Economic Value Added (EVA) Definition: Pros and Cons, With Formula

What Is Economic Value Added (EVA)?

• EVA: Measure of a company's financial performance based on residual wealth.
• Calculated by deducting cost of capital from operating profit, adjusted for taxes.
• Also Known As: Economic profit.
• Devised by Stern Value Management, initially Stern Stewart & Co.

Key Takeaways

• EVA calculates the true economic profit.
• Measures value generated from funds invested in the company.
• Best for asset-rich companies; not ideal for companies with intangible assets.

Understanding Economic Value Added (EVA)

• Incremental Difference: Rate of return over a company's cost of capital.
• Positive EVA: Company is generating value from invested funds.
• Negative EVA: Company not generating value from invested funds.

EVA Formula

• Formula: EVA = NOPAT - (Invested Capital * WACC)
• Components:
  • NOPAT: Net operating profit after taxes.
  • Invested Capital: Debt + capital leases + shareholders' equity.
  • WACC: Weighted average cost of capital.*

Special Considerations

• Components of EVA:
  • NOPAT, invested capital, and WACC are key components.
• Calculations:
  • NOPAT can be manually calculated.
  • Invested capital = Total assets - current liabilities.
  • WACC usually provided or can be calculated.
• Purpose: Quantifies cost of capital investment and assesses whether it generates adequate cash.

Advantages and Disadvantages of EVA

• Advantages:
  • Assesses company performance and management.
  • Focuses on wealth creation and shareholder returns above cost of capital.
  • Includes balance sheet items, encouraging asset and expense awareness.
• Disadvantages:
  • Relies heavily on invested capital.
  • Best for stable or mature, asset-rich companies.
  • Less suitable for companies with significant intangible assets.

Conclusion

• EVA is a beneficial tool for understanding a company's real profit and assessing performance.
• Particularly useful for companies with tangible assets, it may not be as effective for those with intangibles.
• Effective in encouraging thoughtful financial management and investment assessment.