Economic value added

Economic value added, or EVA, measures whether operating profit is sufficient to compensate every provider of capital. It subtracts a charge for invested capital from net operating profit after tax, revealing the economic return left after debt and equity investors’ required return.

When to use it

• Use EVA to assess the economic value created during a defined period by the capital invested in a firm or business unit.

• Use it to identify assets, working capital and operating decisions that may improve capital productivity.

Origins

The idea is older than the trademark: economists and accountants have long called profit after a capital charge residual income or economic profit. Interest revived after the leveraged-buyout era, when investors wanted measures that could not be improved merely through financing choices. Stern Stewart & Co. formalised a set of accounting adjustments, branded the result Economic Value Added and promoted it as a value-based management system.

What it is

EVA applies a stricter test than accounting profit. Return on equity can rise when a firm adds debt, and earnings per share can rise after a buyback even without an operating improvement. EVA instead identifies all capital supplied by lenders and shareholders, assigns that capital an opportunity cost and deducts the resulting charge from NOPAT.

In compact form:

EVA = net operating profit after tax − (invested capital × cost of capital)

A positive result indicates that operations earned more than investors’ required return; a negative result means the business destroyed economic value even if its income statement reported a profit. Accounting figures may require adjustments—for example to recognise operating leases or to treat selected long-term expenditures more consistently with their economic substance.

How to use it

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:

• the present value of operating leases is $15,000;

• short- and long-term debt carry 9 per cent interest, so ($2,000 + $22,000) × 9 per cent = $1,980;

• net other income and expense is $200.

The worksheet calculates invested capital, adjustments, capital charge and EVA:

Cambrian’s EVA is negative, suggesting that capital tied up in long-term assets may not be earning its required return. Selling or redeploying underused assets is one possible response, but management should verify the operational consequences first.

A conventional return-on-equity calculation looks healthier:

• Net profit = NOPAT of $11,000 − interest of $1,980 + other income of $200 = $9,220.

• Return on equity = $9,220 / $49,500 = 18.6 per cent.

The contrast demonstrates why a positive accounting return does not necessarily cover the opportunity cost of all capital.

Top practical tip

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.

Top pitfall

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.

Further reading

• Stewart, G.B. (nineteen ninety-one). The Quest for Value: The EVA Management Guide. HarperBusiness.
• Stern, J.M., Shiely, J.S. and Ross, I. (two thousand and one). The EVA Challenge. Wiley.