Economic Value Added (EVA)

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In corporate finance, Economic Value Added or EVA is an estimate of a firm’s economic profit – being the value created in excess of the required return of the company’s shareholders – where EVA is the profit earned by the firm less the cost of financing the firm’s capital. The idea is that shareholders gain when the return from the capital employed is greater than the cost of that capital; see Corporate finance: working capital management. This amount can be determined, among other ways, by making adjustments to GAAP accounting, including deducting the opportunity cost of equity capital.

Economic Value Added (EVA) Formula

EVA is Net Operating Profit After Taxes (or NOPAT) less the money cost of capital. Any value obtained by employees of the company or by product users is not included in the calculations. The basic formula is:

where:

• , is the Return on Invested Capital (ROIC);
• is the Weighted Average Cost of Capital (WACC);
• is capital employed;
• NOPAT is the Net Operating Profit After Tax, with adjustments and translations for the amortization of goodwill, the capitalization of brand advertising and others.

EVA Calculation

EVA = (r-c) x Capital

EVA = (r x Capital) – (c x Capital)

EVA = (NOPAT- c x Capital

EVA = operating profits – a capital charge

where: r = rate of return, and

             c = cost of capital, or the weighted average cost of capital.

The relevant formula is:
EVA= (Return on Capital – Cost of Capital) x Total Capital

We need three figures:

1. NOPAT
2. Investment
3. WACC

By dividing NOPAT with Investment, we get returns in percentage. From this, we deduct AWCC which is also in percentage; the difference would show %profit per rupee. By multiplying this with total capital, we capture EVA in rupee-terms.

Indus Machine Tools Ltd is a Private Ltd Company at Multan, a city in Punjab, Pakistan. Its Balance Sheet is given on the right-hand side. EVA is calculated as under:

* NOPAT is Rs.1,028,160 against total capital of Rs.10,484,000, the Return on Capital being 9.81%
* The Cost of capital, as calculated below, is 12.42%
* Obviously, the company has ran into economic loss since it could even cover the cost of capital.
* Using the formula given earlier, EVE comes to a minus figure of Rs.274,112.

The poor performance of the company can be seen from the fact that as against Dividend Expectation of 20%, the company is hardly in a position to pay half of it or 10%. This would make share of the company as un-attracative and the investors would not be interested to keep the shares. If they sell the shares, the share value would further drop. The company would not get equity investment if it desired to go for expansion.

EVA can be calculated product wise and it can be combined with ABC, which gives much better insight on true cost of a product.

ABC-EVA would be my next article.

Economic Value Added (EVA) Books on Amazon.com

BOOK NAME:Foundations of Economic Value Added, 2nd Edition

In the completely updated second edition of Foundations of Economic Value Added, James L. Grant provides a fresh look at the role of economic profit in the process of wealth creation. Whether you’re a manager seeking to create substantial shareholder value, or an investor looking for attractive stock selection opportunities, this comprehensive guide will help you better understand and implement one of the most useful financial tools currently available.

Filled with in-depth insights and practical advice, Foundations of Economic Value Added, Second Edition explores the pivotal role of EVA in the theory of finance and explains:

• How to measure EVA with standard accounting adjustments
• How to use EVA to value companies and their stock
• How to compare EVA with traditional financial metrics (such as ROE)
• How to estimate the EVA cost of capital
• How to use EVA to build actively-efficient portfolios
• How to use economic profit principles to identify wealth-creating firms, industries, and even market economies

Foundations of Economic Value Added, Second Edition shows how the EVA measure can be used as a prism to cast a revealing perspective on individual securities, portfolios, and even macro-economic valuations. If you want to stay up to date on the EVA revolution, this book is for you.