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Economic value added eva

What Is Economic Value Added (EVA)?

Economic Value Added (EVA) is a financial performance measure that calculates a company's true economic profit by deducting its Cost of Capital from its operating profit, adjusted for taxes. As a key metric within Financial Performance measurement, EVA aims to quantify the value a company generates beyond the minimum acceptable return required by its capital providers. Essentially, it assesses whether a business creates wealth for its shareholders after accounting for the full cost of all capital employed, both debt and equity60. A positive EVA indicates that a company is generating returns in excess of its capital costs, thereby creating Shareholder Value58, 59.

History and Origin

The concept of Economic Value Added (EVA) was developed and popularized by the management consulting firm Stern Stewart & Co. (now Stern Value Management) in the early 1980s56, 57. The firm introduced EVA as a proprietary metric and a framework designed to help companies align management decisions with the creation of economic value. This approach gained significant traction in the 1990s as a means to measure corporate performance more accurately than traditional accounting profits, which often do not account for the cost of equity capital55. The widespread interest in EVA was highlighted by a 1993 New York Times article, which referred to it as "The New, Improved Metric for Wall Street."

Key Takeaways

  • True Profitability: Economic Value Added measures a company's genuine Economic Profit by accounting for the cost of both debt and equity capital52, 53, 54.
  • Value Creation Indicator: A positive EVA signifies that a company is creating value for its shareholders, while a negative EVA indicates value destruction50, 51.
  • Performance Alignment: EVA encourages managers to make decisions that generate returns above the required rate, fostering a focus on long-term wealth creation47, 48, 49.
  • Capital Efficiency: It highlights how effectively a company utilizes its Invested Capital to generate profits, promoting efficient resource allocation46.

Formula and Calculation

The formula for Economic Value Added (EVA) is calculated as follows:

EVA=NOPAT(Invested Capital×WACC)\text{EVA} = \text{NOPAT} - (\text{Invested Capital} \times \text{WACC})

Where:

  • NOPAT (Net Operating Profit After Taxes): This represents the company's after-tax operating profit, excluding financing costs and non-recurring items. It reflects the profit generated from core operations available to all capital providers44, 45.
  • Invested Capital: Also known as capital employed, this is the total amount of capital (debt + equity) a company uses in its operations to generate profits43.
  • WACC (Weighted Average Cost of Capital): This is the average rate a company expects to pay to all its security holders to finance its assets. It is a weighted average of the cost of debt and the cost of equity, reflecting the company's Capital Structure42.

Interpreting the Economic Value Added

Interpreting Economic Value Added involves assessing whether a company is truly adding value for its shareholders after accounting for the cost of all the capital it employs. A positive EVA indicates that the company's Operating Profit after taxes exceeds the financial charge for using its capital. This suggests that the company is efficient in its operations and is generating returns above the minimum required by investors. Conversely, a negative EVA means that the company is not earning enough to cover its Cost of Capital, implying it is destroying shareholder wealth.

EVA provides a more comprehensive view of profitability than traditional accounting metrics because it incorporates the opportunity cost of capital40, 41. This focus encourages management to consider the capital intensity of their operations and to prioritize investments that genuinely create value. For instance, a company might show a positive net income but a negative EVA if its profits do not sufficiently compensate for the capital invested and the risk taken.

Hypothetical Example

Consider "Alpha Manufacturing Inc." which has the following financial information for the year:

  • Net Operating Profit After Taxes (NOPAT) = $5,000,000
  • Invested Capital = $20,000,000
  • Weighted Average Cost of Capital (WACC) = 15%

Let's calculate Alpha Manufacturing Inc.'s Economic Value Added (EVA):

EVA=NOPAT(Invested Capital×WACC)EVA=$5,000,000($20,000,000×0.15)EVA=$5,000,000$3,000,000EVA=$2,000,000\text{EVA} = \text{NOPAT} - (\text{Invested Capital} \times \text{WACC}) \\ \text{EVA} = \$5,000,000 - (\$20,000,000 \times 0.15) \\ \text{EVA} = \$5,000,000 - \$3,000,000 \\ \text{EVA} = \$2,000,000

In this hypothetical scenario, Alpha Manufacturing Inc. has an EVA of $2,000,000. This positive EVA indicates that the company generated $2 million in economic profit above the cost of the capital it employed. This suggests that Alpha Manufacturing Inc. is creating value for its shareholders and effectively utilizing its Invested Capital39.

Practical Applications

Economic Value Added (EVA) serves as a robust tool in various areas of finance and business management, moving beyond basic accounting profits to offer a more insightful perspective on true value creation.

  • Performance Measurement and Incentives: Companies often use EVA to evaluate the performance of business units and individual managers. Tying compensation and bonuses to EVA targets incentivizes management to focus on projects and operational efficiencies that genuinely create Economic Profit36, 37, 38. This promotes a culture of value-based management throughout the organization35.
  • Capital Allocation and Investment Decisions: EVA guides decisions on where to invest capital within a company. Projects or divisions expected to generate a positive EVA are prioritized, ensuring that new investments yield returns that exceed their Cost of Capital34. This helps optimize the allocation of limited resources across competing opportunities.
  • Valuation and Strategic Planning: For investors and analysts conducting Financial Analysis, EVA can complement traditional valuation methods like Discounted Cash Flow (DCF) analysis. It helps assess whether a company's operations are truly profitable from an economic standpoint33. Strategically, companies can use EVA to set performance targets and align business strategies with long-term wealth creation for shareholders32.

A notable example of EVA's practical influence is its consideration by proxy advisory firms. Institutional Shareholder Services (ISS), a major proxy advisory firm, has explored incorporating EVA metrics into its pay-for-performance evaluations for public companies, signaling its relevance in assessing executive compensation alignment with shareholder interests31.

Limitations and Criticisms

Despite its advantages, Economic Value Added (EVA) has several limitations and has faced criticism.

One primary criticism is that EVA heavily relies on accounting data, which can be subject to various assumptions, adjustments, and potential distortions30. Different accounting methods for depreciation, inventory valuation, or revenue recognition can impact the calculation of Net Operating Profit After Taxes (NOPAT) and Invested Capital, thereby affecting EVA results28, 29. This subjectivity can make it difficult to compare EVA across different companies or even within the same company over time if accounting policies change27.

Another limitation is the complexity involved in accurately determining the Weighted Average Cost of Capital (WACC), which is a crucial component of the EVA formula25, 26. Estimating the cost of equity, for instance, involves assumptions that can vary among analysts24. Furthermore, EVA primarily focuses on financial performance and may not fully capture the value of intangible assets, such as brand reputation or intellectual property, which are increasingly important for many modern businesses22, 23.

Some critics also argue that EVA can encourage a short-term focus, as it typically uses annual or quarterly data20, 21. While designed to promote long-term value creation, managers might prioritize immediate EVA improvements over strategic investments that have longer payback periods but are vital for future growth18, 19. Additionally, EVA's applicability can vary across industries; for example, it may be less suitable for asset-light businesses like technology companies or early-stage startups15, 16, 17.

Research has also explored the relationship between EVA and Corporate Governance. Some studies suggest that firms using EVA as part of their compensation package might sometimes exhibit weaker corporate governance, though this is a complex area of research13, 14.

Economic Value Added vs. Return on Invested Capital

Economic Value Added (EVA) and Return on Invested Capital (ROIC) are both key metrics used in [Financial Analysis] (https://diversification.com/term/financial_analysis) to assess how efficiently a company uses its capital to generate profits. While related, they offer distinct perspectives.

ROIC is a ratio that measures the percentage return a company generates on its invested capital, without explicitly deducting a capital charge. The formula is typically expressed as:

ROIC=NOPATInvested Capital\text{ROIC} = \frac{\text{NOPAT}}{\text{Invested Capital}}

ROIC provides a good indication of operational efficiency and capital productivity. A higher ROIC generally suggests better performance.

In contrast, EVA is an absolute measure (expressed in monetary units) that quantifies the excess profit generated above the cost of capital. Conceptually, EVA can be viewed as the "spread" between ROIC and the Weighted Average Cost of Capital (WACC), multiplied by the invested capital12.

EVA=(ROICWACC)×Invested Capital\text{EVA} = (\text{ROIC} - \text{WACC}) \times \text{Invested Capital}

The primary difference lies in their nature: ROIC is a rate of return, while EVA is a measure of residual wealth11. A company can have a high ROIC, but if its WACC is even higher, it will still result in a negative EVA, indicating value destruction. EVA directly measures whether a company's returns surpass its cost of financing, making it a more direct indicator of economic value creation.

FAQs

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

The primary purpose of Economic Value Added is to measure a company's true Economic Profit by considering the cost of all capital used, including equity. It assesses whether a company is creating value for its shareholders by generating returns that exceed its required rate of return8, 9, 10.

How does a positive EVA differ from a positive net income?

A positive net income (accounting profit) indicates that a company's revenues exceed its explicit expenses. However, a positive Economic Value Added means that the company's profits not only cover all explicit expenses and taxes but also the implicit Cost of Capital (the cost of both debt and equity). A company can have a positive net income but a negative EVA if its earnings do not justify the capital invested.

Can a profitable company have a negative EVA?

Yes, a company can be profitable in accounting terms (positive net income) but still have a negative Economic Value Added. This occurs when the company's Net Operating Profit After Taxes (NOPAT) is less than the cost of the capital it has employed. In such a scenario, the company is not generating enough return to cover the opportunity cost of the funds invested by its shareholders and lenders, indicating that it is destroying Shareholder Value7.

Why is the cost of capital important in calculating EVA?

The Cost of Capital is crucial in EVA because it represents the minimum rate of return required by investors (both debt and equity holders) to compensate them for the risk they undertake by providing capital to the company6. By subtracting this cost, EVA determines whether the company is truly adding economic value beyond what is expected by its financiers4, 5.

Is EVA suitable for all types of businesses?

Economic Value Added is generally most suitable for asset-rich, mature companies where Invested Capital is a significant driver of operations and returns3. It may be less applicable or harder to calculate accurately for companies with substantial intangible assets (like technology or service businesses) or for early-stage startups that are heavily investing for future growth and may not yet be generating significant operating profits1, 2.