Learn, Explain EVA (Economic Value Added): Definition, Calculation, and Implementation!
Economic Value Added (EVA) is a value-based financial performance measure, an investment decision tool and it is also a performance measure reflecting the absolute amount of shareholder value created. The Concept of EVA (Economic Value Added): Definition of Economic Value Added, Calculation of Economic Value Added, Measurement of Economic Value Added, and Implementation Economic Value Added! It is computed as the product of the “excess return” made on an investment or investments and the capital invested in that investment or investments. Also learned, EVA (Economic Value Added): Definition, Calculation, and Implementation!
“Economic Value Added (EVA) is the net operating profit minus an appropriate charge for the opportunity cost of all capital invested in an enterprise or project. It is an estimate of true economic profit, or amount by which earnings exceed or fall short of the required minimum rate of return investors could get by investing in other securities of comparable risk.”
Economic Value Added (EVA) is a variation of residual income with adjustments to how one calculates income and capital. Stern Stewart & Co., a consulting firm based in New York, introduced the concept on EVA as a measurement tool in 1989 and trademarked it. The EVA concept is often called Economic Profit (EP) to avoid problems caused by the trademarking.
Economic Value Added is the financial performance measure that comes closer than any other to capture the true economic profit of an enterprise; Economic Profit = Total revenues from capital – Cost of capital. The basic idea of this criterion is to find, in microeconomics, where it is said that the main goal of a company is the maximization of profit. However, it does not mean book profit (the difference between revenues and costs) but economical profit. The difference between economic and book profit is economic profit. It is the difference between revenues and economic costs, which includes book costs and opportunity costs.
Opportunity costs are presented by the amount of money lost by not investing sources (like capital, labor, and so on) to the best alternative use. Opportunity costs are in reality represented mainly by interests from equity capital including risk-reward and sometimes lost wages too. In short; Book profit = Revenues – Costs. This leads to the conclusion that economic profit appears when its amount is higher than “normal” profit derived from the average cost of capital invested both by creditors (cost interests) and owners– shareholders (opportunity costs). This is the basic idea of the new measure, EVA.
Calculation of EVA (Economic Value Added):
Economic Value Added (EVA) is an operational measure that differs from conventional earnings measures in two ways. First, it explicitly charges for the use of capital (residual income measure). Secondly, it adjusts reported earnings to minimize accounting distortions and to better match the timing of revenue and expense recognition. As such, wealth maximization correlates with EVA maximization. A positive EVA indicates that a company is generating economic profits; a negative EVA indicates that it is not; A measure of a company’s financial performance based on the residual wealth calculated by deducting the cost of capital from its operating profit after taxes. It is also known as economic profit.
Economic Value Added (EVA) is defined as an estimate of true economic profit, the amount by which earnings exceed or fall short of the required minimum rate of return investors could get by investing in other securities of comparable risk. It is the net operating profit minus the appropriate charge for the opportunity cost of capital invested in an enterprise (both debt and equity). The capital charge is the most distinctive and an important aspect of EVA. Under conventional accounting, most of the companies appear profitable.
However, many are actually destroying shareholder value because the profits they earn are less than their cost of capital. EVA corrects this error by explicitly recognizing that when managers employ capital, they must pay for it. By taking all capital costs into consideration, including the cost of equity, EVA shows the amount of wealth a business has created or destroyed in each reporting period.
Expressed as a formula, Economic Value Added (EVA) for a given period can be written as:
Economic Value Added (EVA) = NOPAT – Cost of Capital Employed = NOPAT – WACC x CE
- NOPAT: Refers to the amount of profit remaining of the business after tax and adding back interest payments. It can be calculated as per accounting concept after making necessary adjustments for certain for non-operating incomes and expenses.
- WACC: Weighted Average Cost of Capital. It defined as the weighted average cost of both equity capital and debt. It is the weighted average of both the specified costs with weights equal to the proportion of each in total capital. The tax shield of the debt is adjusted with the cost of debt
- CE: Capital employed or Invested capital refers to total assets (net of revaluation) net of non-interest bearing liabilities. From an operating perspective, invested capital can be defined as Net Fixed Assets, plus investments plus Net Current Assets. Net Current Assets denote current assets net of Non-Interest Bearing Current Liabilities (NIBCLS). From a financing perspective, the same can be defined as Net Worth plus total borrowings. Total borrowings denote all interest bearing debts.
OR equivalently, if the rate of return is defined as NOPAT /Capital Employed, then, it tums into a more revealing formula.
EVA (Economic Value Added) = (Rate of Return – Cost of Capital) x Capital Employed
- Rate of Return: NOPAT /Capital Employed
- Capital Employed: Total of the balance sheet – Non Interest Bearing Current Liabilities (NIBCL) in the beginning of the year
- Cost of Capital: (Cost of equity x Proportion of equity in Capital) + (Cost of debt x Proportion of debt in Capital)(1- Tax)
If, Return on Investment is defined as above after taxes, EVA can be presented with the following familiar terms:
EVA (Economic Value Added) = (ROI – WACC) x Capital Employed
- Capital Employed: Net fixed assets – Revenue reserve – Capital Work in progress + Current assets – Funds Deployed outside the business – NIBCL
EVA (Economic Value Added) is measured by comparing Return on Capital Employed with Cost of Capital, also called Return Spread. A positive Return Spread indicates that earning is more than the cost of capital –there by creating wealth for owners or stockholders. A negative Return Spread means earning is less than cost-of- capital – thus reducing the wealth of owners and stockholders. Economic Value Added (EVA) is an indicator of the market value of service center’s owner’s equity, a measure especially important to closely held companies, which do not have the benefit of a published stock price. For publicly traded companies, EVA correlates very closely with the stock price.
Economic Value Added (EVA) is an estimate of true economic profit and a tool that focuses on maximizing shareholders wealth. Companies best utilize EVA as a comprehensive management tool. EVA has the strategic importance of focusing management and employees on the company’s primary goal of maximizing shareholder value. With this goal in mind, EVA can be used tactically in a number of ways including: shareholder reporting, financial benchmarking, management decision-making tool, and foundation for incentive compensation plans.
Measurement of EVA (Economic Value Added):
It must be noted that measurement of Economic Value Added (EVA) can be made by using either an operating or financing approach. Under the operating approach, deducting cash operating expenses and depreciation from sales derives NOPAT. Interest expense is excluded because it is considered as a financing charge. Adjustments, which are referred to as equity equivalent adjustments, are designed; to reflect economic reality and move income and capital to a more economically based value. These adjustments are considered with cash taxes deducted to arrive at NOPAT. EVA is then measured by deducting the company’s cost of capital from the NOPAT value. The amount of capital to be used in the EVA calculations is the same under either the operating or financing approach, but is calculated differently.
The operating approach starts with assets and builds up to invested capital, including adjustments for economically derived equity equivalent values. The financing approach, on the other hand, starts with debt and adds all equity and equity equivalents to arrive at the invested capital. Finally, the weighted average cost of capital, based on the relative values of debt and equity and their respective cost rates, is used to arrive at the cost of capital which is multiplied by the capital employed and deducted from the NOPAT value. The resulting amount is the current period’s EVA.
Implementing EVA (Economic Value Added):
When a company decides to adopt EVA as a corporate performance measure, here is what it must do:
- Step 1: Run an EVA analysis of the company, its publicly traded peers and business units.
- Step 2: Draw up a definition of EVA that is simple and meets the company’s information needs, existing accounting data, organization and management.
- Step 3: Work out a compensation scheme that fits into the company’s business and culture. The incentive plan has to marry the EVA design with traditional concerns of shareholders and directors.
- Step 4: Train all employees on the basics of EVA and how it affects shareholder value.
- Step 5: Demonstrate the difference between EVA-led decisions vis-à-vis conventional methods through computer simulation exercises.
Positives of EVA:
- No ceiling on the amount managers can take home as incentive pay.
- Managers think like, act like and are paid like owners.
- Targets are set over a time horizon that is more than one year – usually three to five years – forcing a long-term view into managerial decision-making.
- Cuts capital cost and inculcates financial discipline among employees.
- Increasing EVA directly benefits the shareholder and has been found to have a positive influence on a company’s stock price.
Negatives of EVA:
- Involves lots of complexity. Globally, Stern Stewart is said, in some cases, to make as many as 165 adjustments to work out the weighted average capital cost of companies.
- Works better at the individual level than team level, unless goals are appropriately structured.
- May make companies risk-averse. New investments that look risky or difficult to quantify in terms of expected payback may never be made using EVA.