What Is Economic Value Added?
Economic Value Added (EVA) is a financial performance metric that measures a company's true economic profit by accounting for the cost of its capital. It falls under the broader category of Financial Performance Metrics and provides insights into whether a company is creating wealth for its shareholders. Unlike traditional accounting profits, EVA considers the cost of all capital employed, including equity, ensuring that managers are held accountable for the efficient use of assets. A positive Economic Value Added indicates that a company is generating a return greater than its cost of capital, thereby adding value.
History and Origin
While the underlying concept of economic profit has existed for centuries, Economic Value Added (EVA) was popularized and trademarked by the consulting firm Stern Stewart & Co. in the early 1990s. The firm, now known as Stern Value Management, aimed to provide a comprehensive measure that aligned management decisions with shareholder wealth creation.6 Joel Stern and G. Bennett Stewart III were instrumental in developing and promoting EVA as a tool for corporate performance measurement and incentive compensation.5 G. Bennett Stewart III's 1991 book, The Quest for Value, further brought the concept of Economic Value Added into the financial mainstream, influencing how analysts and investors evaluated corporate performance.4
Key Takeaways
- Economic Value Added (EVA) measures a company's true economic profit after accounting for the cost of all capital.
- A positive EVA signifies that a company is creating value, while a negative EVA indicates value destruction.
- EVA encourages managers to optimize asset utilization and invest in projects that generate returns above the cost of capital.
- It serves as a tool for internal performance measurement, capital allocation, and aligning management incentives with shareholder interests.
Formula and Calculation
The formula for Economic Value Added (EVA) is:
Where:
- NOPAT (Net Operating Profit After Tax) is the company's operating income after taxes, but before financing costs. This represents the profit generated from the company's core operations.
- Invested Capital refers to the total capital employed in the business, which typically includes debt and equity, adjusted for certain non-cash items and non-operating assets. It reflects the total funds tied up in the business.
- WACC (Weighted Average Cost of Capital) is the average rate of return a company expects to pay to its investors (both debt and equity holders). It represents the minimum rate of return a company must earn on its existing asset base to satisfy its capital providers. The WACC is a crucial input as it represents the hurdle rate for value creation.
Alternatively, EVA can be expressed as:
This formulation highlights that Economic Value Added is generated when the return on invested capital exceeds the cost of that capital.
Interpreting the Economic Value Added
Interpreting Economic Value Added involves understanding what a positive, negative, or zero figure implies for a company's financial health and its ability to create wealth. A positive EVA indicates that the company's net operating profit after tax exceeds the cost of the capital employed. This means the company is generating economic profit, truly adding value for its shareholders above and beyond the required return for the capital invested. Conversely, a negative EVA suggests that the company is not earning enough to cover its cost of capital, thereby destroying value. A zero EVA implies that the company is earning just enough to cover its capital costs, breaking even from an economic perspective.
For effective interpretation, adjustments to standard accounting measures are often necessary to get a more realistic estimate of surplus value. These adjustments, as highlighted by NYU Stern, may include converting operating leases into financial expenses or adjusting for goodwill, aiming to align accounting data more closely with economic reality for a robust financial analysis.3
Hypothetical Example
Consider "InnovateTech Inc.", a technology company with the following figures for the fiscal year:
- Net Operating Profit After Tax (NOPAT): $20 million
- Invested Capital: $100 million
- Weighted Average Cost of Capital (WACC): 12%
To calculate InnovateTech Inc.'s Economic Value Added:
-
Calculate the capital charge:
Capital Charge = Invested Capital × WACC
Capital Charge = $100 million × 0.12 = $12 million -
Calculate EVA:
EVA = NOPAT - Capital Charge
EVA = $20 million - $12 million = $8 million
In this hypothetical example, InnovateTech Inc. generated an Economic Value Added of $8 million. This positive EVA indicates that the company successfully generated $8 million in wealth above and beyond the cost of its capital, thereby creating value for its investors. This positive outcome signals strong profitability and efficient use of its assets.
Practical Applications
Economic Value Added (EVA) serves as a versatile tool in corporate finance and management accounting. It is widely used for:
- Performance Measurement: EVA provides a more comprehensive measure of corporate performance than traditional accounting metrics because it incorporates the cost of equity capital, which traditional measures like net income do not. This encourages managers to consider both asset utilization and profitability.
- Incentive Compensation: Companies often link executive and employee compensation directly to EVA performance. This aligns the interests of management with those of shareholders, motivating them to make decisions that truly enhance corporate governance and long-term value.
- Capital Allocation: EVA can guide investment decisions. Projects or business units that are expected to generate positive EVA are favored, ensuring that capital is deployed efficiently across the organization. This helps in strategic planning and evaluating new capital expenditure opportunities.
- Valuation: While not a direct valuation method itself, the present value of future EVAs can be used as a component in a company's valuation. As highlighted by G. Bennett Stewart III, EVA helps analysts and investors determine whether management is enhancing value for a firm's owners.
2## Limitations and Criticisms
Despite its strengths, Economic Value Added (EVA) has certain limitations and has faced criticism. One significant challenge lies in the numerous adjustments that may be required to derive NOPAT and invested capital from a company's standard income statement and balance sheet. These adjustments, which can number in the dozens, are often subjective and require significant judgment, potentially leading to inconsistencies and manipulation. For instance, converting operating leases to financial expenses or adjusting for certain working capital items can be complex and introduce variability.
Another criticism is that EVA is an absolute measure, meaning it can be difficult to compare performance over time, across different business units, or between companies of varying sizes. A small company with a positive EVA might be performing exceptionally well relative to its scale, but its absolute EVA figure could be dwarfed by a larger, less efficient company. Additionally, the focus on short-term EVA results could potentially discourage long-term strategic investments that might initially have a negative impact on EVA but yield significant returns over an extended period.
1## Economic Value Added vs. Residual Income
Economic Value Added (EVA) is often confused with or used interchangeably with Residual Income, but there's a key distinction: EVA is a specific, trademarked variant of residual income. Both metrics aim to measure the profit a company generates above and beyond the cost of the capital used to create that profit.
Residual Income is a broader accounting concept that calculates the net operating income less a capital charge based on the minimum required rate of return. Its general formula is:
Economic Value Added builds upon this concept but incorporates specific adjustments to accounting figures for NOPAT and invested capital, as prescribed by Stern Stewart & Co. These adjustments are designed to remove accounting distortions and provide a truer picture of economic profit. Thus, while all EVAs are a form of residual income, not all residual income calculations are EVA. The primary difference lies in the specific, detailed accounting adjustments applied in the calculation of EVA to align reported financial figures more closely with economic realities.
FAQs
Q1: Is Economic Value Added the same as net income?
No, Economic Value Added (EVA) is not the same as net income. Net income is an accounting profit measure that only subtracts explicit expenses, including interest on debt, from revenues. EVA goes a step further by also deducting the cost of equity capital, providing a more comprehensive view of whether a company is truly creating economic value above and all capital costs.
Q2: Why is EVA considered a better performance measure than traditional accounting profits?
EVA is considered superior by many because it addresses a fundamental flaw in traditional accounting profits: the omission of the cost of equity capital. By factoring in the cost of all capital (debt and equity), EVA provides a clearer picture of whether a company's operations are generating a return higher than the minimum required by its investors. This incentivizes managers to manage assets and capital more efficiently, leading to better resource allocation and value creation.
Q3: Can a company have positive net income but negative EVA?
Yes, a company can have a positive net income but a negative Economic Value Added. This scenario occurs when the company's net income is positive, but it is not high enough to cover the full cost of its capital, particularly the implied cost of equity. In such a case, while the company appears profitable on its income statement, it is economically destroying value because it is not earning a sufficient return for its shareholders, highlighting the importance of looking beyond simple accounting profits for comprehensive financial analysis.