Accounting
Economic value added
Economic value added (EVA) takes into account a firm’s total invested capital when evaluating its financial performance.
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Economic value added vs Economic value added (Stern Stewart)
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Economic value added (Stern Stewart)
When an investor backs your firm, he expects a return equivalent to your WACC. If the return is higher, it is because of economic profit or residual.
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Use this when.
Use EVA to assess the economic value created during a defined period by the capital invested in a firm or business unit.
Use EVA when comparing economic performance across businesses with different risk and financing, or when setting a demanding objective above investors’ required return.
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Strengths, limits, and pitfalls.
Economic value added
- Start with a transparent approximation before adding dozens of adjustments. Reconcile NOPAT and invested capital to the financial statements, show the cost of capital assumption and focus managers on the operating drivers they can change.
- Define the operating boundary and period. Calculate NOPAT from operating profit after appropriate tax, calculate invested capital from the operating assets financed by debt and equity, estimate a weighted cost of capital and document every accounting adjustment. Use a consistent definition across periods and business units.
- Consider Cambrian Manufacturing, an oilfield equipment producer, using its 2013 results. Non interest bearing current liabilities include accounts payable, tax payable and similar operating liabilities. Additional assumptions are:
Watch for
- Do not judge a high growth investment from one period’s EVA alone. Current investment can depress the measure while creating future options. Use EVA to diagnose present economic performance, then assess growth opportunities with a multi period valuation and explicit risk analysis.
Economic value added (Stern Stewart)
- Set an EVA target only after managers understand the drivers and the cost of capital estimate. A 5 per cent spread should translate into explicit margin, asset use and capital allocation choices rather than remain a finance slogan.
- Calculate NOPAT, economic capital and WACC consistently. EVA equals NOPAT minus the capital charge. EVA return—EVA divided by capital employed—can make comparison across different sized firms easier.
- A company might set an EVA return objective of 5 per cent, meaning ROCE should exceed WACC by 5 per cent. Achieving that spread consistently normally requires a defensible advantage rather than accounting leverage.
Watch for
- Do not introduce EVA when its complexity outweighs the decision benefit. Document estimation uncertainty and avoid ranking businesses with incompatible accounting boundaries or WACC assumptions.
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