Economic Value Added (EVA)– A measure of a company’s financial performance based on the residual wealth calculated by deducting the cost of capital from its operating profit (adjusted for taxes on a cash basis).
The formula for calculating Economic Value Added (EVA) is as follows:
There are three components necessary to solve EVA,
- Net Operating Profit After Tax (NOPAT)
- Invested capital
- Weighted Average Cost of Capital (WACC)
Net operating profit after taxes (NOPAT) can be calculated, but can usually be easily found on the company’s income statement.
The next component, capital invested, is the amount of money used to fund a particular project. It is necessary to calculate the weighted-average cost of capital (WACC) if the information is not provided. The idea behind multiplying WACC and capital investment is to assess a charge for using the invested capital. This charge is the amount that investors as a group need to make their investment worthwhile. Economic Value Added (EVA) is important because it is used as an indicator of how profitable company projects are and it, therefore, serves as a reflection of management performance.
The idea behind EVA is that businesses are only truly profitable when they create wealth for their shareholders and employees, and the measure of this goes beyond calculating net income. Economic value added asserts that businesses should create returns at a rate above their cost of capital. The economic value calculation has many advantages. It succinctly summarizes how much and from where a company created wealth. It includes the balance sheet in the calculation and encourages managers to think about assets as well as expenses in their decisions. However, the seemingly infinite cash adjustments associated with calculating economic value can be time-consuming. And accrual distortions can still affect the measure, particularly when it comes to depreciation and amortization differences. Also, economic value-added only applies to the period measured; it is not predictive of future performance, especially for companies in the midst of reorganization and/or about to make large capital investments. The EVA calculation depends heavily on invested capital, and it is, therefore, most applicable to asset-intensive companies that are generally stable. On the basis of EVA, the incentives for the employees are worked as incentives also depend upon the performance of the organization as a whole.
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