Active economic value added

What Is Active Economic Value Added?

Active Economic Value Added (Active EVA) is a financial performance measurement tool that assesses the true economic profit generated by a company, emphasizing the proactive management strategies employed to create value for shareholders. It builds upon the foundational concept of Economic Value Added (EVA), which measures a company's profit after accounting for the cost of its capital, including both debt and equity. Active EVA highlights the extent to which management's operational and strategic decisions actively contribute to increasing this economic profit above the minimum required return on capital. It falls under the broader category of Financial Performance Measurement within corporate finance, providing a more comprehensive view than traditional accounting metrics by considering the true cost of all capital used.

History and Origin

The concept of Economic Value Added (EVA), from which Active Economic Value Added derives its principles, was popularized by the consulting firm Stern Stewart & Co. in the early 1990s¹⁷, ¹⁸. Joel Stern and G. Bennett Stewart III were instrumental in developing and promoting EVA as a performance metric that directly links managerial actions to the creation of Shareholder Value. The firm formally developed EVA in 1983 as a model for maximizing value and providing incentives across all levels of a company¹⁶. Earlier notions of economic profit, where wealth is created only when earnings exceed the cost of capital and liabilities, can be traced back to economists like Alfred Marshall in the late 19th century¹⁵. Stern Stewart's work refined this idea, creating a proprietary metric that gained significant traction in the corporate world for its focus on true economic profitability rather than just accounting profit¹⁴. The "active" component of Economic Value Added, while not a separate invention, refers to the deliberate and continuous application of EVA principles to drive better Investment Decision and resource allocation, aiming to actively enhance a company's intrinsic value.

Key Takeaways

• Active Economic Value Added (Active EVA) measures a company's true economic profit by deducting the cost of capital from its after-tax operating profit.
• It highlights the effectiveness of management in creating wealth beyond the minimum return required by investors.
• Unlike traditional accounting profits, Active EVA accounts for the opportunity cost of all capital, including equity.
• A positive Active EVA indicates value creation, while a negative Active EVA suggests value destruction.
• It serves as a powerful tool for aligning management incentives with shareholder wealth maximization.

Formula and Calculation

The calculation of Active Economic Value Added is based on the core EVA formula, which is:

Where:

• (\text{NOPAT}) (Net Operating Profit After Tax) is the company's operating profit less taxes, adjusted for non-cash and non-operating items to reflect the true cash profit available to all capital providers. It represents the profit a company would generate if it had no debt financing.
• (\text{Capital Employed}) is the total capital invested in the business, typically adjusted from book values on the Financial Statements to reflect the economic capital used. This can include operating working capital and net fixed assets.
• (\text{WACC}) (Weighted Average Cost of Capital) is the average rate of return a company is expected to pay to its capital providers (both debt and equity holders). It is a critical component as it represents the minimum acceptable Return on Capital for a company to maintain its value.

Stern Stewart, the firm that popularized EVA, suggested making various adjustments to standard accounting figures for NOPAT and Capital Employed to arrive at a more economically accurate figure. These adjustments aim to convert accounting profit into a closer approximation of economic profit.

Interpreting the Active EVA

Interpreting Active Economic Value Added focuses on whether a company is truly adding value for its shareholders after accounting for the full cost of capital. A positive Active EVA indicates that the company's operations are generating a return higher than the cost of the capital employed, thereby increasing shareholder wealth. This suggests efficient utilization of assets and effective strategic choices by management. Conversely, a negative Active EVA implies that the company is not earning enough to cover its cost of capital, essentially destroying value for its investors.

Companies strive for a consistently positive Active EVA over time. This metric provides a clear, single-period measure of a firm's ability to create wealth¹³. It goes beyond traditional profitability measures like Return on Equity (ROE) or Earnings Per Share (EPS), which may not fully capture the cost of equity capital or can be influenced by accounting policies. Active EVA helps managers understand the real drivers of business performance and align their efforts with maximizing shareholder value¹².

Hypothetical Example

Consider "InnovateTech Solutions," a hypothetical software company.
Year 1 Data:

• Net Operating Profit After Tax (NOPAT) = $10 million
• Capital Employed = $50 million
• Weighted Average Cost of Capital (WACC) = 15%

Calculation for Year 1:
Capital Charge = Capital Employed × WACC
Capital Charge = $50 million × 0.15 = $7.5 million

Active EVA = NOPAT - Capital Charge
Active EVA = $10 million - $7.5 million = $2.5 million

In Year 1, InnovateTech Solutions generated an Active EVA of $2.5 million. This positive figure indicates that the company's operations not only covered the cost of all capital used but also generated an additional $2.5 million in economic profit, effectively adding value for its shareholders.

Year 2 Data (after a new large project):

• NOPAT = $12 million
• Capital Employed = $90 million (due to the new project)
• WACC = 15%

Calculation for Year 2:
Capital Charge = Capital Employed × WACC
Capital Charge = $90 million × 0.15 = $13.5 million

Active EVA = NOPAT - Capital Charge
Active EVA = $12 million - $13.5 million = -$1.5 million

In Year 2, despite an increase in NOPAT, the Active EVA turned negative, reaching -$1.5 million. This indicates that the new, larger project, while increasing operating profit, did not generate sufficient returns to cover its increased Capital Employed cost. Management would need to analyze this result to understand if the project is underperforming or if the benefits are yet to materialize, and take corrective action to improve the company's Performance Measurement.

Practical Applications

Active Economic Value Added is widely applied in various aspects of financial management to promote a focus on value creation. Companies like Coca-Cola, Infosys, and General Electric have reportedly adopted EVA as a key performance metric to guide strategic decisions, capital allocation, and incentive plans. It¹⁰, ¹¹ is used for:

• Performance Evaluation: Active EVA provides a more accurate measure of a company's performance than traditional accounting profits, as it considers the cost of all capital. It helps management and investors assess whether the business is truly generating wealth or merely increasing accounting profits without covering its capital costs.
• Capital Budgeting: By integrating the cost of capital, Active EVA helps in evaluating potential investment projects. Projects are typically deemed viable if they are expected to generate a positive Active EVA over their lifespan, aligning with the principles of Discounted Cash Flow valuation.
• Management Compensation: Tying executive and employee bonuses to Active EVA metrics can align management's interests directly with those of shareholders. If managers are rewarded based on the value they create beyond the cost of capital, they are incentivized to make decisions that truly enhance the firm's worth. Coca-Cola, for example, linked management incentives to EVA as early as 1988.
• ⁹ Strategic Planning: Active EVA can inform strategic choices by highlighting which business units or product lines are creating or destroying value. This allows management to allocate resources more effectively to areas that promise higher economic returns. The company Enviva Inc., for instance, makes regular SEC filings that include discussions of its financial performance, which can be analyzed through a value-added lens.

#⁸# Limitations and Criticisms

Despite its advantages, Active Economic Value Added faces several limitations and criticisms:

• Dependence on Accounting Adjustments: While Active EVA aims to correct distortions in traditional accounting, it still relies on accounting data. The accuracy of Active EVA can be sensitive to the numerous adjustments made to Net Operating Profit After Tax and Capital Employed. Different interpretations and applications of these adjustments can lead to varying EVA figures, making comparisons difficult. Cr⁷itics argue that some of these adjustments can be subjective and may not always reflect economic reality.
• ⁶ Complexity: The calculation of Active EVA, especially with all the proposed adjustments, can be complex and time-consuming, requiring significant effort to implement effectively within an organization. Th⁵is complexity can deter some companies from adopting it or lead to simplified versions that lose some of its theoretical rigor.
• Short-Term Focus: Some critics argue that despite its emphasis on long-term value creation, Active EVA can still be used to justify short-term decisions if managers manipulate the inputs to inflate immediate results. This potential for a short-term focus is a common criticism of many single-period performance measures.
• ⁴ Applicability in Unstable Markets: Research suggests that the conventional EVA formula may not accurately reflect the limitations of emerging or unstable markets and could lead to incorrect managerial decisions that limit shareholder value. Th³e standard calculation may not be universally applicable without significant modifications to account for unique economic environments.
• Correlation with Market Value: While advocates claim a strong correlation between EVA and Market Value, empirical studies have yielded mixed results regarding EVA's superiority over traditional accounting measures like EPS or Book Value in explaining stock returns.

#¹, ²# Active Economic Value Added vs. Economic Value Added

While "Active Economic Value Added" is a descriptive phrase used to emphasize the proactive management of value, it is fundamentally rooted in the concept of Economic Value Added (EVA). The primary difference lies in the emphasis rather than a distinct calculation methodology.

Economic Value Added (EVA) is a specific financial metric, trademarked by Stern Stewart & Co., that quantifies the economic profit a company generates above its cost of capital. It serves as a benchmark for financial performance. "Active Economic Value Added," on the other hand, describes the application or philosophy of utilizing EVA as a central component of a company's Corporate Governance and strategic framework. It implies a continuous, deliberate effort by management to optimize operations, allocate capital efficiently, and make decisions specifically aimed at maximizing this economic profit. Therefore, while EVA is the calculation, Active EVA represents the dynamic process and managerial mindset employed to achieve and sustain positive EVA.

FAQs

Q1: How is Active Economic Value Added different from traditional accounting profit?

Active Economic Value Added differs from traditional accounting profit because it includes the cost of all capital, both debt and equity. Traditional accounting profit (like net income) only accounts for explicit costs, such as interest on debt, but not the implicit cost of equity capital or the opportunity cost of funds. Active EVA provides a more complete picture of true wealth creation.

Q2: Why is the Weighted Average Cost of Capital (WACC) important in Active EVA?

The Weighted Average Cost of Capital (WACC) is crucial because it represents the minimum rate of return a company must earn on its existing asset base to satisfy its investors. If a company's operations do not generate a return greater than its WACC, it is not truly creating value for its shareholders, even if it reports a positive accounting profit.

Q3: Can Active EVA be used by non-public companies?

Yes, Active EVA can be a valuable Performance Measurement tool for both public and private companies. While public companies have readily available market data for calculating the cost of equity, private companies can estimate their cost of capital using industry benchmarks or comparable public companies. The core principle of covering all capital costs to create value remains relevant for any business, regardless of its ownership structure.