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, and it
attempts to capture the true economic profit of a company. This measure was devised by
Stern Stewart and Co.

BREAKING DOWN 'Economic Value Added - EVA'

EVA is the incremental difference in the rate of return over a company's cost of capital.
Essentially, it is used to measure the value a company generates from funds invested into 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.

Calculating EVA
The formula for calculating EVA is: Net Operating Profit After Taxes (NOPAT) - Invested
Capital * Weighted Average Cost of Capital (WACC)
The equation above shows 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 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 as
public record.
The goal of EVA is to quantify the charge, or cost, for investing capital into a certain project,
and then assess whether it is generating enough cash to be considered a good investment.
The charge represents the minimum return that investors require to make their investment
worthwhile. A positive EVA shows a project is generating returns in excess of the required
minimum return.

The Benefits of EVA

The purpose of EVA is to assess company and management performance. EVA champions
the idea a business is only profitable when it creates wealth and returns for shareholders,
and requires 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.

Economic Value Added (EVA)

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WHAT IT IS:

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Economic value added (EVA) is an internal management performance measure that

compares net operating profit to total cost of capital. Stern Stewart & Co. is credited with
devising this trademarked concept.
HOW IT WORKS (EXAMPLE):

Economic value added (EVA) is also referred to as economic profit.

The formula for EVA is:
EVA = Net Operating Profit After Tax - (Capital Invested x WACC)
As shown in the formula, there are three components necessary to solve EVA: net
operating profit after tax (NOPAT), invested capital, and the weighted average cost of
capital (WACC) operating profit after taxes (NOPAT) can be calculated, but can usually
be easily found on the corporation's income statement.
The next component, capital invested, is the amount of money used to fund a particular
project. We will also need to calculate the weighted-average cost of capital(WACC) if
the information is not provided.

The idea behind multiplying WACC and capital investment is to assess a charge for
using the invested capital. This charge is the amount that investors as a group need to
make their investment worthwhile.
Let's take a look at an example.
Assume that Company XYZ has the following components to use in the EVA formula:
NOPAT = $3,380,000
Capital Investment = $1,300,000
WACC = .056 or 5.60%
EVA = $3,380,000 - ($1,300,000 x .056) = $3,307,200
The positive number tells us that Company XYZ more than covered its cost of capital. A
negative number indicates that the project did not make enough profit to cover the cost
of doing business.
WHY IT MATTERS:

Economic Value Added (EVA) is important because it is used as an indicator of how

profitable company projects are and it therefore serves as a reflection of management
performance.
The idea behind EVA is that businesses are only truly profitable when they
create wealth for their shareholders, and the measure of this goes beyond
calculating net income. Economic value added asserts that businesses should create
returns at a rate above their cost of capital
The economic value calculation has many advantages. It succinctly summarizes how
much and from where a company created wealth. It includes the balance sheet in the
calculation and encourages managers to think about assets as well as expenses in their
decisions.
However, the seemingly infinite cash adjustments associated with calculating economic
value can be time-consuming. And accrual distortions can still affect the measure,
particularly when it comes to depreciation and amortization differences. Also, economic
value added only applies to the period measured; it is not predictive of future
performance, especially for companies in the midst of reorganization and/or about to
make large capital investments.
The EVA calculation depends heavily on invested capital, and it is therefore most
applicable to asset-intensive companies that are generally stable. Thus, EVA is more

useful for auto manufacturers, for example, than software companies or service
companies with a lot of intangible assets.

Return on Investment (ROI)

WHAT IT IS:

Return on investment (ROI) measures the gain or loss generated on

an investment relative to the amount of money invested. ROI is usually expressed as a
percentage and is typically used for personal financial decisions, to compare a
company's profitability or to compare the efficiency of different investments.
The return on investment formula is:
ROI = (Net Profit / Cost of Investment) x 100
HOW IT WORKS (EXAMPLE):

The ROI calculation is flexible and can be manipulated for different uses. A company
may use the calculation to compare the ROI on different potential investments, while an
investor could use it to calculate a return on a stock.
For example, an investor buys $1,000 worth of stocks and sells the shares two years
later for $1,200. The net profit from the investment would be $200 and the ROI would be
calculated as follows:
ROI = (200 / 1,000) x 100 = 20%
The ROI in the example above would be 20%. The calculation can be altered by
deducting taxes and fees to get a more accurate picture of the total ROI.
The same calculation can be used to calculate an investment made by a company.
However, the calculation is more complex because there are more inputs. For example,
to figure out the net profit of an investment, a company would need to track exactly how
much cash went into the project and the time spent by employees working on it.

WHY IT MATTERS:

ROI is one of the most used profitability ratios because of its flexibility. That being said,
one of the downsides of the ROI calculation is that it can be manipulated, so results
may vary between users. When using ROI to compare investments, it's important to use
the same inputs to get an accurate comparison.
Also, it's important to note that the basic ROI calculation does not take time into
consideration. Obviously, it's more desirable to get a +15% reuturn over one year than it
is over two years.

Using EVA and MVA within a Company

All managers have the same goal of obtaining capital and a earning rate of return on it
that exceeds the return offered by other seekers of capital funds. EVA can be used as a
financial management system that allows managers and employees to focus on how
capital is used and the cash flow generated from it. There are two benefits from
focusing on growth in EVA; managements attention is focused more towards its
primary responsibility, which is increasing investors wealth and secondly, distortion
caused by using historical cost accounting data are reduced or eliminated so that
managers can spend their time finding ways to increase EVA. This increased
awareness of the efficient use of capital will eventually produce additional shareholder
value.
Managers can do a better job of asset management and EVA can be used to hold
management accountable for all economic outlays whether they appear in the income
statement, on the balance sheet or in the footnotes to the financial statements. This is
possible because EVA creates one financial statement that includes all the costs of
being in business, while making managers aware of every dollar they spend.
Another benefit of using EVA is that it creates a common language for making
decisions, especially long-term decisions. Examples are: resolving budgeting issues
and evaluating the performance of organizational units and managers. EVA
quantification of results in financial terms also helps to energize other management
programs such as TQM, quick response and customer development by demanding and
getting continuous financial improvement.
Mangers and employees adopt a long-term focus and begin to think more like owners
as they start to feel responsible for and take part in the economic value of the firm.

Economic Value Added (EVA) Vs. Return on Investment

(ROI)
Most of the companies employing investment centers evaluate business units on
the basis of Return on Investment (ROI) rather than Economic Value Added (EVA).
There are three apparent benefits of an ROI measure.
1. First, it is, a comprehensive measure in that anything that affects financial
statements is reflected in this ratio.
2. Second, Return on Investment (ROI) is simple to calculate, easy to
understand, and meaningful in an absolute sense. For example, an ROI of less
than 5 percent is considered low on an absolute scale, and an ROI of over 25
percent is considered high.
3. Finally, it is a common denominator that may be applied to any organizational
unit responsible for profitability, regardless of size or type of business.
The performance of different units may be compared directly to one another.
Also, ROI data are available for competitors and can be used as a basis for
comparison.
The collar amount of Economic Value Added (EVA) does not provide such a basis for
comparison. Nevertheless the EVA approach has some inherent advantages. There
are four competing reasons to use EVA over ROI:
1. First, with EVA all business units have the same profit objective for comparable investments. The ROI approach, on the other hand, provide, different
incentive; for investments across business units. For example, a business unit
that currently is achieving an ROI of 30 percent would be reluctant to expand
unless it is able to earn on ROI of 30 percent or more on additional assets: a
lesser return would decrease its overall ROI below its current 30 percent
level. Thus, this business unit might forgo investment an opportunity thats
ROI is above the cost of capital but below 30 percent.
2. The use of ROI as a measure deals with both these problems. They relate to
asset investment whose ROI falls between the cost of capital and the centers
current ROI. If investment centers performance is measured by EVA,
investments that practice a profit in excess of the cost of capital will increase
EVA and therefore economically attractive to the manager.
3. A third advantage of EVA is that different interest rates may be used for
different types of assets. For example, a low rate may be used for inventories
while a relatively higher rate may be used for investments in fixed assets.
Furthermore, different rates may be used for different types of fixed assets to
take into account different degrees of risk. In short, management control
systems can be made considered with the framework used for decisions
about capital investments and resources allocation. It follows that the same
type of asset may be required to earn the same return throughout the
company, regardless of the particular business nits profitability. Thus,

business unit managers should act consistently when a deciding to invest in

new assets.
4. A fourth advantage is that EVA, in contrast to ROI, has a stronger positive
correction with changes in a companys market value. There are several
reasons why shareholder value creation is critical for the firm: It (a) reduces
the risk of takeover, (b) creates currency for aggressiveness in mergers and
acquisitions, and (c) reduces cost of capital, which allows faster investment
for future growth, Thus, optimizing shareholder value is an important goal of
an enterprise. However, since shareholder value measures the worth of the
consolidated enterprise as whole n is nearly impossible to use it as a
performance criterion for an organization individual responsibility centers.
The best proxy for shareholder value at the business unit level is to ask
business unit managers to create and grow EVA. It indicates that companies
with high EVA tend to show high market value added (MVA) or high gains for
shareholders. When used as a performance metric, EVA motivates managers
to increase EVA by taking actions consistent with increasing stockholder
value.