Economic value added (EVA) and weighted average cost of capital (WACC)

Economic value added, or EVA, expresses performance after charging an organisation for the capital required to produce that performance. Value is created only when after-tax operating profit exceeds the required return of lenders and shareholders. Stern Stewart & Co. popularised the branded measure in 1990.

When to use it

EVA brings two principles into investment and operating decisions:

1. Management should allocate capital in ways that increase owner value over time.
2. A business creates value only when expected operating profit exceeds the cost of the capital employed to generate it.

Use the measure to compare projects, business units or companies with similar risk, and to understand whether a higher accounting profit justifies its larger capital requirement.

EVA complements value-based management and capital budgeting. WACC can also supply the discount rate for a net-present-value analysis when its financing and risk assumptions match the project. It blends the after-tax cost of debt with shareholders’ required return according to their proportions in the financing structure.

Origins

Residual-income thinking predates the trademark, but Stern Stewart systematised accounting adjustments and management incentives around Economic Value Added. G. Bennett Stewart presented the approach in The Quest for Value in 1990. WACC developed from modern corporate-finance theory as a blended opportunity cost for debt and equity capital.

What it is

EVA is:

EVA = NOPAT − (invested capital × WACC)

NOPAT captures after-tax operating performance independent of financing. Invested capital represents the operating funds committed to the business. WACC is the weighted required return of the capital providers. Positive EVA means operating profit covered that charge; negative EVA means reported profit was insufficient to compensate investors for time and risk.

How to use it

Calculate NOPAT from EBIT after correcting items that materially distort operating performance, then apply the appropriate operating tax. Decide whether expenses such as goodwill amortisation, inventory write-downs or long-lived investments require an economic adjustment and keep the policy consistent.

Calculate WACC by identifying each financing source, its current required return and its share of the relevant capital structure. Use the after-tax cost of debt where interest is tax-deductible. Estimate the cost of equity with a defensible method such as CAPM, then weight debt and equity consistently.

Multiply invested capital by WACC to obtain the capital charge and subtract it from NOPAT. Compare alternatives using the same boundary, period and accounting policy, and test sensitivity to the cost of equity and capital-base assumptions.

Final analysis

EVA states in monetary terms how much wealth operations created or destroyed after funding cost. Return on net assets offers a related ratio—NOPAT divided by capital employed—but does not deduct the required return and is therefore less suited where financing risk differs.

Implementation is more demanding than the formula suggests. NOPAT adjustments and the cost of equity require judgement, and alternative EVA variants can reduce comparability. Use only adjustments that materially improve economic interpretation and reconcile them to reported accounts.

Top practical tip

Use EVA to compare the return from an opportunity with the complete capital charge, then trace the result to operating margin, asset intensity, working capital and financing assumptions that management can inspect.

Top pitfall

Do not substitute RONA or accounting profit when capital sources carry meaningfully different required returns. Conversely, do not add elaborate adjustments whose subjectivity is greater than the distortion they claim to correct.

Further reading

Stewart, G.B. (1990) The Quest for Value. New York: HarperCollins.

Walsh, C. (2008) Key Management Ratios: the 100+ Ratios Every Manager Needs to Know. Harlow: Pearson.

Young, S.D. and O’Byrne, S.F. (2000) EVA and Value-based Management: A Practical Guide to Implementation. McGraw-Hill.