Economic Value Added (EVA) is a financial performance metric that measures a company’s true economic profit—the value created in excess of the required return of the company’s investors.
Unlike traditional accounting measures like net income, EVA explicitly accounts for the cost of capital (both debt and equity).
It reflects the idea that a company creates value only if its return on invested capital is greater than the cost of that capital.
EVA Formula and Components
The fundamental formula for calculating Economic Value Added is:
EVA = NOPAT – (Invested Capital x WACC)
This formula can also be expressed as:
EVA = (Return on Capital – Cost of Capital) x Invested Capital
The key components of the formula are:
- NOPAT (Net Operating Profit After Taxes): This is the company’s operating profit after deducting cash taxes, but before accounting for financing costs (interest expense). It represents the total pool of profit available to provide a cash return to all capital providers.
- Invested Capital: The total amount of money tied up in the business’s operations. This is typically calculated as the sum of interest-bearing debt and shareholders’ equity.
- WACC (Weighted Average Cost of Capital): The minimum rate of return a company must earn on its existing asset base to satisfy its creditors, bondholders, and shareholders. It is the weighted average of the cost of debt and the cost of equity.
- Capital Charge (Invested Capital x WACC): This is the dollar amount that represents the minimum profit a company must generate to cover the cost of all the capital it uses.
Interpretation of EVA
The resulting EVA figure provides a clear measure of value creation:
- Positive EVA: Indicates that the company is generating returns that exceed its cost of capital, meaning it is creating value for its shareholders.
- Negative EVA: Indicates that the company’s returns are less than its cost of capital, meaning it is destroying value for its shareholders.
Advantages of Using EVA
EVA is often considered a superior performance metric to traditional measures because:
- Accounts for Cost of Equity: Unlike Net Income, EVA deducts a charge for the cost of all capital, including the cost of equity (the return shareholders require), not just the explicit cost of debt (interest expense).
- Aligns with Shareholder Wealth Maximization: A policy of maximizing the present value of all future EVAs is theoretically equivalent to maximizing the Net Present Value (NPV) of a firm, which is the ultimate goal of corporate finance.
- Encourages Better Management Decisions: It links operating performance (NOPAT) with capital efficiency (Invested Capital and WACC), encouraging managers to focus on increasing profit, reducing capital employed, and optimizing the capital structure.