Economic Value Added
Economic Value Added (EVA) is a performance metric that is used to measure the economic profit of a company. The concept was developed and trademarked by consulting firm Stern Stewart & Co. and is also referred to as economic profit.
EVA is calculated by deducting a company’s operating costs and capital costs from its net operating profit after taxes (NOPAT). This gives a measure of the company’s profitability after taking into account the cost of capital.
The formula for EVA is:
EVA = NOPAT – (Capital Invested * Weighted Average Cost of Capital)
Where:
- NOPAT is the company’s net operating profit after taxes, which can be calculated by multiplying the operating profit by (1 – tax rate).
- Capital Invested is the total amount of money that has been invested in the business.
- Weighted Average Cost of Capital (WACC) is the average rate of return a company is expected to provide to all its security holders (both debt and equity).
EVA is considered a more comprehensive measure of profitability because it takes into account the cost of capital, which is a cost that a business incurs in order to finance its operations. This is a cost that is not considered in traditional profit measures such as net income.
By using EVA, businesses can identify whether they are truly creating wealth for their shareholders. A positive EVA indicates the company is generating value beyond the required return for its investors, while a negative EVA suggests the company is not generating a return that covers its cost of capital.
Example of Economic Value Added
Suppose Company ABC has the following financials:
- Net Operating Profit After Taxes (NOPAT) = $500,000
- Capital Invested in the Business = $2,500,000
- Weighted Average Cost of Capital (WACC) = 12%
Using the EVA formula:
EVA = NOPAT – (Capital Invested * WACC) EVA = $500,000 – ($2,500,000 * 0.12) EVA = $500,000 – $300,000 EVA = $200,000
So, Company ABC’s EVA is $200,000. This means that after accounting for all operating costs and the cost of capital, Company ABC generated an economic value of $200,000. It indicates that the company is creating wealth above the required return for its investors.
It’s worth noting that EVA can be used in conjunction with other financial metrics for a more comprehensive analysis of a company’s performance. Also, the calculation can become complex depending on how companies calculate NOPAT and WACC, and what they include as capital invested.
