What Is Economic Value Added (EVA)?
Economic value added (EVA) is a new concept that companies and their consultants use as a performance measure.
In generic terms, “value-added” refers to the additional or incremental value created by an activity or business venture.
Economic value added, or EVA, is also known as economic rent. It is a widely-recognized tool for measuring the efficiency of a company’s resource use.
In other words, EVA is the difference between the return achieved on resources invested and the cost of resources. The higher the EVA, the better the level of resource utilization.
EVA can be calculated as net operating profit after tax minus a charge for the opportunity cost of the capital invested. EVA is based on the idea that a company must cover both the operating costs and capital costs.
EVA can be positive or negative. Ideally, it will be positive. If EVA is negative, managers should quickly become concerned with how to improve and transform it.
EVA helps managers to satisfy two important objectives when making financial decisions, namely:
- Maximize shareholder wealth
- Improve company value by earning surplus profit over the cost of capital
With all this in mind, it’s clear that managers within companies should place considerable efforts in continuously improving EVA.
Economic Value Added: Explanation
Economic value added (EVA) is a financial measure of what economists sometimes refer to as economic profit or economic rent. This phrase is used because EVA measures the economic rather than the accounting profit created by a business.
The difference between economic profit and accounting profit is essentially the cost of equity capital.
A finance manager does not deduct the cost of equity capital when calculating profit. Their job is to measure the earnings per share (EPS) on behalf of the company’s shareholders.
By contrast, an economist calculates earnings by charging all types of costs, including the opportunity cost for the equity capital invested. Thus, earnings (profits) from the finance manager’s viewpoint are different compared to the economist.
EVA, in reality, does not consider whether the business is profitable. Instead, it takes into account whether any earnings remain after considering the cost of all resources (including the opportunity cost for equity capital).
The opportunity cost for equity capital is the cost incurred to compensate the equity shareholders at a market-determined rate of return.
If the earnings of the business are able to meet this obligation and some earnings are left for the exclusive use of a business, that “leftover portion” is called EVA, which is “positive.”
EVA is “negative” if the company’s earnings do not compensate the opportunity cost for equity shareholders.
This means that the firm’s earnings (profits) are inadequate to compensate the equity capital at the required rate of return, as determined by the market.
From the viewpoint of measuring EVA, all profitable businesses may not be capable of contributing to EVA (positive). If EVA is consistently negative, investors may move their funds elsewhere, believing that the company cannot generate adequate returns.
EVA is gaining recognition as a useful measure today. This is because every company is interested in understanding the psychology of their investors and trying to retain them.
How to Calculate Economic Value Added (EVA)
Calculating economic value added (EVA) is fairly easy. In normal accounting practice, we subtract the financial charge in the form of interest on debt capital from EBIT to arrive at EBT.
From EBT, the tax on profit is deducted to arrive at EAT. In turn, subtract the dividends payable to preference shareholders to arrive at the earnings (profits) available for distribution to equity shareholders.
From these earnings (profits), subtract the financial charge (return on investment) to equity shareholders at the market-determined rate.
If the earnings can fully absorb this charge and some earnings remain in the business, the leftover balance is treated as EVA (positive).
If the market-determined rate of return is not fully absorbed by the earnings (profits) of the business, the unabsorbed portion is treated as EVA (negative).
When Economic Value Added (EVA) is negative, the finance managers have to take measures to correct the situation, ensuring a positive EVA in the future.
How to Transform Negative EVA Into Positive EVA
- Generate more revenue without using more capital and by improving operating profit margins or asset turnover ratios.
- Sell under-utilized assets, thereby reducing the capital invested in the business. This will have a two-fold positive impact, improving the asset turnover ratio and reducing capital cost.
- Redeploy the capital invested to projects and activities with higher operating performance compared to existing projects and activities.
- Change the company’s capital structure for positive leverage advantages.
Regarding the last point, this could involve altering the firm’s capital structure by substituting lower-cost debt for higher-cost equity. Of course, this measure may lower net earnings, but it would improve EVA by lowering the total cost of debt and equity.
How Economic Value Added (EVA) Helps Financial Managers
EVA as an economic measure informs financial managers about the profitability status of their company. It enables them to take the necessary steps to improve the company’s position if EVA is nil or negative.
If EVA is positive, the question of how to improve it further is also a consideration that interests most professional managers.
Benefits of EVA
- It is simple, which means that anyone can understand the concept.
- EVA is a powerful representation of corporate performance.
- It can be used as a powerful motivational and communication tool.
- The power of EVA is derived from its focus on shareholder value and its expression of performance as a relative term.
- EVA adapters tend to have greater asset dispositions and faster turns.
According to Stern and Stewart & Co., the developers of EVA, equity market values tend to be more highly correlated with annual EVA levels compared to most other performance measures of return on equity, cash flow growth, or EPS growth.
Limitations of EVA
- The major weakness of EVA is its single-period focus (i.e., its value can be calculated only for a single period at a time).
- EVA cannot capture all the long-term implications of decision-making.
- Strict reliance on EVA can distract managers from other important issues
How Does EVA Work?
When calculating EVA, the following three factors should be considered:
- Net operating profit after tax (NOPAT): This is the annual cash flow available to cover the cost of raising all equity and debt capital on an after-tax basis.
- Economic book value (EBV) capital: This is an estimate of the total capital utilized by an enterprise for a period, including debt and equity.
- The enterprise’s cost of capital: This is the appropriate risk-adjusted rate applied to any one of the divisions or to the entity.
Adjustments need to be made to arrive at figures for NOPAT and EBV. These adjustments are necessary to ensure accurate figures, which will form a good basis for calculations.
According to Stern and Stewart & Co., there are over 160, and other different adjustments that can be made. The question of which type of adjustment to use and where depends on the industry, technology, and value creation process.
If managers prudently use this tool, decisions are likely to be more effective and results-oriented.
How to Calculate Economic Value Added (EVA)
There are three ways to calculate EVA:
- Based on return on assets as calculated using:
EVA = NOPAT – Required Return on Assets,
Required return on assets = Assets employed x cost of capital.
- Based on capital structure theories which assume that capital structure consists of only debt and equity and there is no corporate tax (generally this approach is followed).
- A new dimension can be attributed to calculate EVA by considering preference dividend also as a financial charge.
Note: In the case of approaches (2) and (3), the return to equity shareholders is based on the market-determined rate of return.
The new dimension is explained using the following format:
Format for calculating economic value added (EVA)
- EVA is positive if the earnings available to shareholders are greater than the market-determined rate of returns.
- EVA is negative if the earnings available to shareholders are less than the market-determined rate of returns.
- EVA is nil (undefined) if the earnings available to shareholders are equal to the market-determined rate of returns.
The EBIT of EREHWON Company is $50,000. Its capital structure consists of 50,000 equity shares of 10 each, 10,000 5% preference shares of $10 each, and 6% debentures to the extent of $400,000.
The company comes under the tax bracket of 30%. The market rate of return on equity shares is 40%.
Required: Calculate EVA and comment.
Calculation of EVA for EREHWON Company
EREHWON Company has been able to absorb the market rate of return to equity shareholders (40%) fully. There is excess earning leftover after charging all costs, including the opportunity cost of capital.
Hence, this is not only a profitable company but also a thriving company with high prospects. Therefore, the financial manager should have no problem continuing with the same strategic operations.
Another worthwhile point to note is that if the value of earnings available to equity shareholders is less than the EVA would be negative or it was equal to $200,000, EVA would be undefined or nil.
Finally, if the EVA is either negative or undefined, the financial manager should seek to find corrective measures to change EVA to positive, helping the company to prosper.