What is Economic Value Added (EVA)?

There are numerous ways to discuss a company’s value, including share price, debt-to-equity and other ratios, fair market value, and so forth. But if you want to sound really smart around business professionals, you really need to understand Economic Value Added (EVA). So what is EVA?

As the statement above implies, EVA has to do with the valuation of a corporation – specifically, the value of the corporation to equity holders or lenders. Investors have always judged the value of their investments, at least in part, on the basis of residual income. EVA adds the insight that capital costs money (i.e., a corporation has to pay a required rate of return to investors or lenders in order to use capital). EVA, therefore, is the calculation fo a corporation’s residual income, adjusted for the cost of capital.

You can use the following equation to calculate EVA:

Net Sales – Operating Expenses = EBIT (Earnings Before Interest and Taxes)

EBIT – Taxes = Net Operating Profit After Taxes (NOPAT)

NOPAT – Capital Charges (Invested Capital x Cost of Capital) = Economic Value Added (EVA)

[Source: http://www.valuebasedmanagement.net/methods_eva.html]

There are other ways to describe EVA, but this equation makes pretty good intuitive sense. EBIT (earnings before interest and tax) is a common measure of a company’s profitability. After adjustment for taxes, it becomes NOPAT, which represents the “after-tax operating profit for all investors, including shareholders and debt holders.” [Source: http://en.wikipedia.org/wiki/NOPAT]

The real insight comes when capital charges are subtracted from NOPAT to result in EVA. The calculation of capital charges is simply the amount of invested capital time the cost of capital. The result is the actual cost of the amount of capital being used to create the NOPAT. Once that cost is subtracted from NOPAT, you have a number (EVA) that tells investors and lenders the profit the corporation is generating in excess of the required rate of return. [Source: http://en.wikipedia.org/wiki/Economic_Value_Added]

Why is this important? All other factors being equal, a company with a higher EVA is more attractive than a company with a lower EVA. This is true because investors and lenders want businesses that will generate returns in excess of the amount necessary to cover capital costs, thereby generating extra returns for investors and a safety buffer for lenders; and the greater the excess returns, the better.

EVA is not perfect, of course. To understand its primary flaw, think of a start-up company that has huge potential (e.g., a young Amazon.com or Google). Many such companies have negative earnings for years before generating a profit. Consequently, their EVA is negative, and yet many of them still manage to have high share prices. How is that possible? In that type of situation, investors are paying for expected future growth, a critical aspect of a company’s value which is not reflected in the EVA calculation.

Despite its flaws, though, EVA is a useful tool for investors and lenders. When combined with other tools, it can add valuable insights.

Sources:

Economic Value Added (EVA).” Management Methods | Management Models | Management Theories. N.p., n.d. Web. 7 Dec. 2010. .

Economic Value Added – Wikipedia. Downloaded 12/7/2010 from http://en.wikipedia.org/wiki/Economic_Value_Added.

NOPAT – Wikipedia. Downloaded 12/7/2010 from http://en.wikipedia.org/wiki/NOPAT.