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Economic Value Added (EVA): Definition, Formula, Examples
Economic Value Added (EVA), sometimes referred to as Economic Profit, aims to accurately represent the real value of a company.
QUOTE
All intelligent investing is value investing.
Big ideas
- The main aim of the EVA is to accurately reflect the true economic value of a company. It is the excess profit generated above and beyond the minimum rate of return.
- The EVA is a marker of return as generated from invested funds. The formula relies on three financial metrics: NOPAT, WACC, and Invested Capital.
- EVA is more suited to companies that have a lot of assets; it is not particularly suited to companies with intangible assets, such as technology companies.
What is Economic Value Added (EVA)?
The Economic Value Added was originally invented by the Stern Value Management firm in 1983. It enables investors to understand potential returns, proportional to the amount invested in a specific project.
DEFINITION
Economic Value Added (EVA) is a financial performance measure that evaluates how effectively a company generates value for its shareholders. It is calculated by subtracting the cost of capital (both equity and debt) from the operating profit after taxes (NOPAT). EVA essentially shows whether the business is generating returns above its cost of capital.
Economic Value Added highlights the surplus value created beyond what investors expect in return for their Invested Capital. Positive EVA indicates the company is generating value and exceeding its capital costs. Negative EVA suggests the company is underperforming and not covering its cost of capital.
Economic Value Added highlights the surplus value created beyond what investors expect in return for their Invested Capital. Positive EVA indicates the company is generating value and exceeding its capital costs. Negative EVA suggests the company is underperforming and not covering its cost of capital.
The Economic Value Added formula is closely related to the residual income technique; a measure of the return generated above the required minimum rate (aka the hurdle rate). The EVA formula is founded on the following two premises:
- Profit should be a function of wealth created for investors.
- Projects need to offer returns that are more than the cost of capital.
Economic Value Added is useful in terms of encouraging managers to think about increasing value for shareholders. If the management can consistently deliver a high EVA across multiple projects, it is a strong sign they are effective decision-makers with intelligent capital allocation strategies.
What is the formula to calculate EVA?
The EVA formula consists of only three variables; Net Operating Profit After Tax (NOPAT), Weighted Average Cost of Capital (WACC), and Invested Capital (the total capital invested in the company using both debt and equity).
FORMULA
EVA = NOPAT - (Invested Capital × WACC)
It is an easy formula provided these variables are known in advance; otherwise, it can take a while to calculate each financial metric individually.
Step-by-step guide to calculate EVA
The calculation involves subtracting the cost of capital from the net operating profit after tax. In simple terms, Economic Value Added shows whether the return from business operations exceeds the capital cost.
We will now walk through an example using a UK-based company, British Tech Ltd. We will break down the process into four steps: NOPAT, WACC, Invested Capital, and the final EVA calculation.
We will now walk through an example using a UK-based company, British Tech Ltd. We will break down the process into four steps: NOPAT, WACC, Invested Capital, and the final EVA calculation.
EXAMPLE
Step 1: Calculating NOPAT
NOPAT represents the profits a company generates from its operations after taxes, yet before financing costs.
For British Tech Ltd, assume the operating income is £500,000, and the effective tax rate is 20%. The formula is:
NOPAT = Operating Income × (1 − Tax Rate) = £500,000 × (1 − 0.20) = £400,000
Step 2: Calculating WACC
WACC, the cost of capital, accounts for both equity and debt. For British Tech Ltd, assume 60% of the capital is financed by equity and 40% by debt.
The cost of equity is 8%, and the cost of debt is 5%.
WACC = (E/V × Cost of Equity) + (D/V × Cost of Debt x (1 − Tax Rate) = (0.60 × 8%) + (0.40 × 5% × (1 − 0.20)) = 6.4%
Step 3: Calculating Invested Capital
Invested Capital is the total amount of capital that has been invested into a company by both equity holders and debt holders. For British Tech Ltd, assume the total debt is £1,000,000 and the equity is £2,000,000. The formula is:
Invested Capital = Total Debt + Total Equity = £1,000,000 + £2,000,000 = £3,000,000
Step 4: Final EVA calculation
Finally, we can calculate the EVA by subtracting the capital charge (Invested Capital multiplied by WACC) from the NOPAT. The formula for EVA is:
EVA = NOPAT − (Invested Capital × WACC) = £400,000 − (£3,000,000 × 6.4%) = £400,000 − £208,800 = £208,000
British Tech Ltd has thus generated an EVA of £208,000, indicating value creation.
This example is for illustrative purposes only and does not represent actual figures or financial performance. The calculations are hypothetical and intended solely for educational use. Past performance or hypothetical scenarios do not guarantee future results.
NOPAT represents the profits a company generates from its operations after taxes, yet before financing costs.
For British Tech Ltd, assume the operating income is £500,000, and the effective tax rate is 20%. The formula is:
NOPAT = Operating Income × (1 − Tax Rate) = £500,000 × (1 − 0.20) = £400,000
Step 2: Calculating WACC
WACC, the cost of capital, accounts for both equity and debt. For British Tech Ltd, assume 60% of the capital is financed by equity and 40% by debt.
The cost of equity is 8%, and the cost of debt is 5%.
WACC = (E/V × Cost of Equity) + (D/V × Cost of Debt x (1 − Tax Rate) = (0.60 × 8%) + (0.40 × 5% × (1 − 0.20)) = 6.4%
Step 3: Calculating Invested Capital
Invested Capital is the total amount of capital that has been invested into a company by both equity holders and debt holders. For British Tech Ltd, assume the total debt is £1,000,000 and the equity is £2,000,000. The formula is:
Invested Capital = Total Debt + Total Equity = £1,000,000 + £2,000,000 = £3,000,000
Step 4: Final EVA calculation
Finally, we can calculate the EVA by subtracting the capital charge (Invested Capital multiplied by WACC) from the NOPAT. The formula for EVA is:
EVA = NOPAT − (Invested Capital × WACC) = £400,000 − (£3,000,000 × 6.4%) = £400,000 − £208,800 = £208,000
British Tech Ltd has thus generated an EVA of £208,000, indicating value creation.
This example is for illustrative purposes only and does not represent actual figures or financial performance. The calculations are hypothetical and intended solely for educational use. Past performance or hypothetical scenarios do not guarantee future results.
Alternative measures of value
Economic Value Added is interesting due to the fact that it accounts for profits based on an economic perspective as opposed to a purely financial or accounting-based perspective.
Valuation Model | Measure | Discount Factor | Considerations |
Enterprise Discounted Cash Flow | Free Cash Flow | WACC | Best suited for projects, business units, or companies that maintain their capital structure at a target level. |
Discounted Economic Profit | EVA | WACC | Clearly identifies when a company is generating value. |
Adjusted Present Value | Free Cash Flow | Unlevered Cost of Equity | Provides a better view of changing capital structures compared to models based on WACC. |
The main difference between Economic Value Added (EVA) and Free Cash Flow (FCF) lies in how they account for the cost of capital. EVA explicitly includes the opportunity cost of Invested Capital, which means it considers the minimum return expected by investors. However, Free Cash Flow (FCF) does not include a deduction for the cost of capital, so it doesn’t directly show value creation beyond cash generation.
In summary:
In summary:
- Economic Value Added (EVA) evaluates value creation by adjusting for the cost of capital.
- Free Cash Flow (FCF) measures cash generation but does not incorporate the cost of capital.
Comparison with Net Economic Value
Economic Value Added focuses on operational performance, telling investors if a firm earns more than it spends on its capital. Net Economic Value (NEV) goes beyond this. NEV considers not just financials but also environmental, social, or longer-term impacts on stakeholders.
It is a broader measure of value creation for society, while EVA stays more focused on internal financial efficiency. EVA is a direct metric for investors to understand profitability, while NEV appeals to those who look at a wider range of value, including non-financial outcomes.
It is a broader measure of value creation for society, while EVA stays more focused on internal financial efficiency. EVA is a direct metric for investors to understand profitability, while NEV appeals to those who look at a wider range of value, including non-financial outcomes.
Comparison with Market Value Added
EVA and Market Value Added (MVA) both focus on value creation, but they work differently. EVA is about internal efficiency, showing if a company generates more profit than it costs to run. It is backwards-looking, based on what the business has already done. MVA is about market perception.
It is the difference between the company’s market value and its Invested Capital. MVA reflects investor confidence in the company’s future value creation. If MVA is positive, it means investors expect the company to outperform. EVA shows current success, while MVA reveals what the market expects in the future.
It is the difference between the company’s market value and its Invested Capital. MVA reflects investor confidence in the company’s future value creation. If MVA is positive, it means investors expect the company to outperform. EVA shows current success, while MVA reveals what the market expects in the future.
Value measure comparison table
The following table outlines a comparison between EVA and other common valuation models for reference.
Performance Model | Definition | Focus | Key Metrics | Use Case |
Economic Value Added (EVA) | Measures the surplus value created after covering the cost of capital. | Internal operational performance | NOPAT, WACC, Invested Capital | To evaluate whether a company generates returns above capital cost. |
Net Economic Value (NEV) | Measures the total value created, considering both financial returns and broader stakeholder impact. | Value to society and stakeholders | Financial and non-financial factors | To assess overall long-term impact, beyond pure financials. |
Return on Invested Capital (ROIC) | Measures the return generated on all capital invested in a company. | Efficiency in using capital and generating returns | NOPAT (or EBIT) and Invested Capital | To compare company efficiency in generating profit from Invested Capital. |
Earnings Per Share (EPS) | Shows the portion of a company’s profit allocated to each outstanding share of common stock. | Profitability per share | Net Income, Outstanding Shares | To assess profitability from a shareholder perspective. |
Market Value Added (MVA) | Compares the market value of a company to the capital invested in it by shareholders and creditors. | Market perception of value | Market Value, Invested Capital | To evaluate market expectations of a company’s future performance. |
The table highlights the distinct focus and use of each performance model. EVA concentrates on internal value creation, while the other models provide different perspectives, from capital efficiency (ROIC) to shareholder value (EPS) and market sentiment (MVA).
Pros & Cons of using EVA
The EVA has become increasingly common since the 1990s onwards as a reasonably objective measure of returns, along with providing a fair means of assessing management capabilities.
Pros of Economic Value Added
✅ Enhancing decision-making processes - the EVA helps companies focus on value creation by measuring how well investments generate returns above the cost of capital. It provides clear metrics for management to decide where to allocate resources, ensuring decisions lead to higher profitability.
✅ Aligning management and shareholder interests - the EVA ties management performance to shareholder value. When managers are incentivised to improve EVA, they focus on strategies that increase profits above the cost of capital, aligning their actions with shareholder goals for sustainable growth and higher returns.
✅ Encouraging efficient capital allocation - the EVA pushes management to invest in projects that generate more value than they cost. It discourages overinvestment or inefficient use of resources, promoting a disciplined approach to capital allocation and maximising returns on Invested Capital.
✅ Cross-industry comparison of projects/companies - the EVA allows for comparison of projects or companies across different industries by using a common measure of value creation. It shows which firms or sectors are better at generating returns above their cost of capital, aiding in benchmarking and investment decisions.
✅ Aligning management and shareholder interests - the EVA ties management performance to shareholder value. When managers are incentivised to improve EVA, they focus on strategies that increase profits above the cost of capital, aligning their actions with shareholder goals for sustainable growth and higher returns.
✅ Encouraging efficient capital allocation - the EVA pushes management to invest in projects that generate more value than they cost. It discourages overinvestment or inefficient use of resources, promoting a disciplined approach to capital allocation and maximising returns on Invested Capital.
✅ Cross-industry comparison of projects/companies - the EVA allows for comparison of projects or companies across different industries by using a common measure of value creation. It shows which firms or sectors are better at generating returns above their cost of capital, aiding in benchmarking and investment decisions.
Cons of Economic Value Added
❌ Limitations in certain industries - the EVA is only really applicable to companies that have plenty of tangible assets. It does not really apply to companies with intangible assets such as software companies.
❌ Complex calculations - the EVA requires detailed adjustments to financial statements, such as calculating NOPAT, WACC, and Invested Capital, which can be time-consuming.
❌ Capital intensity bias - companies with high capital requirements may show lower EVA, even if they are profitable, making it harder to assess industries like manufacturing or utilities.
❌ Complex calculations - the EVA requires detailed adjustments to financial statements, such as calculating NOPAT, WACC, and Invested Capital, which can be time-consuming.
❌ Capital intensity bias - companies with high capital requirements may show lower EVA, even if they are profitable, making it harder to assess industries like manufacturing or utilities.
Recap
EVA has become a very important financial metric, even if its calculation can be tedious. It allows for company comparison across different sectors, highlighting which ones are genuinely creating value for shareholders.
It is a fairly unbiased metric that further aligns management interest with shareholder interest, encouraging executives to take a long-term approach to maximise value.
The only real drawback is that the EVA applies only to asset-intensive companies. Aside from this, investors can rely on the EVA to determine whether they are getting an adequate return on their allocations.
It is a fairly unbiased metric that further aligns management interest with shareholder interest, encouraging executives to take a long-term approach to maximise value.
The only real drawback is that the EVA applies only to asset-intensive companies. Aside from this, investors can rely on the EVA to determine whether they are getting an adequate return on their allocations.
FAQ
Q: How do you interpret EVA results?
EVA results show whether a company creates value beyond its cost of capital. A positive EVA means the company earns more than it costs to fund its operations, indicating value creation. A negative EVA means the opposite: the company fails to cover its capital costs, leading to value destruction. It is a direct measure of performance, with higher EVA being better for investors seeking efficiency and returns.
Q: What is EVA value analysis?
EVA value analysis examines a company’s ability to generate returns above its capital costs. It focuses on operational efficiency and capital management, aiming to identify areas where the company is creating or destroying value. Investors use this analysis to understand how well a company allocates resources and whether its profits justify the cost of its investments, ultimately helping guide investment decisions.
Q: What is the difference between EVA and ROI?
EVA measures the value created above the cost of capital, focusing on operational efficiency after considering financing costs. ROI (Return on Investment) shows the percentage return on the Invested Capital but does not directly account for the cost of capital. While ROI is a general measure of profitability, EVA provides a deeper look into whether the company creates real value after all capital costs are covered.
Q: What is the meaning of EVA testing?
EVA testing refers to the process of calculating and assessing a company’s Economic Value Added to determine whether it is creating or destroying value. It involves measuring NOPAT, WACC, and Invested Capital to evaluate the firm’s performance. The test shows if the company earns enough to cover its capital costs, which helps investors understand if the business is truly profitable after accounting for financing.
Q: How can EVA be improved?
EVA can be improved by increasing operating profits, reducing operating expenses, or optimising the capital structure to lower the cost of capital. A company can also enhance EVA by using resources more efficiently, growing revenue, or focusing on higher-margin products and services. Managing debt levels and reducing wasteful investments are also strategies to improve overall performance and boost EVA.
- Intangible assets: Non-physical resources—such as software, patents, or brand reputation—that often don’t appear clearly on a balance sheet but can significantly impact a company’s overall value.
- Opportunity cost: The benefits forgone by choosing one option over another. In finance, it often refers to the return you miss out on by investing in one project instead of a potentially better alternative.
- Value investing: An approach focused on buying shares believed to be underpriced relative to their intrinsic worth, with the anticipation of profiting once the market recognises their true value.
- Stakeholders: Any party affected by a company’s activities, not just shareholders. This can include employees, suppliers, customers, and the wider community.
