, or unexpected market shifts, while impacting profitability, are not explicitly quantified within the formula.
Market Volatility: External market conditions, which are beyond the control of the acquiring company, can significantly influence the post-acquisition performance and thus the Acquired EVA.

Acquired Economic Value Added vs. Economic Value Added (EVA)

Acquired Economic Value Added is a specific application of the broader concept of Economic Value Added (EVA). The fundamental principle behind both is identical: to measure a company's true economic profit by subtracting the cost of all capital employed from its net operating profit after tax.

The key distinction lies in their scope and purpose. Standard EVA is used to evaluate the financial performance and value creation of an entire ongoing business or a specific internal project over a given period. It assesses whether the company, as a whole, is generating returns above its cost of capital.

Acquired EVA, on the other hand, focuses specifically on the economic value generated by a newly acquired company or the incremental value contributed by an acquisition to the parent company. It's a metric tailored for post-mergers and acquisitions (M&A) analysis, seeking to determine if the specific capital deployed in the acquisition is yielding returns that exceed its financing costs. While the underlying formula is similar, the application and the specific NOPAT and invested capital figures relate directly to the acquired entity, allowing for a granular assessment of individual deal success rather than overall corporate performance.

FAQs

What does Acquired Economic Value Added tell us about an acquisition?

Acquired EVA indicates whether an acquisition is genuinely creating wealth for the acquiring company's shareholders, after accounting for all capital costs. A positive value means the deal is value-accretive, while a negative value implies it is destroying value.

How does Acquired EVA differ from traditional M&A success metrics like EPS accretion?

Unlike metrics such as earnings per share (EPS) accretion, which might show an increase in reported earnings without considering the full cost of capital or the risk associated with the acquisition, Acquired EVA provides a more economically sound measure. It explicitly incorporates the cost of capital, revealing the true economic profit.

Can Acquired EVA be used for pre-acquisition analysis?

Yes, it can. Companies often use projected Acquired EVA in their due diligence phase to forecast the potential value creation of a target company. This helps in determining an appropriate acquisition price and assessing the strategic fit and financial viability of the deal.

Why is including the cost of capital important in Acquired EVA?

Including the cost of capital is crucial because it represents the opportunity cost of investing in the acquisition. Without it, a seemingly profitable acquisition might actually be destroying value if its returns do not surpass what investors could earn elsewhere for a similar level of risk. This makes Acquired EVA a superior measure for evaluating true economic profit.