The goal of all companies is to create value for the shareholder. But how is value measured? Wouldn't it be nice if there were a simple formula to figure out whether a company is creating wealth?
A growing number of analysts and consultants think there is an answer. Like many economic formulas, the measure - economic value added (EVA) - is both intriguingly clever and maddeningly deceptive. Does EVA simplify the task of finding value-generating companies or does it just muddy the waters?
What Is EVA?
EVA is a performance metric that calculates the creation of shareholder value, but 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 - both debt and equity - are deducted from operating profit. The idea is simple but rigorous: true profit should account for the cost of capital.
To understand the difference between EVA and its older cousin, net income, let's use an example based on a hypothetical company, Ray's House of Crockery. Ray's earned $100,000 on a capital base of $1 million thanks to big sales of stew pots. Traditional accounting metrics suggest that Ray is doing a good job. His company offers a return on capital of 10%. However, Ray'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 for having their money locked up in an early-stage venture add up to an investment cost of capital of 13%. That means that, although Ray's is enjoying accounting profits, the company lost 3% last year for its shareholders.
Conversely , if Ray'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 a year, Ray will add economic value for his shareholders only when profits are more than $13 million a year. If Ray's earns $20 million, the company's EVA will be $7 million.
In other words, EVA charges the company rent for tying up investors' cash to support operations. There is a hidden opportunity cost that goes to investors to compensate them for forfeiting the use of their own cash. EVA captures this hidden cost of capital that conventional measures ignore.
Developed by the management consulting firm Stern Stewart, EVA really caught fire in the 1990s. Big corporations, including Coca-Cola, GE and AT&T, employ EVA internally to measure wealth creation performance. In turn, investors and analysts are now scrutinizing company EVA just as in the past they observed EPS and P/E ratios. Stern Stewart has gone so far as to trademark the concept.
There are four steps in the calculation of EVA:
|1. Calculate Net Operating Profit After Tax (NOPAT)
2. Calculate Total Invested Capital (TC)
3. Determine a Cost of Capital (WACC)
4. Calculate EVA = NOPAT – WACC% * (TC)
The steps appear straightforward and simple, but looks can be deceiving. For starters, NOPAT hardly represents a reliable indicator of shareholder wealth. NOPAT might show profitability according to the generally accepted accounting principles (GAAP), but standard accounting profits rarely reflect the amount of cash left at year end for shareholders. According to Stern Stewart, literally dozens of adjustments to earnings and balance sheets - in areas like R&D, inventory, costing, depreciation and amortization of goodwill - must be made before the calculation of standard accounting profit can be used to calculate EVA.
Figuring out the weighted average cost of capital (WACC) is even more thorny. WACC is a complex function of the capital structure (proportion of debt and equity on the balance sheet), the stock's volatility measured by its beta, and the market risk premium. Small changes in these inputs can result in big changes in the final WACC calculation.
That said, if carried out consistently, EVA should help us identify the best investments, that is, the companies that generate more wealth than their rivals. All other things being equal, firms with high EVAs should over time outperform others with lower or negative EVAs.
But the actual EVA level matters less than the change in the level. According to research conducted by Stern Stewart, EVA is a critical driver of a company's stock performance. If EVA is positive but is expected to become less positive, it is not giving a very good signal. Conversely, if a company suffers negative EVA but is expected to rise into a positive territory, a good buying signal is given.
Of course, Stern Stewart is hardly unbiased in its assessment. New research challenges the close relationship between rising EVA and stock price performance. Still, the growing popularity of the concept reflects the importance of EVA's basic principle: the cost of capital should not be ignored but kept at the forefront of investors' minds. Best of all, EVA gives analysts and anyone else the chance to look skeptically at EPS reports and forecasts.
InvestingWhile stocks have rallied since the economic recovery in 2009, many active portfolio managers have struggled to deliver investor returns in excess.
InvestingWe share some lessons from friends and family on saving money and planning for retirement.
EconomicsAfter the Paris attacks investors are focusing on central bank policy and its potential for divergence: tightened by the Fed while the ECB pursues easing.
Stock AnalysisLearn the biggest potential risks that may affect the price of Pfizer's stock, complete with a fundamental analysis and review of other external factors.
ProfessionalsLearn how these must-watch movies for accountants teach about the importance of ethics in a world driven by greed and financial power.
Credit & LoansThese terms may sound the same, but they mean very different things for homebuyers.
Options & FuturesInvesting during an economic downturn simply means changing your focus. Discover the benefits of defensive stocks.
Active TradingCompanies make choices and assumptions in calculating depreciation, and you need to know how these affect the bottom line.
MarketsLearn how this simple calculation can help you determine a stock's earnings potential.
InsuranceTough times call for desperate measures, but is raiding your life insurance policy even worth considering?
Generally, profit is the difference between costs and revenue. Accounting profit and economic profit may sound similar, but ... Read Full Answer >>
Working capital as current assets cannot be depreciated the way long-term, fixed assets are. In accounting, depreciation ... Read Full Answer >>
While working capital funds do not expire, the working capital figure does change over time. This is because it is calculated ... Read Full Answer >>
The amount of working capital a small business needs to run smoothly depends largely on the type of business, its operating ... Read Full Answer >>
If a company has high working capital, it has more than enough liquid funds to meet its short-term obligations. Working capital, ... Read Full Answer >>
Working capital, or total current assets minus total current liabilities, can affect a company's longer-term investment effectiveness ... Read Full Answer >>