Economic Value Added (EVA): An Essential Measure for Business Growth
Economic Value Added (EVA) is a significant measure of a company’s financial performance, gauged by the residual wealth generated. This is calculated by subtracting the cost of capital from the operating profit, adjusted for taxes on a cash basis. Often synonymous with economic profit, EVA aims to reveal the true economic profit a business makes.
Key Insights
- True Value Creation: Economic Value Added (EVA) focuses on uncovering the actual economic profit of a company.
- Investment Efficiency: It evaluates how efficiently a company utilizes invested capital to generate value.
- Best Practices: While beneficial for asset-rich firms, EVA may underrepresent the value of companies built upon intangible assets, like technology firms.
Delving Deeper into EVA
EVA represents the incremental difference between a company’s rate of return (RoR) and its cost of capital. It essentially measures the value a company creates through investments. A negative EVA suggests that the company isn’t generating meaningful value from its investments. Conversely, a positive EVA indicates productive value generation.
EVA Calculation Formula:
EVA = NOPAT - (Invested Capital * WACC)
Where:
- NOPAT: Net Operating Profit After Taxes
- Invested Capital: Sum of Debt, Capital Leases and Shareholders’ Equity
- WACC: Weighted Average Cost of Capital
Crucial Considerations
The core components of EVA encompass NOPAT, invested capital, and WACC:
- NOPAT is generally listed in a public company’s financial documents or calculated manually.
- Invested Capital refers to funds used for company operations or specific projects.
- WACC indicates the average return rate a company is expected to pay its investors, weighted per each financial source’s impact within the capital structure.
Typically, invested capital in EVA is assessed using total assets minus current liabilities, easily found on a balance sheet. Thus, EVA can also be expressed as NOPAT - (total assets - current liabilities) * WACC.
EVA, originally devised by Stern Value Management in 1983, introduced a comprehensive model for maximizing value creation and incentivizing at all organizational levels. The goal is to measure whether investments generate satisfactory returns beyond just covering capital costs. A positive EVA denotes returns exceeding the required minimum.
Pros and Cons of EVA
Advantages:
- Enhanced Performance Evaluation: EVA highlights that a company is truly profitable only if it surpasses its cost of capital requirements.
- Data-Driven Decision Making: By incorporating balance sheet items, managers gain insights into asset and expense impacts when making decisions.
Challenges:
- Investment Intensity: EVA heavily relies on the adequacy of invested capital, favoring asset-heavy companies, often excluding less tangible-asset-centric businesses like those in tech.
Related Terms: Net Operating Profit After Taxes (NOPAT), Weighted Average Cost of Capital (WACC), Invested Capital, Rate of Return (RoR), Capital Structure.
References
- Stern Value Management. “Our History”.
