What Is Economic Value Added?
Economic value added (EVA) is an internal management performance measure that compares net operating profit to the total cost of capital.
More simply, this measure goes beyond calculating net income and indicates how profitable company projects are while reflecting management performance
Economic value added (EVA) may also be referred to as economic profit.
What Is the Economic Value Added Formula?
The EVA formula is:
EVA = Net Operating Profit After Tax – (Capital Invested x WACC)
Components of EVA Calculation
Three components are necessary to solve for the EVA:
Net operating profit after tax (NOPAT) compares multiple companies in the same industry, based entirely on earnings (and with no reference to leverage differences).
While it’s easier to find on the company income statement, the simple NOPAT formula is as follows:
Capital invested measures the total investments made by a company’s shareholders and bondholders. Because this sum must eventually be returned to these parties, it is considered a liability.
EVA calculation depends heavily on invested capital. Therefore, it is most applicable to stable, asset-intensive companies (e.g. auto manufacturers), than companies with a great deal of intangible assets (e.g. software companies).
Invested Capital Formula
The invested capital formula is as follows:
Weighted Average Cost of Capital (WACC)
WACC shows the average rate paid by companies to finance their operations. WACC can help investors understand whether the stock has room to grow (or if it’s limited by a business’ finances).
How to Calculate WACC
Though it can be found on the right side of the balance sheet, you may also calculate WACC using the following formula:
Economic Value Added Example
Assume that Company XYZ has the following components of EVA:
- NOPAT = $3,380,000
- Capital Investment = $1,300,000
- WACC = .056 or 5.60%
The EVA will be: $3,380,000 - ($1,300,000 x .056) = $3,307,200
Because of this positive number, we can determine that Company XYZ more than covered its cost of capital. A negative number would indicate that the project didn’t make enough profit to cover its business costs.
The Importance of Economic Value Added
The economic value added summarizes how much (and where) a company created wealth. By including the balance sheet in the calculation, EVA encourages managers to consider assets – as well as expenses – in their decisions.
Limitations of EVA
The seemingly infinite cash adjustments associated with calculating economic value can be time-consuming. Accrual distortions can still affect the measure, particularly when it comes to depreciation and amortization differences.
EVA also only applies to the measured period and isn’t predictive of future performance. This is especially true for companies that are in the midst of reorganization and/or about to make large capital investments.