Economic Value Added (EVA) is a financial metric used to evaluate a firm’s economic profit. It is calculated by subtracting the company’s cost of capital from its operating profit. Essentially, EVA measures the value a company generates beyond the required return of its shareholders and debt holders.
Formula
Economic Value Added can be expressed with the following formula:
where:
- \(\text{NOPAT}\) stands for Net Operating Profit After Taxes.
- \(\text{Capital Employed}\) means the total capital investment in the business.
- \(\text{WACC}\) is the Weighted Average Cost of Capital.
Calculation of EVA
Components
-
Net Operating Profit After Taxes (NOPAT)
- This represents the profit a company makes from its operations after taxes, but before financing costs and non-operating expenses are subtracted.
-
Capital Employed
- This is the total amount of capital used for the acquisition of profits. It includes both equity and debt capital.
-
Weighted Average Cost of Capital (WACC)
- WACC is the average rate of return a company is expected to pay its security holders to finance its assets.
Example Calculation
Consider a company with:
- NOPAT of $2,000,000
- Capital Employed of $10,000,000
- WACC of 8%
In this scenario, the company has an EVA of $1,200,000, indicating it generated $1.2 million in economic profit beyond the required return for its capital providers.
Benefits of EVA
Performance Measurement
EVA is a robust measure of company performance, particularly useful in aligning management decisions with shareholder value creation.
Incentive Alignment
By benchmarking with EVA, companies can design incentive structures to ensure that managers aim for projects that generate returns greater than the cost of their capital.
Periodic Analysis
It helps in periodic performance comparisons and identifies areas where more value can be created.
Drawbacks of EVA
Complexity
The calculation requires detailed information on NOPAT, WACC, and capital employed, which can be complex and time-consuming.
Misleading Signals
EVA might not always provide accurate indicators in scenarios of high market volatility or for startups with large R&D investments and delayed returns.
Short-Term Focus
Management may avoid long-term beneficial projects due to their short-term negative impact on EVA.
Historical Context of EVA
EVA was popularized by the Stern Stewart & Co. consulting firm in the late 1980s. It quickly gained acceptance as a powerful performance metric among firms looking to maximize shareholder value. Over the years, it has been widely adopted by large corporations and serves as a staple in corporate finance textbooks.
Comparison with Related Terms
Residual Income
Like EVA, residual income also measures the net income generated beyond the required return on investment. However, EVA uses weighted average cost of capital for a more comprehensive cost consideration.
Economic Profit
Economic profit is broadly similar to EVA as both provide an excess return figure. EVA, however, is distinguished by its emphasis on after-tax operating profit and a uniform calculation method.
FAQs
What is the significance of EVA in corporate finance?
How can EVA improve management decision-making?
Are there any limitations to using EVA?
References
- Stewart, G. Bennett. “The Quest for Value: A Guide for Senior Managers.” HarperBusiness, 1991.
- Brealey, Richard, Stewart Myers, and Franklin Allen. “Principles of Corporate Finance.” McGraw-Hill Education, 2019.
- Stern Stewart & Co. “EVA: The Real Key to Creating Wealth.”
Summary
Economic Value Added (EVA) is a powerful financial metric that assesses a firm’s ability to generate profit beyond its cost of capital. By focusing on residual wealth, EVA encourages efficient capital utilization and aligns managerial decisions with shareholder value. Despite its complexities and some drawbacks, EVA remains a vital tool in corporate finance for performance measurement and strategic financial planning.
