What Is Economic Value Added (EVA)?
Economic Value Added (EVA) is a financial performance metric and a component of corporate finance that measures a company's true economic profit by calculating the profit remaining after deducting the cost of capital from its operating profit. Unlike traditional accounting profits, EVA considers the opportunity cost of all capital, both debt and equity, used to generate those profits. This approach provides a clearer picture of whether a company is creating value creation for its shareholders, aligning management incentives with the goal of maximizing shareholder wealth. By explicitly factoring in the capital employed, Economic Value Added helps assess the efficiency with which a company uses its resources.
History and Origin
The concept of Economic Value Added (EVA) was popularized in the early 1990s by Stern Stewart & Co., specifically through the work of G. Bennett Stewart III, whose book "The Quest for Value" (1991) brought the metric into mainstream financial discourse.6 The underlying principles, however, trace back to earlier economic thought regarding residual income and economic profit. Stern Stewart & Co. developed EVA as a proprietary performance measurement tool designed to improve upon traditional accounting-based metrics like return on equity (ROE) or earnings per share (EPS), which often do not fully account for the true cost of doing business. The aim was to create a metric that directly reflects whether a company's operations generate returns in excess of its required rate of return, thereby adding real economic value.
Key Takeaways
- Economic Value Added (EVA) calculates a company's true economic profit by deducting the cost of capital from its operating profit.
- It emphasizes that value is created only when returns exceed the total cost of the capital employed.
- EVA encourages management to make decisions that enhance shareholder wealth by focusing on efficient capital utilization and profitable growth.
- Unlike traditional accounting metrics, Economic Value Added explicitly includes a charge for both debt and equity capital.
- It serves as a tool for internal performance measurement, capital allocation, and incentive compensation.
Formula and Calculation
The formula for Economic Value Added (EVA) is:
Where:
- NOPAT (Net Operating Profit After Tax): Represents the company's operating profit after taxes, but before interest expenses. It is calculated as Operating Profit × (1 - Tax Rate).
5* Invested Capital: The total capital employed by the company, including both debt and equity. It can be calculated as Total Assets - Non-interest Bearing Current Liabilities. - WACC (Weighted Average Cost of Capital): The average rate a company expects to pay to finance its assets, considering all sources of capital (debt and equity), weighted by their respective proportions in the capital structure. This represents the total cost of capital for the firm.
The term ((Invested Capital \times WACC)) is often referred to as the capital charge.
Interpreting the Economic Value Added (EVA)
Interpreting Economic Value Added (EVA) involves understanding whether a company is generating wealth for its shareholders. A positive EVA indicates that the company's net operating profit after tax exceeds its capital charge, meaning it is creating value above and beyond the cost of the capital it employs. This suggests efficient use of capital and potentially strong financial performance. Conversely, a negative EVA implies that the company is not generating enough profit to cover its cost of capital, thereby destroying shareholder wealth.
EVA provides a more comprehensive view than traditional accounting measures because it incorporates the cost of equity, which is an implicit cost not reflected in standard income statements. Companies strive to achieve a positive and growing EVA, as this signals effective strategic management and a capacity to generate returns that satisfy investors' required rates of return.
Hypothetical Example
Consider a hypothetical manufacturing company, "Alpha Corp."
- Net Operating Profit After Tax (NOPAT): $10 million
- Invested Capital: $50 million
- Weighted Average Cost of Capital (WACC): 12%
To calculate Alpha Corp.'s Economic Value Added:
-
Calculate the Capital Charge:
Capital Charge = Invested Capital × WACC
Capital Charge = $50,000,000 × 0.12 = $6,000,000 -
Calculate Economic Value Added (EVA):
EVA = NOPAT - Capital Charge
EVA = $10,000,000 - $6,000,000 = $4,000,000
In this example, Alpha Corp. has an EVA of $4 million. This positive Economic Value Added indicates that Alpha Corp. is generating $4 million in wealth beyond the cost of the capital it uses. This suggests that the company is effectively deploying its invested capital to produce returns that exceed the expectations of its capital providers, signaling successful value creation.
Practical Applications
Economic Value Added (EVA) is widely used in various financial and managerial contexts. It serves as a robust internal performance measurement tool, enabling companies to evaluate the efficiency of their operations and individual business units. Many organizations incorporate EVA into their capital budgeting decisions, using it to appraise potential investment projects and prioritize those that are expected to generate positive economic profit.
F4urthermore, EVA is frequently integrated into executive compensation plans, aiming to align the incentives of management with the interests of shareholders. By tying bonuses and long-term incentives to EVA targets, companies encourage managers to focus on making decisions that enhance shareholder wealth, such as investing in projects with returns exceeding the cost of capital, managing existing assets more efficiently, or divesting underperforming assets. The Federal Reserve Bank of San Francisco's economic letters often discuss broader financial conditions that influence the context for such metrics, highlighting how macroeconomic shifts can impact a firm's financial environment.
#3# Limitations and Criticisms
Despite its advantages, Economic Value Added (EVA) is not without its limitations and criticisms. One common critique is that it can be complex to calculate, requiring numerous adjustments to traditional accounting data to arrive at an accurate net operating profit after tax and invested capital. These adjustments can be subjective, potentially leading to inconsistencies in reporting and comparability across different companies or even within the same company over time.
A2nother limitation is that EVA, as an absolute measure, may not be suitable for comparing companies of vastly different sizes or industries without normalization. While a larger company might have a higher positive EVA simply due to its scale, a smaller, more agile company might be creating value more efficiently on a relative basis. Academic research has also explored whether the adoption of EVA systems consistently leads to improved stock performance or profitability, with some studies finding insufficient evidence to draw such a conclusion. Th1is suggests that while Economic Value Added provides a valuable framework for internal management, its direct correlation with market performance can be influenced by many other factors.
Economic Value Added (EVA) vs. Net Present Value (NPV)
Economic Value Added (EVA) and Net Present Value (NPV) are both essential concepts in financial performance and capital budgeting, yet they serve distinct purposes. NPV is a project-specific valuation method that discounts all future cash flows of an investment back to their present value, then subtracts the initial investment cost. A positive NPV indicates that the project is expected to generate returns above the required rate of return, thus increasing shareholder wealth. NPV is primarily used for making investment decisions for individual projects or acquisitions.
Economic Value Added, conversely, is typically a company-wide or division-level performance measurement tool used to assess value creation over a period. While NPV looks at the total value added by a project over its entire life, EVA measures the value added or destroyed by a business's operations in a given year. Conceptually, EVA can be thought of as a period-by-period representation of the value created that, if summed and discounted, would theoretically equate to a project's NPV. However, NPV is forward-looking and focuses on incremental decision-making, while EVA is often used for ongoing operational assessment and incentive alignment.
FAQs
What does a positive Economic Value Added (EVA) signify?
A positive Economic Value Added indicates that a company's net operating profit after tax exceeds its cost of capital, meaning it is generating returns that are greater than the cost of all the capital it uses. This signifies that the company is creating economic value for its shareholders.
How does Economic Value Added differ from traditional accounting profits?
Economic Value Added differs from traditional accounting profits because it explicitly subtracts a capital charge for both debt and equity. Accounting profits (like net operating profit after tax) only account for explicit costs, such as interest on debt, but typically do not include the cost of equity capital. EVA provides a more comprehensive view of true economic profit.
Why is the Weighted Average Cost of Capital (WACC) important in EVA?
The Weighted Average Cost of Capital (WACC) is crucial in Economic Value Added because it represents the minimum rate of return a company must earn on its existing asset base to satisfy all its capital providers, both debt holders and equity investors. It serves as the "hurdle rate" that profits must clear for true value creation to occur.
Can Economic Value Added be negative?
Yes, Economic Value Added can be negative. A negative EVA indicates that the company's operating profit, after taxes, is insufficient to cover its total cost of capital. This means the company is destroying shareholder wealth and not generating enough return to justify the capital invested in its operations.