Adjusted economic ratio

What Is Economic Value Added (EVA)?

Economic Value Added (EVA) is a financial performance metric that assesses a company's true economic profit by accounting for the cost of all capital, both debt and equity. It falls under the broader category of financial performance metrics and is designed to measure the value a company creates beyond the minimum required return for its investors. Unlike traditional accounting measures, EVA aims to provide a more comprehensive view of profitability by recognizing that capital, like other inputs, has an opportunity cost that must be covered before true value is created.

History and Origin

The concept of economic profit, which forms the basis of Economic Value Added, has roots in classical economics. However, the specific metric known as Economic Value Added (EVA) was developed and popularized by the consulting firm Stern Stewart & Co. in the early 1980s, gaining significant traction in the 1990s.²⁰, ²¹, ²² Stern Stewart & Co., officially incorporated in 1982, aimed to provide companies with a clearer understanding of their profitability and value creation, leading them to trademark the term EVA.¹⁹ The firm's work built upon earlier economic theories that emphasized how companies create wealth by earning more than their own capital costs and liabilities.¹⁸

Key Takeaways

• Economic Value Added (EVA) measures a company's true economic profit after accounting for all capital costs, including equity.
• A positive EVA indicates that a company is creating wealth for its shareholders, while a negative EVA suggests value destruction.
• EVA encourages managers to make better investment decisions by focusing on projects that generate returns above the cost of capital.
• It requires adjustments to conventional financial statements to reflect economic realities.
• EVA is often used for capital allocation, performance measurement, and executive compensation.

Formula and Calculation

The formula for Economic Value Added (EVA) is:

Where:

• ( NOPAT ) = Net Operating Profit After Taxes. This represents the profit a company earns from its operations after taxes, but before interest expenses.¹⁷
• ( Invested Capital ) = The total capital employed by the company, including both debt and equity capital.
• ( WACC ) = Weighted Average Cost of Capital. This is the average rate of return a company expects to pay to its investors to finance its assets.¹⁶

In essence, the formula subtracts the capital charge (the cost of using the invested capital) from the net operating profit after taxes (NOPAT). The calculation of EVA often involves numerous adjustments to a company's accounting data to align them more closely with economic principles, rather than just accounting conventions.¹³, ¹⁴, ¹⁵

Interpreting the Economic Value Added (EVA)

Interpreting Economic Value Added involves understanding whether a business is generating a return that exceeds its cost of capital. A positive EVA signifies that the company has generated wealth for its shareholders, as its operating profit has more than covered the cost of the capital employed. Conversely, a negative EVA indicates that the company is not earning enough to cover its cost of capital, implying that it is destroying shareholder value.

EVA provides a measure of economic profit, moving beyond merely showing an accounting profit. It emphasizes that for a company to truly be profitable, it must generate a return greater than what investors could earn on alternative investments of similar risk. This focus on value creation helps management make decisions that are aligned with long-term wealth maximization for owners.

Hypothetical Example

Consider a hypothetical manufacturing company, "Widgets Inc.," with the following financial data:

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

To calculate Widgets Inc.'s Economic Value Added:

1. Calculate the Capital Charge:
   Capital Charge = Invested Capital × WACC
   Capital Charge = $40,000,000 × 0.10 = $4,000,000

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

In this scenario, Widgets Inc. has an EVA of $1,000,000. This positive result indicates that the company is generating $1 million in value above and beyond the cost of the capital it employs, effectively creating wealth for its owners. This metric helps management assess whether specific projects or the overall corporate strategy are financially viable.

Practical Applications

Economic Value Added (EVA) is applied across various aspects of corporate finance and investment analysis. Companies use EVA as a key metric for performance measurement and executive incentive compensation, aligning managerial actions with shareholder wealth creation. I¹²t helps organizations assess which business units, projects, or products are truly profitable after accounting for the cost of capital, guiding more efficient resource allocation.

In banking and financial services, related concepts like economic capital are used to quantify the capital required to cover unexpected losses from various risks, ensuring financial stability. F¹⁰, ¹¹urthermore, institutional bodies, such as Institutional Shareholder Services (ISS), have begun incorporating EVA metrics into their proxy research reports, influencing how company performance is evaluated by investors and shareholders. T⁹his highlights EVA's role in promoting greater accountability and a focus on long-term value creation within publicly traded entities.

Limitations and Criticisms

Despite its advantages, Economic Value Added (EVA) has faced several limitations and criticisms. One primary critique is the complexity and subjectivity involved in making the numerous accounting adjustments required for its calculation. Critics argue that these adjustments can be difficult to determine accurately, potentially leading to inconsistencies and making EVA challenging to implement for many organizations. T⁷, ⁸he data requirements for precise EVA calculation can be extensive, particularly for smaller companies or those with fewer tangible assets.

⁶Some studies suggest that while EVA is a valuable measure, it does not necessarily outperform traditional accounting measures like earnings per share or return on capital employed in explaining stock returns or firm value. T⁴, ⁵here is also a debate on whether EVA can serve as a universal financial metric across all financial environments, particularly those with unstable interest rates. M³oreover, some researchers point out that EVA, like other residual income measures, may not fully capture all aspects of a company's financial performance or the complexities of risk management.

¹, ²## Economic Value Added (EVA) vs. Accounting Profit

The fundamental distinction between Economic Value Added (EVA) and accounting profit lies in how they treat the cost of capital. Accounting profit, typically reported on a company's income statement, calculates profit by subtracting explicit costs (such as wages, rent, and depreciation) from total revenue. It focuses on the historical costs and revenues recorded based on generally accepted accounting principles (GAAP).

In contrast, Economic Value Added (EVA) goes a step further by incorporating both explicit and implicit costs, most notably the cost of capital. This means EVA subtracts not only the out-of-pocket expenses but also the opportunity cost of the capital invested in the business. Economic profit acknowledges that shareholders expect a return on their invested capital, and unless a company generates a profit exceeding this expected return, it is not truly creating value. Therefore, a company can have a significant accounting profit but a negative EVA if its profit does not cover the full cost of its capital.

FAQs

What is the main purpose of Economic Value Added (EVA)?

The main purpose of Economic Value Added (EVA) is to measure the true economic profit generated by a company, evaluating whether it is creating or destroying wealth for its shareholders after accounting for the full cost of all capital employed.

How does EVA differ from traditional profitability measures?

EVA differs from traditional profitability measures by including the cost of equity in its calculation, which traditional accounting profit typically omits. This provides a more comprehensive view of value creation.

Can a company have positive accounting profit but negative EVA?

Yes, a company can have a positive accounting profit but a negative Economic Value Added (EVA). This occurs when the accounting profit is not large enough to cover the company's full cost of capital, meaning the business is not generating sufficient returns to compensate its investors for the capital they have provided.

What are "adjustments" in EVA calculation?

The "adjustments" in EVA calculation refer to modifications made to a company's traditional financial statements, particularly the balance sheet and income statement, to better reflect the economic reality of the business. These can include reclassifying certain expenses, adjusting for intangible assets, or normalizing certain items that distort economic performance.

Is EVA suitable for all types of companies?

While Economic Value Added (EVA) offers valuable insights, its suitability can vary. It is often more widely adopted by larger companies due to the extensive data requirements and the complexity of making necessary adjustments. Companies with fewer tangible assets or those less focused on maximizing short-term shareholder returns might find other performance metrics more appropriate or easier to implement.