Economic Value Added - EVA

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What is 'Economic Value Added - EVA'

Economic value added (EVA) is a measure of a company's financial performance based on the residual wealth calculated by deducting its cost of capital from its operating profit, adjusted for taxes on a cash basis. EVA can also be referred to as economic profit, and it attempts to capture the true economic profit of a company. This measure was devised by Stern Stewart and Co.

BREAKING DOWN 'Economic Value Added - EVA'

EVA is the incremental difference in the rate of return over a company's cost of capital. Essentially, it is used to measure the value a company generates from funds invested into it. If a company's EVA is negative, it means the company is not generating value from the funds invested into the business. Conversely, a positive EVA shows a company is producing value from the funds invested in it.

Calculating EVA

The formula for calculating EVA is: Net Operating Profit After Taxes (NOPAT) - Invested Capital * Weighted Average Cost of Capital (WACC)

The equation above shows there are three key components to a company's EVA: NOPAT, the amount of capital invested and the WACC. NOPAT can be calculated manually but is normally listed in a public company's financials. Capital invested is the amount of money used to fund a specific project. WACC is the average rate of return a company expects to pay its investors; the weights are derived as a fraction of each financial source in a company's capital structure. WACC can also be calculated but is normally provided as public record.

The goal of EVA is to quantify the charge, or cost, for investing capital into a certain project, and then assess whether it is generating enough cash to be considered a good investment. The charge represents the minimum return that investors require to make their investment worthwhile. A positive EVA shows a project is generating returns in excess of the required minimum return.

The Benefits of EVA

The purpose of EVA is to assess company and management performance. EVA champions the idea a business is only profitable when it creates wealth and returns for shareholders, and requires performance above a company's cost of capital.

EVA as a performance indicator is very useful. The calculation shows how and where a company created wealth, through the inclusion of balance sheet items. This forces managers to be aware of assets and expenses when making managerial decisions. However, the EVA calculation relies heavily on the amount of invested capital, and is best used for asset-rich companies that are stable or mature. Companies with intangible assets, such as technology businesses, may not be good candidates for an EVA evaluation.

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