Economic Value Added (EVA) is the estimate of a company’s profit or value created in excess of the required rate of return of its shareholders. It is the company’s economic capital created that exceeds its cost of capital. As such, it is a measure of financial performance of a company. EVA is also referred to as Economic Profit, as it tries to capture the true economic value of a company.
EVA is the incremental difference in the rate of return over a company's cost of capital. Essentially, it is used to measure the value a company generates from funds invested into it. If a company's EVA is negative, it means the company is not generating value from the funds invested into the business. If a company demonstrates a positive EVA, it shows a company is producing value from the funds invested in it. The variables of the EVA are as follows:
Return on capital (ROC), or return on invested capital (ROIC), is a ratio used in finance, valuation and accounting, as a measure of the profitability and value-creating potential of companies relative to the amount of capital invested by shareholders and other debtholders. It indicates how effective a company is at turning capital into profits.
The ratio is calculated by dividing the after tax operating income (NOPAT) by the average book-value of the invested capital (IC).
ROC = NOPAT / IC
The weighted average cost of capital (WACC) is the rate that a company is expected to pay on average to all its security holders to finance its assets. The WACC is commonly referred to as the firm's cost of capital.
The amount of capital invested through equity or debt in a company. It is commonly worked out as the sum of total assets minus the sum of current liabilities.
The value achieved after calculating the economic value added of a company’s activities. This is the final value used by investors to determine whether or not a project or investment is worth the initial cashflow input.
Economic Value Added is the surplus of value created by an investment. An investor invests in a company, project or investment with the expectation that they will earn a profit from the investment.
For example, assume a company has a return on capital of 15%, a capital investment of $1,500,000 and a WACC of 0.07 or 7%. The EVA can be calculated as follows:
EVA = (ROC – WACC) *CI
EVA = (0.15 – 0.07) * 1,500,000
EVA = $120,000
In this example, the economic value added by investing in the company would be $120,000.
The economic value calculation has many advantages. It succinctly summarizes how much and from where a company created wealth. It includes the balance sheet in the calculation and encourages managers to think about assets as well as expenses in their decisions.
However, the seemingly infinite cash adjustments associated with calculating economic value can be time-consuming. Accrual distortions can still affect the measure, particularly when it comes to depreciation and amortization differences. Also, economic value added only applies to the period measured and is not predictive of future performance, especially for companies in the midst of reorganization and/or about to make large capital investments.
Economic Value Added (EVA) is important as it serves as an indicator of how profitable company and its projects are. As such, the EVA serves as a key performance indicator of management decisions.
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