Economic Value Added
(EVA)

Calculation of the true economic profit of a corporation. Explanation of Economic Value Added. EVA.

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 ( © / ™ Stern Stewart & Co.) is an estimate of the amount that earnings differ from the required minimum rate of return (against comparable risk) for shareholders or lenders. The difference can be both a surplus or a shortage.

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

Unlike accounting profit, such as EBIT, Net Income and EPS, EVA is economic and is based on the idea that a company must cover both the operating costs AND the capital costs.

Calculation of EVA. Formula

The basic formula for calculating EVA is:

      Net Sales

-     Operating Expenses

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      Operating Profit (EBIT)

-     Taxes

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      Net Operating Profit After Tax (NOPAT)

-     Capital Charges (Invested Capital x Cost of Capital)

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      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.

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:

1. The primary financial objective of any company should be to maximize the wealth of its shareholders.
2. The value of a company depends on the extent to which investors expect that future profits will differ from the cost of capital. By definition, a sustained increase in EVA will result in an increase in the market value of a company. This approach has proved valid and effective for many types of organizations. This is because the level of EVA isn't what really matters. Current performance already is reflected in share prices. It is the (continuous) improvement in EVA that brings (continuous) increases in shareholder wealth.

Some specific usages of EVA include:

• To set organizational goals.
• Performance measurement.
• Determining of bonuses.
• Communication with shareholders and investors.
• Motivation of managers.
• Capital budgeting.
• Corporate valuation.
• Analyzing equities.

Book: S. David Young, Stephen F. O'Byrne - EVA and Value-Based Management.. -

Book: Aswath Damodaran - Investment Valuation: Tools and Techniques for Determining.. -

Book: James R. Hitchner - Financial Valuation: Applications and Models -

Economic Value Added Special Interest Group

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Economic Value Added Forum

Rishi Bhargav Das - India

Actual Meaning of EVA

"Measures surplus value of investments."

3

Justus - Kenya

EVA Calculation across a Whole Value Chain

"I request to all members to help me on how to go about an EVA calculation across the value chain from production down to consumption. What is important to keep in mind?"

0

Sonal - India

Eva of a Proprietary Concern

"EVA can be easily calculated when the organisation is Public Limited. But it is difficult to calculate EVA of a proprietary company as the cost of equity does not exist. Please advise me."

1

lori - usa

EVA applied to consulting services

"How can I apply an EVA model to the value added of consulting services on increased revenues."

0

asad shah - Pakistan

EVA & Amortization of R&D

"The amortization of R&D on straight line basis does not justify the concept of equal opportunity through out the life of amortization and it seems to be more biased towards the earlier years of product. We know that companies get maximum benefits from R&D in the earlier years and with the passage of time the advantage starts diminishing as the competitors or company itself can come up with the new R&D. Therefore in the later years of a product the company bears the R&D presence in its books but the real advantage does not hold good in these years. Therefore I think that the amortization should be larger in the earlier years of R&D."

4

Peter Rubin - USA

EVA growth is what matters

"Improving EVA should be the goal of any major firm. After all, shareholders, who are providing the capital for the firm, have options to invest money elsewhere. To keep them onboard, managers must focus on growing the business when the returns are greater than the cost of capital, and on re-deploying capital when the returns are less than the cost of capital. On top of this, they must try to improve returns on existing capital and arrange an optimal capital structure (debt/equity). How management precisely accomplishes the above is highly complex, depends on many interrelated and dynamic forces, and requires skillful decisions. But in any case, EVA is the transparent system that is needed to ensure managers take these decisions responsibly and are accountable."

13

Marcelo Nagase - Brazil

Alternative methods

"Are there alternative methods for EVA? I am developing a research study, comparing some valuation methods. I am not concerned about asset valuation, but with value creation. I found TBR, only, does anyone know other ones? Thank you all."

4

- Indonesia

EVA to SVA

"EVA is how to approach economic value for a company, but now we must added social value added, why? Now CSR is one of the factors determining how a company exists because social comunities have a big function to support it."

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