What is Economic Value Added

Economic Value Added (EVA) is a financial performance measure that shows how much value a company has created for its shareholders. It goes beyond traditional profit metrics by factoring in the cost of capital used to generate earnings.

EVA is essentially the net profit a company earns after deducting the cost of financing its capital. This means it reflects whether a business is truly generating returns above what investors expect from their investment.

It was popularized by the consulting firm Stern Stewart & Co. and is widely used by companies, analysts, and investors to assess corporate performance and value creation.

How to Calculate It

The basic formula for EVA is: EVA = Net Operating Profit After Taxes (NOPAT) – (Capital Invested × Cost of Capital). NOPAT represents the company's operating income after taxes but before interest expenses.

To compute it, first determine the capital invested, which includes both equity and debt. Then multiply that total by the weighted average cost of capital (WACC). Subtract this from NOPAT to find the economic value added.

For example, if a company has a NOPAT of $500,000, capital invested of $2 million, and a cost of capital of 10%, the EVA is $500,000 – ($2,000,000 × 0.10) = $300,000.

Why Use It

EVA is used because it reveals whether a company is creating wealth beyond its basic costs. Many businesses show accounting profits but fail to provide returns that exceed their cost of capital.

Using EVA helps avoid the misleading impression of success when profits are earned below investor expectations. It ensures that companies stay focused on value creation, not just revenue growth or net income.

It’s a powerful tool for aligning management decisions with shareholder interests, promoting investments that contribute to long-term value.

Interpreting Economic Value Added

A positive EVA indicates that a company is adding value and exceeding its cost of capital. This suggests that the business is well-managed and strategically sound from a financial perspective.

Conversely, a negative EVA means the company is not covering the cost of the capital it uses. While this may be acceptable in the short term for startups or during expansion, it's a red flag for mature companies.

Monitoring EVA trends over time can help identify whether a business is improving or destroying shareholder value, giving important clues about its financial health.

Practical Applications

Companies use EVA for performance measurement and internal decision-making. It’s a key metric in value-based management systems that aim to tie performance directly to shareholder value.

EVA is also used for executive compensation. Tying bonuses and incentives to positive EVA encourages managers to focus on decisions that create lasting value rather than short-term gains.

Investors and analysts often include EVA in their valuation models. By comparing EVA across companies or industries, they can identify firms that are truly delivering excess returns on capital.

Conclusion

Economic Value Added is a vital tool for measuring a company's real performance. Unlike traditional profit measures, it accounts for the cost of capital, offering a clearer picture of value creation.

It empowers both companies and investors to make informed decisions based on whether the business is truly profitable in economic terms. EVA promotes strategic thinking and long-term financial health.

In a competitive market, using EVA can be the difference between apparent and actual success. It helps businesses grow intelligently while ensuring resources are used to their highest potential.