What Is Adjusted Economic Value?
Adjusted Economic Value is a financial performance metric that measures a company's true economic profit by accounting for the cost of all capital used, including equity, not just debt. It is a refinement of traditional accounting measures and falls under the broader category of Performance Measurement. While traditional financial statements focus on historical costs and explicit expenses, Adjusted Economic Value seeks to provide a more comprehensive view of a business's actual value creation by incorporating the Opportunity Cost of capital. This approach aims to align managerial decisions with the long-term interests of shareholders by emphasizing value creation over mere reported profits.
History and Origin
The concept underlying Adjusted Economic Value, often known by its trademarked name Economic Value Added (EVA), gained significant prominence in the early 1990s. It was introduced and popularized by the U.S.-based consulting firm Stern Stewart & Co.12, 13. While the theoretical underpinnings, particularly the idea of economic profit and residual income, have roots in economic thought dating back to Alfred Marshall's "Principles of Economics" (1920), Stern Stewart operationalized and aggressively marketed EVA as a management tool11. By the mid-1990s, many large corporations in the United States adopted this metric to better understand and enhance Shareholder Value9, 10.
Key Takeaways
- Adjusted Economic Value (EVA) measures a company's true economic profit by subtracting the cost of all capital employed.
- It highlights whether a company is creating value above and beyond the required return for its capital providers.
- EVA considers both explicit accounting costs and the implicit cost of equity capital.
- A positive Adjusted Economic Value indicates that a company is generating wealth for its shareholders.
- It serves as a tool for internal performance evaluation, capital allocation, and strategic decision-making.
Formula and Calculation
The core formula for Adjusted Economic Value (EVA) is calculated as:
Where:
- NOPAT (Net Operating Profit After Taxes): The company's potential cash earnings if it were unleveraged and excluding non-cash bookkeeping entries. It represents the profits generated from operations after cash taxes but before financing costs.
- Invested Capital: The total amount of capital a company employs in its operations. This typically includes the sum of interest-bearing debt and equity, or net assets less non-interest-bearing current liabilities. Understanding a company's Balance Sheet is crucial for determining this figure.
- WACC (Weighted Average Cost of Capital): The average rate of return a company expects to pay to all its capital providers (both debt and equity holders)8. It represents the minimum rate of return on capital required to compensate investors for the risk they undertake.
For a comprehensive understanding of the components, financial statements such as the Income Statement and Cash Flow Statement are essential for deriving NOPAT and invested capital figures.
Interpreting the Adjusted Economic Value
A positive Adjusted Economic Value indicates that a company's Net Operating Profit After Taxes (NOPAT) exceeds the cost of the capital it employs. This signifies that the company is creating wealth for its shareholders, as it is generating returns above the minimum required by its investors. Conversely, a negative Adjusted Economic Value suggests that the company is destroying value, as its profits are not sufficient to cover the cost of its capital, even if it reports an accounting profit. This metric moves beyond simple Profitability by incorporating the fundamental economic principle of opportunity cost, making it a robust measure for evaluating true Financial Performance.
Hypothetical Example
Consider "Alpha Solutions Inc.," a technology firm evaluating a new project.
- Alpha Solutions' NOPAT from the project: $5,000,000
- Invested Capital for the project: $20,000,000
- Weighted Average Cost of Capital (WACC): 15%
Using the Adjusted Economic Value formula:
In this hypothetical example, Alpha Solutions Inc. generated an Adjusted Economic Value of $2,000,000 from the project. This positive figure indicates that the project is creating value for the company and its shareholders, as the $5,000,000 operating profit after tax comfortably covers the $3,000,000 cost of capital. This insight helps management decide on future Capital Budgeting decisions and resource allocation.
Practical Applications
Adjusted Economic Value is applied across various aspects of corporate finance and investment analysis. Companies use it internally as a performance measurement tool to evaluate business units, projects, and even individual managers. It helps in making informed decisions about resource allocation, ensuring that capital is directed toward ventures that promise to create true economic value. For investors, understanding a company's Adjusted Economic Value can offer deeper insights into its ability to generate returns beyond its cost of capital, making it a valuable complement to traditional metrics like Return on Investment (ROI). Publicly traded companies often report figures like "adjusted operating profit" or "adjusted net profit" to provide a clearer view of their underlying performance, which aligns with the spirit of Adjusted Economic Value7. A basic understanding of corporate Financial Statements is essential to analyze the inputs for EVA and other performance metrics.
Limitations and Criticisms
While Adjusted Economic Value offers a more comprehensive view of profitability, it is not without limitations. One primary criticism revolves around the complexity and subjectivity involved in calculating its components. Determining the precise Net Operating Profit After Taxes (NOPAT) requires numerous adjustments to conventional accounting figures, which can introduce discretion and potential manipulation6. Similarly, accurately estimating the Weighted Average Cost of Capital (WACC) can be challenging, as it depends on market conditions and the company's capital structure.
Furthermore, economic factors such as inflation can distort the accuracy of financial records and asset valuations, impacting the inputs used in calculating Adjusted Economic Value5. While efforts can be made to adjust for inflation, such adjustments introduce additional complexity and potential for error. The application of Adjusted Economic Value is generally more suited for large companies that have the detailed financial data required for accurate calculation; smaller firms may find the data requirements prohibitive4.
Adjusted Economic Value vs. Accounting Profit
The fundamental difference between Adjusted Economic Value and Accounting Profit lies in their treatment of the cost of capital.
| Feature | Adjusted Economic Value (EVA) | Accounting Profit |
|---|---|---|
| Costs Considered | Explicit costs (e.g., wages, rent) + Implicit cost of equity | Primarily explicit costs (e.g., cost of goods sold, operating expenses, interest) |
| Capital Charge | Includes a charge for both debt and equity capital | Accounts for interest expense on debt, but not the cost of equity |
| Focus | True economic surplus and value creation | Net income as reported on the income statement |
| Goal | Measures value generated above required return for all capital providers | Measures profit after all explicit expenses |
| Reporting | Primarily an internal management and analysis tool | Required for external reporting (e.g., to investors, IRS) |
Accounting profit, often referred to as net income, is the bottom-line figure on a company's income statement after all explicit expenses, including taxes and interest, have been deducted from revenue3. It adheres to generally accepted accounting principles (GAAP) or International Financial Reporting Standards (IFRS) and is the profit figure most commonly reported to external stakeholders. In contrast, Adjusted Economic Value goes a step further by recognizing that equity capital, like debt, has a cost—the opportunity cost of investors' funds. This distinction means that a company can show a positive accounting profit but still have a negative Adjusted Economic Value if its earnings are not sufficient to cover the implicit cost of equity capital.
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FAQs
What is the primary purpose of Adjusted Economic Value?
The primary purpose of Adjusted Economic Value is to measure whether a company or project is creating true economic value above and beyond the cost of all the capital it uses, including the cost of equity. It helps align management decisions with maximizing Shareholder Value.
Why is the "cost of equity" included in Adjusted Economic Value?
The "cost of equity" is included because equity capital, like debt, is not free. Investors expect a return on their equity investment, and this expected return represents an Opportunity Cost for the company. By including this cost, Adjusted Economic Value provides a more accurate picture of a company's genuine profitability and efficiency in using its capital.
How does Adjusted Economic Value relate to Net Present Value (NPV)?
Adjusted Economic Value is conceptually similar to Net Present Value (NPV), particularly in the context of Capital Budgeting. Both metrics aim to assess whether an investment creates value. A series of positive annual Adjusted Economic Value figures over a project's life, when discounted, can approximate the project's NPV. EVA can be seen as a period-by-period measure of value creation, whereas NPV is a total value creation measure over the project's lifespan.
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Can a company have a positive accounting profit but a negative Adjusted Economic Value?
Yes, absolutely. This is a key insight that Adjusted Economic Value provides. A company might report a positive Accounting Profit on its income statement, but if that profit is not high enough to cover the cost of both its debt and equity capital, it will have a negative Adjusted Economic Value. This implies that while the business is earning money, it is not generating sufficient returns to compensate its capital providers adequately, effectively destroying economic value.