There are numerous ways that investors and lenders can estimate the value of a company. This becomes increasingly important for individuals seeking out value investing opportunities in small and large companies. Valuations can also be used to determine whether a business is a good credit risk.
The most-common metrics used to determine a company's value include economic value added and market value added. However, there are distinct differences between these two valuation strategies, and investors need to be aware of how to use each.
What Is Economic Value Added?
Economic value added (EVA) is a performance measure developed by Stern Stewart & Co. (now known as Stern Value Management) that attempts to measure the true economic profit produced by a company. It is frequently also referred to as "economic profit," and provides a measurement of a company's economic success (or failure) over a period of time. Such a metric is useful for investors who wish to determine how well a company has produced value for its investors, and it can be compared against the company's peers for a quick analysis of how well the company is operating in its industry.
Economic profit can be calculated by taking a company's net after-tax operating profit and subtracting from it the product of the company's invested capital multiplied by its percentage cost of capital.
For example, if a fictional firm, Cory's Tequila Company (CTC), had 2017 net after-tax operating profits of $200,000 and invested capital of $2 million at an average cost of 8.5 percent, then CTC's economic profit would be computed as $200,000 - ($2 million x 8.5%) = $30,000.
This $30,000 represents an amount equal to 1.5 percent of CTC's invested capital, providing a standardized measure for the wealth the company generated over and above its cost of capital during the year.
Additionally, EVA takes into account the opportunity cost of alternative investments while other valuation techniques do not. A company's profitability can be gauged by calculating EVA, as its focus is on a business project's profitability and therefore the efficiency of company management.
What Is Market Value Added?
Market value added (MVA), on the other hand, is simply the difference between the current total market value of a company and the capital contributed by investors (including both shareholders and bondholders). It is typically used for companies that are larger and publicly-traded. MVA is not a performance metric like EVA, but instead is a wealth metric, measuring the level of value a company has accumulated over time.
As a company performs well over time, it will retain earnings. This will improve the book value of the company's shares, and investors will likely bid up the prices of those shares in expectation of future earnings, causing the company's market value to rise. As this occurs, the difference between the company's market value and the capital contributed by investors (its MVA) represents the excess price tag the market assigns to the company as a result of it past operating successes.
Unlike EVA, MVA is a simple metric of the operational capability of a business and, as such, does not incorporate the opportunity cost of alternative investments.