Define in Detail
Economic Value Added (EVA) is a measure used in financial management—and introduced by consultants Stern Stewart & Co.—to calculate the true economic profit of a company. Unlike traditional profit figures, EVA considers both the operating profit and the cost of capital employed in the business. Mathematically, it can be expressed as:
\[ \text{EVA} = \text{NOPAT} - \text{(Capital \times WACC)} \]
Where:
- NOPAT (Net Operating Profit After Taxes): The profit a company has left after deducting taxes, but before accounting for interest.
- WACC (Weighted Average Cost of Capital): Represents the average rate of return a company is expected to pay its stakeholders to finance its assets.
- Capital: Total capital employed in the business.
EVA focuses on value creation and loss measurement, making it a useful tool for assessing whether a company’s projects are yielding returns above the required threshold.
Examples
-
Example 1: Calculating EVA Suppose a company has a NOPAT of $500,000. The employed capital is $2,000,000, and the firm’s WACC is 10%. The EVA calculation will be:
\[ \text{EVA} = $500,000 - ($2,000,000 \times 0.10) \] \[ \text{EVA} = $500,000 - $200,000 \] \[ \text{EVA} = $300,000 \]
This positive EVA indicates that the company is generating value exceeding the required return on its capital.
-
Example 2: Negative EVA Consider another company with a NOPAT of $150,000, a capital employed of $1,500,000, and a WACC of 12%. The EVA would be:
\[ \text{EVA} = $150,000 - ($1,500,000 \times 0.12) \] \[ \text{EVA} = $150,000 - $180,000 \] \[ \text{EVA} = -$30,000 \]
Here, the negative EVA indicates that the company is destroying value as it is not meeting the capital cost threshold.
Frequently Asked Questions (FAQs)
What is the significance of Economic Value Added (EVA)?
EVA is significant because it helps investors and company managers evaluate the true economic profit, taking into account the cost of capital. It ensures that the profit figures reflect the return required by all sources of capital.
How does EVA differ from traditional accounting profit?
Traditional accounting profit does not deduct the cost of equity capital, whereas EVA includes all capital costs (both debt and equity). This makes EVA a more comprehensive measure of profitability.
What can a company do with EVA results?
Companies can use EVA results to make informed decisions on investment projects, improve capital allocation, and evaluate managerial performance.
Can EVA be negative?
Yes, EVA can be negative, indicating that the company is not generating sufficient returns to cover the cost of capital.
What does a positive EVA indicate?
A positive EVA signifies that the company is generating returns that exceed the cost of capital, suggesting value creation for shareholders.
Who typically uses EVA?
EVA is commonly used by corporate managers, financial analysts, and investors to assess and compare the economic performance of companies.
Is EVA applicable to all industries?
While EVA can be applied broadly, its relevance varies by industry depending on capital intensity and other factors. Industries with high capital expenditures may find it particularly useful.
How frequently should EVA be calculated?
EVA can be calculated quarterly or annually, similar to other financial performance metrics, to monitor ongoing performance.
Is EVA an internal or external measure?
EVA serves both internal managerial purposes for performance assessment and external purposes for investor value evaluation.
Can EVA drive executive compensation?
Yes, some organizations tie executive bonuses and compensation to EVA, thus aligning management’s interests with shareholders’ value creation.
Related Terms
- Net Operating Profit After Taxes (NOPAT): A company’s after-tax profit from operations without considering interest costs.
- Weighted Average Cost of Capital (WACC): The average rate of return a company is expected to provide to its financial stakeholders; both equity and debt holders.
- Return on Investment (ROI): A measure of the return earned on every dollar invested in the business.
- Cost of Capital: The opportunity cost of choosing one investment over another.
- Performance Metrics: Quantitative measures used to gauge the efficiency and effectiveness of a company’s actions.
Online References
- Investopedia: Economic Value Added (EVA)
- Corporate Finance Institute: EVA - Economic Value Added
- Stern Stewart & Co.: EVA
Suggested Books for Further Studies
- “The Quest for Value” by G. Bennett Stewart III
- “Value: The Four Cornerstones of Corporate Finance” by Tim Koller, Marc Goedhart, and David Wessels
- “Principles of Corporate Finance” by Richard A. Brealey, Stewart C. Myers, and Franklin Allen
- “Value-Based Management: Developing a Systematic Approach to Create Shareholder Value” by James Atkinson
Accounting Basics: “Economic Value Added” Fundamentals Quiz
Thank you for embarking on this journey through our comprehensive accounting lexicon and tackling our challenging sample exam quiz questions. Keep striving for excellence in your financial knowledge!
