Economic Value Added (EVA) is a performance metric used to determine the true economic profit of a company. It is a widely used tool in finance and accounting to measure the value a company generates from funds invested in it. This article delves into EVA’s definition, historical context, formula, applications, importance, and more.
Historical Context
EVA was popularized by the consulting firm Stern Stewart & Co. in the 1990s. The concept is rooted in economic profit theory, which goes back to the works of economist Alfred Marshall in the late 19th century. Stern Stewart developed EVA to help companies focus on value creation beyond accounting profits.
Definition and Explanation
EVA is calculated as the Net Operating Profit After Taxes (NOPAT) minus the capital charges (cost of capital times the capital invested):
Where:
- NOPAT = Net Operating Profit After Taxes
- WACC = Weighted Average Cost of Capital
- Capital Invested = Total capital used for investment purposes
Types/Categories
- Traditional EVA: Calculates the economic profit based on historical financial statements.
- Market-Value EVA: Considers the market value of equity and debt, aiming for a forward-looking approach.
Key Events
- 1990s: Introduction and popularization of EVA by Stern Stewart & Co.
- 1997: Coca-Cola and other large corporations start adopting EVA for internal performance measurement.
Detailed Explanations
Net Operating Profit After Taxes (NOPAT): Represents the operating income earned by a company after deducting taxes, excluding financing costs and non-operating items.
Weighted Average Cost of Capital (WACC): The average rate of return a company is expected to pay its shareholders for the capital used. It encompasses the cost of equity and debt.
Capital Invested: Includes both equity and debt capital utilized to fund a company’s operations and investments.
Mathematical Formula
The basic formula to compute EVA is:
Chart/Diagram
graph TD
A[Revenue] --> B[Operating Expenses]
B --> C[NOPAT]
C --> D{WACC x Capital Invested}
D --> E[EVA]
Importance and Applicability
- Performance Measurement: EVA helps in assessing the true profitability by considering the cost of capital.
- Value Creation: It provides insight into whether a company is creating or destroying value.
- Decision Making: EVA aids in capital budgeting, performance evaluation, and incentive compensation.
Examples
Company A:
- NOPAT: $1,000,000
- WACC: 10%
- Capital Invested: $8,000,000
Considerations
- Data Accuracy: Accurate computation of WACC and NOPAT is crucial.
- Economic Conditions: Changes in market conditions can affect WACC and hence EVA.
- Complexity: May be complex to compute for companies with diverse operations.
Related Terms
- Return on Investment (ROI): Measures the profitability of an investment.
- Net Present Value (NPV): Calculates the present value of future cash flows.
- Residual Income: The excess income after covering the cost of capital.
Comparisons
EVA vs. ROI:
- EVA considers the cost of capital, providing a more comprehensive measure of value creation.
- ROI is simpler but might not account for the capital cost effectively.
Interesting Facts
- Companies that implement EVA tend to outperform peers in terms of shareholder returns.
- EVA has been integral in the compensation packages of several high-performing executives.
Inspirational Stories
Coca-Cola’s EVA Implementation: Coca-Cola adopted EVA in the late 1990s, leading to improved capital allocation and enhanced shareholder value. The focus on value creation helped the company navigate economic challenges and maintain its market position.
Famous Quotes
- “EVA is the financial equivalent of the recipe for Coca-Cola: if properly executed, it allows a company to earn more than its cost of capital.” - G. Bennett Stewart III
Proverbs and Clichés
- “You can’t manage what you can’t measure.” – Common cliché related to management and performance measurement.
Expressions, Jargon, and Slang
- Value Creation: Process of generating economic value from business operations.
- Capital Charge: The cost of capital multiplied by the capital invested.
- NOPAT: Acronym for Net Operating Profit After Taxes.
FAQs
Q: What is the primary purpose of EVA? A: EVA is used to measure a company’s true economic profit, considering the cost of capital.
Q: How does EVA benefit companies? A: EVA helps in better capital allocation, performance measurement, and aligning management incentives with shareholder value creation.
Q: Is EVA applicable to all industries? A: Yes, EVA can be applied across various industries, though its computation may vary based on industry-specific factors.
References
- Stewart, G. Bennett. “The Quest for Value: A Guide for Senior Managers.” Harper Business, 1991.
- Damodaran, Aswath. “Corporate Finance: Theory and Practice.” Wiley, 2001.
Summary
Economic Value Added (EVA) is a comprehensive metric that measures a company’s ability to generate value beyond the required return on its capital. By factoring in the cost of capital, EVA provides a true picture of economic profit, guiding better decision-making and value creation. Its application in performance measurement, capital budgeting, and incentive structures underscores its importance in modern finance.
