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, as it attempts to capture the true economic profit of a company. This measure was devised by management consulting firm Stern Value Management, originally incorporated as Stern Stewart & Co.
- Economic value added (EVA), also known as economic profit, aims to calculate the true economic profit of a company.
- EVA is used to measure the value a company generates from funds invested in it.
- However, EVA relies heavily on invested capital and is best used for asset-rich companies, where companies with intangible assets, such as technology businesses, may not be good candidates.
Understanding Economic Value Added (EVA)
EVA is the incremental difference in the rate of return (RoR) over a company's cost of capital. Essentially, it is used to measure the value a company generates from funds invested in 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.
The formula for calculating EVA is:
EVA = NOPAT - (Invested Capital * WACC)
- NOPAT = Net operating profit after taxes
- Invested capital = Debt + capital leases + shareholders' equity
- WACC = Weighted average cost of capital
The equation for EVA shows that 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 company or 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.
The equation used for invested capital in EVA is usually total assets minus current liabilities—two figures easily found on a firm's balance sheet. In this case, the modified formula for EVA is NOPAT - (total assets - current liabilities) * WACC.
As noted by Stern Value Management, in 1983 the management team developed EVA, "a new model for maximizing the value created that can also be used to provide incentives at all levels of the firm." The goal of EVA is to quantify the cost of investing capital into a certain project or firm and then assess whether it generates enough cash to be considered a good investment. A positive EVA shows a project is generating returns in excess of the required minimum return.
Advantages and Disadvantages of EVA
EVA assesses the performance of a company and its management through the idea that a business is only profitable when it creates wealth and returns for shareholders, thus requiring 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.