Economic Value Added (EVA) is a financial metric that measures the value a company creates in excess of its cost of capital. It is calculated by subtracting a firm’s invested capital multiplied by its cost of capital from its net operating profit after taxes (NOPAT).
EVA is a measurement of a company’s economic success (or failure) over a period of time, as it tells you the additional value created above the cost of capital.
Want to know more? Keep reading:
What Is Economic Value Added (EVA)
Economic Value Added (also called economic profit) is a financial metric that captures the true income of a company. That is, the value the company generates from funds invested in it.
It is useful for investors looking to determine how profitable a company’s projects and investments are. Analysts compare it against the company’s peers to see how well the company is operating within its industry.
EVA exposes when a company creates true economic profit or destroys value, and helps you understand the financial performance of the business.
How do you interpret the Economic Value Added number?
A positive EVA means the company is creating value from the funds invested in it, as it makes surplus returns above its cost of capital. A negative EVA indicates the business isn’t generating value for its investors.
The concept of EVA goes beyond the surface accounting numbers in the income statement (such as EBITDA and revenue) to analyze value creation. It is based on the principle that real profitability is when a business generates returns above the returns required by its shareholders and debtholders.
This is what differentiates EVA from other financial metrics, which don’t account for the cost of capital and may be subject to accounting creativity.
As noted by Stern Value Management (creators of the EVA metric):
(The EVA is) a new model for maximizing the value created that can also be used to provide incentives at all levels of the firm.
Economic Value Added is particularly important in capital-intensive businesses. Why?
Because these companies need large investments in fixed assets, such as buildings, equipment, and infrastructure, to generate revenue. The result?
A significant portion of the company’s earnings is reinvested to grow its assets and create shareholder value.
Therefore, it is crucial to ensure operational investments generate a return greater than the cost of capital.
If the company struggles to generate returns on its assets that exceed the cost of capital, it won’t be able to fund its operations, repay its debts, and stay profitable.
EVA is a performance metric, as opposed to Market Value Added (MVA)—a wealth metric that follows the accumulated value of a company over time.
Now that you understand the importance of Economic Value Added, let’s see how to calculate it:
How to Calculate Economic Value Added
To calculate EVA, you compute the difference between the operating net income and the capital invested multiplied by the total cost of capital.
The fundamental Economic Value Added formula is:
More specifically:
EVA = NOPAT – (Invested capital * WACC)
Where:
- NOPAT (Net Operating Profit After Taxes) is the earnings of the company if there was no debt. It tells you the efficiency and profitability of the company’s core business, without the influence of interest expenses. How to calculate it? Multiply EBIT by (1 – Tax rate).
- Invested capital is how much money funds the company or the project you’re analyzing. It is the sum of equity capital and long-term debt (including leases) the firm has raised by issuing securities.
- WACC (Weighted Average Cost of Capital) is the return the company pays its investors. Why is it called weighted? Because both the cost of equity and cost of debt are taken into account according to their respective proportions in the total capital structure: WACC = Cost of equity * Equity / Company Value + Cost of debt * Debt / Company Value * (1 – Tax rate).
Alternatively, you can determine the difference between the actual rate of return on assets and the cost of capital and multiply this difference by the net capital invested.
The formula above is equivalent to the following:
EVA = (ROIC – WACC) * Invested capital
Where:
- ROIC (Return on Invested Capital) evaluates the efficiency with which the company uses its capital to generate profits. You calculate it by dividing NOPAT by Invested capital.
As you can see, the EVA calculation always depends on the amount of capital invested. This means it is best used for companies with substantial assets that are stable/mature. Firms with intangible assets, such as the technology sector, may not be good candidates for an EVA evaluation.
If you can’t find the invested capital, you can use the following balance sheet items to compute it:
Invested capital = Long-term debt + Shareholders’ equity
Invested capital = Total assets – Current liabilities
Where:
- Long-term debt includes debt and capital leases.
- Current liabilities are financial obligations the company owes its creditors and suppliers and expects to settle within one year.
Isn’t subtracting assets from liabilities equal to shareholders’ equity? Yes. But notice we’re using current liabilities only, not total liabilities.
Economic Value Added Example
Let’s go through an example to put these concepts in motion. Consider the following data of the company ABC:
- Equity book value: $100,000
- Financial debt: $60,000
- Total liabilities: $90,000
- Cost of equity: 9%
- ROIC: 12%
- Net interest expense: $4,000
- EBIT: $30,000
The goal is to compute the Economic Value Added of ABC. But to make this more interesting, you don’t have everything you need right away.
At first glance, it seems like information is missing. You need the WACC and the invested capital, and they aren’t given.
But they are… You just need to extrapolate them from the available data.
Let’s start with the invested capital, as it is simply debt + shareholders’ equity:
Invested capital = $60,000 + $100,000 = $160,000
Next, to get the WACC you need to first figure out the cost of debt and the corporate tax rate.
The cost of debt, which is the interest rate ABC pays its lenders and bondholders, is the interest expenses divided by the debt:
Cost of debt = $3,000 / $60,000 = 5%
As to the tax rate, you can extrapolate it from the ROIC formula:
ROIC = NOPAT / Invested capital
Given that NOPAT = EBIT * (1 – Tax rate), you have:
12% = $30,000 * (1 – Tax rate) / $160,000 <=> Tax rate = 36%
By the way, now you know NOPAT is $30,000 * (1 – 36%) = $19,200. Finally, you can calculate the WACC:
WACC = 9% * ($100,000 / $190,000) + 5% * ($90,000 / $190,000) * (1 – 36%) = 6.25%
Where does the $190k come from? It is the total assets of ABC, calculated by summing liabilities and shareholders’ equity. It’s different from invested capital because invested capital doesn’t include current liabilities (as these don’t pay interest to investors).
Now you have everything we need to calculate EVA:
EVA = $19,200 – ($160,000 * 6.25%) = $9,200
Or:
EVA = (12% – 6.25%) * $160,000 = $9,200
As Economic Value Added is positive, it means ABC is creating value for its equity holders and lenders.
Economic Value Added Calculator
Key Takeaways
What is EVA and how is it calculated?
Economic Value Added (EVA) highlights when a company creates or destroys value and helps understand its performance in a given year. It is calculated by subtracting a firm’s cost of capital from its operating profit. That is, subtracting the product of the company’s invested capital multiplied by its percentage cost of capital from its net after-tax operating profit.
Why is economic value added important?
EVA evaluates the performance of a company and the efficiency of its management. The main idea behind it is that a business is only profitable when it creates wealth and returns for shareholders and lenders, thus requiring performance above the cost of capital. A positive EVA shows a project is generating returns in excess of the required minimum return, thus creating value.
What is the difference between ROI and EVA?
The goal of EVA is to quantify the cost of investing capital into a project or firm and then analyze whether it generates enough cash flow to be a profitable investment. Similarly, the goal of ROI is to measure the return on investment from a project, by comparing the net gain generated to the amount of capital invested. ROI measures the return on the total amount of capital invested, rather than just the return on the capital used to finance a company’s core business operations. Unlike the EVA, it does not take into account the cost of capital or the opportunity cost of some other capital investment.
