What is EVA or Economic value added?
EVA or Economic Value Added is a measure of profitability. As a measure of profitability, it is just another way to calculate profits. Therefore, this is not really the accounting profits that you find in any income statement, but it is just another way of calculating profit.
Difference between Economic Profit and Accounting Profit
There is a very important distinction between economic profits and accounting profits and the profits that you probably hear all the time are actually accounting profits. All those that you have to file on a quarterly basis because the regulations say so. All those are accounting profits, they are based on accounting standards, and that gives you an accounting number.
EVA is just another way of calculating profits. A company called Stern Stewart introduced it, and they did so in the early 80’s. Whether they actually introduced something that is completely new, or they sort of piggybacked on an older idea that some people call residual income, that some people call economic profit. It is related to an older idea that some people have been calling for many years, either economic profit or residual income. The name EVA is a trademarked concept that was actually pioneered by Stern and Stewart in the ear, the early 80’s.
What is the idea behind EVA?
The idea behind EVA is exactly the same idea behind the concept of economic profit or residual income. And that is the very a basic notion of charging managers for the capital that they use. In other words, this is nothing that is going to be shown in an accounting income statement but what we want to do is to force managers to recognize that the capital providers want a return. They demand a return from whom they provided capital and that you cannot really say that you have created value if you have not first compensated the capital providers with the return that they expect. So that is a very simple idea.
What we are going to do is we are going to charge managers for the use of capital. If there’s any cash left after that, then we are creating value. But if we fall short of compensating capital providers, then we will not be creating value. So EVA economic profit residual income, all of them are just a slight variations of the idea that we need to make managers recognize built into their decisions, that they’re using capital and that there’s a return required on that capital. So at the end of the day when we say, well, you know, we go by our accounting standards in whatever country you are. There must be accounting standards that companies actually need to follow. Then you get to the bottom line, which some people call the profit or the net income of the company. That is the bottom line result. That is what we call an accounting profit. But that accounting profit may actually be, however large that number may happen to be, may be hiding a process of value destruction. That is, it is perfectly possible for a company to have positive accounting profits, and at the same time, destroying economic value. That is why the number that we are going to calculate, we are going to call it economic profit. So again, EVA residual income economic profit, for our purposes, all these terms are going to be interchangeable. Because of they all point in the same direction, which is forcing managers to admit that there is a cost to the capital they are using and that, when they say we are creating or destroying value, they are considering that cost.
So let us go with the expressions. There are two ways of writing EVA, and mathematically they are identical. They are both equally intuitive, although they reflect a slightly different ways of thinking about the process of value creation.
The first expression that you are seeing thereof EVA, economic value added, basically starts with a NOPAT and then you subtract the Capital that we are using in the corporation, multiply by the weighted average cost.
EVA = NOPAT – (Capital) (WACC)
Where…
- NOPAT: Net Operating Profit After Tax
- Capital: Equity + Debt + …
- WACC: The Usual
- NOPAT & Capital subject to proprietary adjustments
Now, the NOPAT is the cash flow generated by the company. And what comes after that, capital multiplies by the cost of capital is what some people would call the capital chart. That is a capital being invested in this company. There is a return required on that capital and when you multiply one times the other, it gives you in dollars and cents what is the return that you need to deliver to the capital providers.
Although we are making money before we say that we’re creating or destroying value, we need to take into account that we are using capital, and that capital has a cost. After taking into account that capital charge, if there is something left, we are creating value. In other words, if EVA is positive, we are creating value. If EVA is negative, that means that we have actually produced some cash, but it is not enough to compensate the capital providers, given the required return on that capital. So, a positive EVA in this framework says that you are creating value, and a negative EVA says that you are not creating value.
The NOPAT and the capital that they are sub-subject to some proprietary adjustments. And that basically is a fancy way of saying that, when a company provides this service to you, they will tell you something like look, for the reason of being this particular company in this particular sector and the type of company that you are then we need to calculate the NOPAT in this specific way, and we need to calculate the capital in this specific way. So there is a lot of adjustments that need to be made in the calculations of this.