Economic Value Added (EVA) is a financial performance metric that measures the value a company generates from its invested capital. It is calculated by subtracting the cost of capital from the net operating profit after taxes (NOPAT). EVA is used to assess the true economic profit of a company, beyond traditional accounting measures. It emphasizes the importance of considering the cost of capital in evaluating business performance, thus providing a clearer picture of value creation for shareholders. By focusing on EVA, companies can better align their operational decisions with long-term value creation and strategic financial management.

What is Economic Value Added?

EVA is a performance metric that calculates the creation of shareholder value; however, it distinguishes itself from traditional financial performance metrics, such as net profit and earnings per share (EPS). EVA is the calculation of what profits remain after the costs of a company’s capital—debt and equity—are deducted from operating profit. The idea is simple but rigorous: true profit should account for the cost of capital.

Key takeaways:

• Economic value added (EVA) calculates the profits that remain after deducting a company’s cost of capital.
• The consulting firm Stern Stewart developed and trademarked EVA, and many large, global companies use it internally to measure performance.
• To calculate EVA, you’ll need to know net operating profit after tax (NOPAT), weighted average cost of capital (WACC), and total invested capital (TC).
• The formula for finding EVA is EVA = NOPAT – (WACC x TC).

Importance of Economic Value Added

• Measures True Profitability: Traditional profit measures like net income don’t consider the cost of capital. EVA factors in the cost of capital, reflecting the minimum return investors expect for their investment. This provides a clearer picture of whether a company is creating real wealth for its shareholders.
• Improves Decision-Making: By highlighting the cost of capital, EVA encourages companies to focus on projects that generate returns exceeding that cost. This approach leads to better resource allocation and investment decisions.
• Incentivizes Long-Term Value Creation: EVA focuses on long-term value creation for shareholders. It discourages short-term decisions that might boost immediate profits but harm long-term sustainability.
• Performance Benchmarking: EVA allows companies to compare their performance with competitors within the same industry, providing a more apples-to-apples comparison than just looking at net income.
• Internal Performance Evaluation: EVA can be used to evaluate the performance of different departments or business units within a company, identifying areas for improvement and highlighting value-generating activities.

How to Calculate Economic Value Added (formula)

There are four steps in the calculation of EVA:

• Calculate Net Operating Profit After Tax (NOPAT)
• Calculate Total Invested Capital (TC)
• Determine the Weighted Average Cost of Capital (WACC)

EVA= NOPAT – WACC x TC

Here,

• EVA= Economic value added
• NOPAT= Net operating profit after tax
• WACC= Weighted average cost of capital
• TC= Total invested capital

Economic Value Added Calculation Example

Let’s use an example based on the company PAPRIKA. PAPRIKA’s earned $100,000 on a capital base of $1 million thanks to its sales of stew pots. Traditional accounting metrics suggest that PAPRIKA is doing a good job. His company offers a return on capital of 10%. However, PAPRIKA’s has only been operating for a year, and the market for stew pots still carries significant uncertainty and risk. Debt obligations plus the required return that investors demand add up to an investment cost of capital of 13%. That means that, although PAPRIKA’s is enjoying accounting profits, the company was unable to grant 3% to its shareholders.

Conversely, if PAPRIKA’s capital is $100 million—including debt and shareholder equity—and the cost of using that capital (interest on debt and the cost of underwriting the equity) is $13 million per year, PAPRIKA will add economic value for his shareholders only when profits are more than $13 million per year. If PAPRIKA’s earns $20 million, the company’s EVA will be $7 million.

How to Increase Economic Value Added?

Growing Revenue:

• Increase Sales Volume: Implement strategies to sell more products or services, such as expanding into new markets, launching new product lines, or enhancing marketing efforts.
• Raise Prices: If the market allows, consider strategic price increases to improve margins. However, ensure it doesn’t negatively impact demand.
• Improve Revenue Collection: Implement efficient processes to collect payments promptly and minimize bad debt.

Reducing Operating Costs:

• Optimize Resource Allocation: Identify areas where resources are underutilized and reallocate them to more profitable activities.
• Negotiate Better Deals with Suppliers: Renegotiate contracts with suppliers to secure lower prices for raw materials or services.
• Improve Operational Efficiency: Streamline processes, eliminate waste, and leverage technology to reduce operational costs.
• Reduce Employee Turnover: High employee turnover can be expensive. Invest in employee development and retention programs to minimize turnover.

Advantages of Economic Value Added:

EVA offers several key advantages for companies seeking to assess their true economic performance and make informed financial decisions:

• Measures True Profitability: Unlike traditional profit measures like net income, EVA considers the cost of capital – the minimum return investors expect for their investment. This provides a clearer picture of whether a company is creating real wealth for its shareholders.
• Improves Decision-Making: By highlighting the cost of capital, EVA encourages companies to prioritize projects that generate returns exceeding that cost. This approach leads to better resource allocation and investment decisions that drive long-term value creation.
• Incentivizes Long-Term Value Creation: Unlike short-term profit maximization strategies, EVA focuses on creating sustainable economic profit for shareholders in the long run. It discourages decisions that might inflate immediate profits but harm long-term growth.
• Performance Benchmarking: EVA allows companies to compare their performance with competitors within the same industry on a more level playing field. Since it considers the cost of capital, EVA provides a clearer picture of value creation compared to just looking at net income.
• Internal Performance Evaluation: EVA can be used to evaluate the performance of different departments or business units within a company. This helps identify areas for improvement and highlight departments or activities that are generating the most economic value.

Disadvantages of Economic Value Added (EVA):

• Relies on Estimates: EVA calculations rely on estimates for the cost of capital, which can be subjective and affect the final figure. The chosen method for calculating the cost of capital can significantly impact the EVA result.
• Focus on Short-Term Measures: While EVA encourages long-term value creation, some managers might be tempted to focus on short-term measures that artificially inflate EVA in the short run. This could involve cutting corners on essential investments or delaying maintenance to boost short-term profits.
• Implementation Challenges: Implementing EVA can be complex and require significant changes in a company’s financial reporting and performance evaluation systems. Integrating EVA effectively might require training for staff and adjustments to internal processes.
• Industry Dependence: EVA might be less effective in certain industries with intangible assets that are difficult to quantify. For example, a tech company with significant intellectual property might not see the full value of its assets reflected in an EVA calculation.

Conclusion:

EVA goes beyond simple profit by factoring in the cost of capital. This provides a clearer picture of a company’s true economic performance, highlighting its ability to generate wealth for shareholders after accounting for the cost of financing its operations.

Economic Value Added – FAQs

What Is the Formula to Calculate EVA?

Very simply, the formula for finding EVA is EVA = NOPAT – WACC x TC, where NOPAT is Net Operating Profit After Tax, WACC is Weighted Average Cost of Capital, and TC is Total Invested Capital.

Before you can calculate EVA, you need to calculate Net Operating Profit After Tax (NOPAT), then calculate Total Invested Capital (TC), then determine the Weighted Average Cost of Capital (WACC) in order to run the calculation.

What Causes EVA to Increase?

There are two ways you can increase EVA: by increasing revenues (through raising prices or increasing sales) or by decreasing capital costs (such as by increasing efficiency or taking advantage of economies of scale).

What Are the Pros and Cons of Using EVA?

One advantage of EVA is that it helps compare companies in terms of value to shareholders while taking the cost of capital into account. EVA is also useful because it incentivizes a firm’s managers to align their decisions with the interests of shareholders. However, a drawback of EVA is that it’s not well-suited for companies with intangible assets, nor does it consider a company’s potential for growth. Some companies with a low EVA may still have great growth potential.

Should I use EVA alone to make financial decisions?

No. EVA is a valuable tool, but it shouldn’t be the sole metric. Use it in conjunction with other financial metrics, industry benchmarks, and strategic considerations for a comprehensive understanding of your company’s health.

How does EVA differ from net income?

Net income simply shows a company’s overall profit. EVA takes net income and subtracts the cost of capital, providing a more accurate picture of the profit generated after accounting for the cost of financing the business.