What is EVA? Definition
Economic Value Added (EVA) is a financial performance method to calculate the true economic profit of a corporation. EVA can be calculated as Net Operating Profit After Tax minus a charge for the opportunity cost of the capital invested.
EVA compared with MVA
Unlike Market-based measurements, such as MVA, EVA can be calculated for a divisional (Strategic Business Unit) level.
Unlike Equities measurements, EVA is a flow and can be used for performance evaluation over time.
EVA compared with EBIT and EPS
Calculation of EVA. Formula
The basic formula for calculating EVA is:
– Operating Expenses
Operating Profit (EBIT)
Net Operating Profit After Tax (NOPAT)
– Capital Charges (Invested Capital x Cost of Capital)
Economic Value Added (EVA)
By taking all capital costs into account, including the cost of equity, EVA shows the financial amount of wealth a business has created or destroyed in a reporting period. In other words, EVA is profit in the way that shareholders define it. If the shareholders expect, say, a 10% return on their investment, they earn money only to the extent that their share of the NOPAT exceeds 10% of equity capital. Everything before that just builds up to the minimum acceptable compensation for investing in a risky enterprise.
What is EVA? Definition
USAGE of the EVA method: Aligning decisions with shareholder wealth
EVA was developed to help managers to incorporate two basic principles of finance into their decision making:
Some specific usages of EVA include:
Economic value added
In corporate finance, economic value added (EVA) is an estimate of a firm’s economic profit, or the value created in excess of the required return of the company’sshareholders. EVA is the net profit less the equity cost of the firm’s capital. The idea is that value is created when the return on the firm’s economic capital employed exceeds the cost of that capital. This amount can be determined by making adjustments to GAAP accounting. There are potentially over 160 adjustments but in practice only several key ones are made, depending on the company and its industry. EVA is a service mark of Stern Value Management.
EVA is net operating profit after taxes (or NOPAT) less a capital charge, the latter being the product of the cost of capital and the economic capital. The basic formula is:
EVA = net operating profit after taxes – a capital charge [the residual income method]
therefore EVA = NOPAT – (c × capital), or alternatively
NOPAT is profits derived from a company’s operations after cash taxes but before financing costs and non-cash bookkeeping entries. It is the total pool of profits available to provide a cash return to those who provide capital to the firm.
Capital is the amount of cash invested in the business, net of depreciation. It can be calculated as the sum of interest-bearing debt and equity or as the sum of net assets less non-interest-bearing current liabilities (NIBCLs).
The capital charge is the cash flow required to compensate investors for the riskiness of the business given the amount of economic capital invested.
The cost of capital is the minimum rate of return on capital required to compensate investors (debt and equity) for bearing risk, their opportunity cost.
Another perspective on EVA can be gained by looking at a firm’s return on net assets (RONA). RONA is a ratio that is calculated by dividing a firm’s NOPAT by the amount of capital it employs (RONA = NOPAT/Capital) after making the necessary adjustments of the data reported by a conventional financial accounting system.
If RONA is above the threshold rate, EVA is positive.
Comparison with other approaches
Other approaches along similar lines include residual income valuation (RI) and residual cash flow. Although EVA is similar to residual income, under some definitions there may be minor technical differences between EVA and RI (for example, adjustments that might be made to NOPAT before it is suitable for the formula below). Residual cash flow is another, much older term for economic profit. In all three cases, money cost of capital refers to the amount of money rather than the proportional cost (% cost of capital); at the same time, the adjustments to NOPAT are unique to EVA.
Although in concept, these approaches are in a sense nothing more than the traditional, commonsense idea of “profit”, the utility of having a more precise term such as EVA is that it makes a clear separation from dubious accounting adjustments that have enabled businesses such as Enron to report profits while actually approaching insolvency.
Other measures of shareholder value include: