Economic value added (EVA), also known as economic profit, is a measure of a company's or project's financial success based on residual wealth, calculated as subtracting the cost of capital from operating profits. The purpose of EVA is to determine the value a company generates from the capital invested into it with the overall goal of improving the returns generated for shareholders.
There are two major ways a company can improve its economic value added (EVA): increase revenues or decrease capital costs. Revenue can be increased by raising prices or selling additional goods and services. Capital costs can be minimized in several ways, including increasing economies of scale. It is also possible for a firm to offset capital costs by choosing investments that earn more than their associated capital charges.
- Economic value added (EVA) is a measure of a company's financial success determined by comparing its returns on invested capital to the cost of capital. It shows a company's economic profit.
- A positive EVA indicates a company is generating wealth for shareholders whereas a negative EVA indicates that a company is not generating returns above its cost of capital.
- To improve its EVA, a company can increase revenues by increasing the price for its goods or services or it can sell more goods.
- A company can also increase its EVA by reducing its capital costs by improving efficiency and reaching economies of scale.
What Is Economic Value Added (EVA)?
EVA was developed by Stern Value Management to measure the difference between the cost of capital and the rate of return, creating a path for companies to determine whether capital invested into the company will be a drag on assets or help it in terms of successful financial performance.
When the EVA is positive, it indicates that a company is generating economic profit. A negative EVA would show that a company is not generating wealth for shareholders from its capital commitments.
Economic value added is sometimes also referred to as shareholder value added (SVA), although some companies might make different adjustments in their NOPAT and cost of capital calculations. These are not the same as cash value added (CVA), which is a metric used by value investors to see how well a company can generate cash flow.
Formula for Economic Value Added (EVA)
The formula for EVA is as follows:
Economic Value Added = Net Operating Profits After Tax - (Weighted Average Cost of Capital x Capital Invested)
Capital Invested = Equity + Long Term Debt at the Start of the Period
How to Increase Economic Value Added (EVA)
In the EVA formula, a firm's revenue is expressed as being equal to net operating profits after tax (NOPAT). Capital costs are traditionally estimated using a weighted average cost of capital (WACC). EVA is the result of subtracting all net capital charges from NOPAT. Below are two ways to increase EVA.
Traditional methods of increasing revenue include increasing prices and increasing the number of goods sold. Increasing prices is straightforward, a company charges more for a product or service than it did before. If costs remain the same this will then increase the profit margin. The only downside to this tactic is that certain consumers may not be willing to pay more for the same product, which could lead to a decrease in demand and, therefore, a decrease in revenue.
Selling more goods would increase revenues, as long as the cost of producing more goods to meet the increased demand doesn't outweigh the benefit. Meaning, if a company wants to improve its EVA by adding to its revenues, it must ensure the marginal revenue gain is larger than the accompanying marginal costs, including taxes. This makes sense; you would not spend $150 to earn an additional $100 in revenue.
For example, if you need to create a new factory to meet the additional demand for goods, you would need to ensure that the return on investment of the factory is greater than the WACC.
Since revenue generation is usually uncertain, it is often easier for a company to reduce its net capital costs.
Decreasing Capital Costs
Net capital costs can be lowered by reducing operating expenses, increasing marginal productivity, or liquidating capital that does not cover the cost of capital for the purpose that it is associated with.
The costs associated with research and development (R&D) should be included as part of costs invested into the company.
To reduce operating expenses, a company might renegotiate with its creditor to acquire a lower interest rate on debt, it may negotiate better terms with its suppliers, and it may be able to get better terms on rent for its office or factory space.
A company may also improve its marginal productivity by reaching economies of scale. Here, a company would be able to figure out a way to produce the same amount of goods at a lower cost, or conversely, produce more goods without a significant increase in costs. This can be achieved by arriving at improved means of efficiency, such as a better production plan or new technology.
The Bottom Line
Economic value added (EVA) is a way for companies to determine if the capital invested into the company will add value to shareholders. A positive EVA indicates that the capital invested is generating returns above the minimum required return and a negative EVA indicates the opposite.
To increase EVA, a company can increase revenues by increasing the price or the number of goods sold, as long as the marginal cost to produce more units is not above the marginal return. Companies can also decrease their capital costs by improving operational efficiency and reaching economies of scale.