What is Economic Value Added (EVA)?
Economic value added (EVA) is an internal management performance measure that compares net operating profit to total cost of capital. Stern Stewart & Co. is credited with devising this trademarked concept.
How Does Economic Value Added (EVA) Work?
Economic value added (EVA) is also referred to as economic profit.
The formula for EVA is:
As shown in the formula, there are three components necessary to solve EVA: net operating profit after tax (NOPAT), invested capital, and the weighted average cost of capital (WACC) operating profit after taxes (NOPAT) can be calculated, but can usually be easily found on the corporation's income statement.
The next component, capital invested, is the amount of money used to fund a particular project. We will also need to calculate the weighted-average cost of capital(WACC) if the information is not provided.
The idea behind multiplying WACC and capital investment is to assess a charge for using the invested capital. This charge is the amount that investors as a group need to make their investment worthwhile.
Let's take a look at an example.
Assume that Company XYZ has the following components to use in the EVA formula:
NOPAT = $3,380,000
Capital Investment = $1,300,000
WACC = .056 or 5.60%
EVA = $3,380,000 - ($1,300,000 x .056) = $3,307,200
The positive number tells us that Company XYZ more than covered its cost of capital. A negative number indicates that the project did not make enough profit to cover the cost of doing business.
Why Does Economic Value Added (EVA) Matter?
Economic Value Added (EVA) is important because it is used as an indicator of how profitable company projects are and it therefore serves as a reflection of management performance.
The idea behind EVA is that businesses are only truly profitable when they create wealth for their shareholders, and the measure of this goes beyond calculating net income. Economic value added asserts that businesses should create returns at a rate above their cost of capital
The economic value calculation has many advantages. It succinctly summarizes how much and from where a company created wealth. It includes the balance sheet in the calculation and encourages managers to think about assets as well as expenses in their decisions.
However, the seemingly infinite cash adjustments associated with calculating economic value can be time-consuming. And accrual distortions can still affect the measure, particularly when it comes to depreciation and amortization differences. Also, economic value added only applies to the period measured; it is not predictive of future performance, especially for companies in the midst of reorganization and/or about to make large capital investments.
The EVA calculation depends heavily on invested capital, and it is therefore most applicable to asset-intensive companies that are generally stable. Thus, EVA is more useful for auto manufacturers, for example, than software companies or service companies with a lot of intangible assets.