1. EVA: Introduction
  2. EVA: Overview
  3. EVA: Calculating NOPAT
  4. EVA: Calculating Invested Capital
  5. EVA: Pulling It All Together
  6. EVA: What Does It Really Mean?
  7. EVA: Conclusion


By David Harper, (Contributing Editor - Investopedia Advisor)
Contact David

Economic profit - otherwise known as "Economic Value Added" (EVA™) is based on classic financial theory, and, for this reason, is not entirely different from traditional free cash flow measures. Three conceptual pillars support economic profit:

  1. Cash flows are more reliable than accruals.
  2. Some period expenses are - in economic reality - actually long-term investments.
  3. The company does not create value until a threshold level of return is generated for shareholders.

As you perform your own economic profit calculations, keep the following in mind:

  • Economic profit boils down to a set of adjustments that translate an accrual-based earnings before interest and taxes (EBIT) into a cash-based net operating profit after taxes (NOPAT).

  • Although the list of potential adjustments is long, it is important not to be seduced into an almost-impossible quest for absolute precision. From an investor's perspective, consistency is more important. That is, an income statement adjustment should always be matched by a balance sheet adjustment. For example, if we add back minority interest to earnings, then we need to add the minority interest balance sheet account to invested capital. We can add neither or both, but there is no truly right answer. In this example, it comes down to whether we prefer our economic profit to have an operational perspective (add both) or a financial perspective (add neither).

  • Avoid seeking precision in the calculation of weighted average cost of capital (WACC), a dubious academic exercise. It is far better to charge the company with an approximate but consistent estimate of WACC than to try to chase down the elusive cost of equity. (Several companies, after trying to explain a precise WACC to employees, have come to abandon a precise WACC in favor of a round number like 10%; e.g. "cost of capital is 10%".)
Finally, to help you consider whether economic profit is an appropriate performance metric for the company you are evaluating, we have discussed the following strengths and weaknesses:

Strengths
  • If you had to rely on only one single performance number, economic profit is probably the best because it contains so much information (mathematicians would call it "elegant"): economic profit incorporates balance sheet data into an adjusted income statement metric.
  • Economic profit works best for companies whose tangible assets (assets on the balance sheet) correlate with the market value of assets - as is often the case with mature industrial companies.
Weaknesses
  • Although some proponents argue economic profit is "all you need", it is very risky to depend on an single metric.
  • The companies least suited for economic profit are high-growth, new-economy and high-technology companies, for whom assets are 'off balance sheet' or intangible.

Related Articles
  1. Investing

    Investors Need A Good WACC

    Weighted average cost of capital may be hard to calculate, but it's a solid way to measure investment quality.
  2. Markets

    Calculating Economic Profit

    Economic profit is the difference between the revenue a firm earns from sales and the firm’s total opportunity costs.
  3. Investing

    Accounting Basics: Financial Statements

    By Bob Schneider Financial statements present the results of operations and the financial position of the company. Four statements are commonly prepared by publicly-traded companies: balance ...
  4. Investing

    All About EVA

    Looking for a formula to determine whether a company is creating wealth? Time to learn all about economic value added.
  5. Investing

    Comparing the P&L Statement and the Balance Sheet

    Basically, the balance sheet shows how much a company is worth, while the P&L statement reveals if a company is profitable or not.
  6. Markets

    Top Things To Know For An Investment Banking Interview

    Without some basic knowledge, you won't get the job. Find out what you need to know and how to prepare.
  7. Managing Wealth

    Interpreting A Strategy Performance Report

    These key performance metrics will help you decide if your trading strategy is a winner.
  8. Investing

    4 Tips to Evaluate Growth Companies (KO, AAPL)

    Discover the best metrics for stock investors to utilize when selecting and evaluating the best opportunities in growth investing.
  9. Markets

    How To Evaluate A Company's Balance Sheet

    Asset performance shows how what a company owes and owns affects its investment quality.
  10. Entrepreneurship & Small Business

    Is Net Income The Same As Profit?

    Net income and profit both deal with positive cash flow, but there are important differences between the two concepts.
Trading Center