The economic value added (EVA) is the value added by an entity by utilizing its capital resources. Unlike profitability, it considers both debt and equity sources of capital.
Let us discuss what is EVA, its important components, and how it is calculated.
What is Economic Value Added (EVA)?
The economic value added (EVA) is the measure of return generated above the total cost of capital of a business.
EVA is also called the economic profit of a business. It is the value generated by a business using available resources. These resources include both equity and debt capital.
The EVA aims to measure the performance of a business beyond net income. It measures the value created by a business by considering the overall its overall performance and not just the net profit figures.
Economic value-added pinpoints two important aspects of the performance evaluation of a business:
- A business is really profitable when it generates additional wealth for its shareholders (beyond net income).
- Projects are profitable when their rate of return is above the total costs of capital (including debt and equity).
In this way, EVA addresses two basic problems that come with using net profit figures.
- Net profits only consider the cost of debt and ignore the cost of equity. EVA included the total cost of capital employed by a business.
- Profit calculations follow the conventional accounting standards that can be manipulated by managers. (For example, adjusting depreciation rates changes gross profits)
A business should continue if its EVA is positive. A business showing negative EVA must consider its important components to know where ratification is needed.
The aim of EVA calculations should be to evaluate the real profitability and value added for the shareholders beyond net income indicators.
How to Calculate Economic Value Added (EVA)?
The EVA is the incremental differential above the rate of return of a business. The rate of return should be calculated using the total cost of capital of the business.
The weighted average cost of capital or simply called WACC is the most suitable measure for calculating the rate of return of a business as it includes all types of capital used by the business.
The EVA formula is:
EVA = NOPAT – (WACC × Capital)
The economic value-added formula uses the net operating profit after tax figure rather than net income. It also uses WACC as the cost of capital to calculate the rate of return on capital employed.
EVA formula is closely linked with the residual income concept. It provides a refined measure of evaluating the additional wealth created for the shareholders.
Components of EVA Formula
The EVA concept can be fully understood by analyzing the key components of its formula. In practice, it uses all three components that relate to the analysis of incremental value created by a business for its shareholders.
Let us discuss these three components briefly.
NOPAT
Net operating profit after taxes is the measure of profit without considering the leverage level of a business. It is the return generated by a business net of interest costs and the tax shelter that comes with the interest payments.
The simple formula to calculate NOPAT is:
NOPAT = Operating Income × (1 – Tax Rate)
NOPAT adds back the cost of interest payments to the profit after tax figure. Therefore, it is multiplied by the tax charge multiplier.
NOPAT also excludes the effects of one-time financial gains or losses incurred by a business. Thus, it mainly focuses on profits generated from the core operations of a business.
Therefore, NOPAT forms the basis of the EVA calculations. It takes the NOPAT to the next level of finding the value added by a firm for its shareholders.
WACC
The use of the weighted average cost of capital (WACC) is also in line with the concept of EVA. It argues that the conventional profit calculations only consider the cost of debt.
By using WACC, a business considers its total cost of capital including the cost of equity as well.
The formula to calculate WACC is:
WACC = Ke × E/ (E+D) + Kd (1-t) × D/ (E+D)
Ke represents the cost of equity and Kd is the cost of debt. E and D represent the total value of equity and debt respectively.
Invested Capital
Invested capital is also an important input value for the EVA calculations. The invested capital figure should include all investments made by equity and debt contributors.
It means invested capital should include every source of capital that becomes a liability for the business.
Invested capital can be calculated by the formula:
Invested Capital = Debt + Equity + Leases – Non-Operating Cash and Investments
Debt should include short-term and long-term debts of the business. For example, commercial bank loans and bonds.
Equity should include common and preferred shares issued by the business as both types of shares are the liability of the business.
Operating and financial leases are also part of the debt. However, if a business separately records them, they should be included in the invested capital calculations.
Finance Charge
The finance charge is basically calculated by multiplying the WACC with the invested capital of the business.
In the formula, (WACC × Invested Capital) is the finance charge.
Adjustments for EVA
One of the main themes of the EVA concept is that it propagates the economic value generated by a business rather than accounting profits.
Therefore, the EVA calculations require a few adjustments to fully reveal the impact of the economic profit or value added by the entity for its shareholders.
Broadly, we can classify these adjustments into these categories.
- EVA calculations should follow the cash accounting principles rather than accrual accounting. Shareholders and creditors are keener to observe the cash flows of a business than accounting profits.
- Contrary to the accounting standards, an entity must capitalize its marketing and developments costs. For example, research and development is a long-term expense that generates benefits in the long run. Therefore, it should be capitalized.
- EVA should exclude unusual or one-off profit/expense items.
We can further elaborate these adjustments for EVA calculations in the following manner.
Start with the profit after tax (PAT) figure and make the following adjustments.
ADD BACK:
- Accounting depreciation amount to PAT. The EVA considers only the economic depreciation charge.
- NOPAT prefers cash flows over accounting profits. Therefore, add back any non-cash expenses.
- Goodwill amortization should also be added back as it represents the value added through intangible assets for the business.
- The interest paid net of the tax amount should be added back as it is included in the NOPAT calculations with the tax multiplier.
- Unlike the conventional accounting practices, EVA considers R&D as a long-term cost. So, they should be capitalized rather than recorded as expenses on the financial statements.
- EVA also argues to include operating leases as capitalized items rather than expenses.
DEDUCT:
- As goodwill amortization is added back, so any goodwill impairment should be deducted from the PAT figure.
- Similarly, any economic depreciation amount as a result of obsolescence and wear of assets should be deducted.
- Amortized expenses like R&D should be deducted and capitalized as mentioned above.
Example Calculation of EVA
Let us calculate the EVA of a company ABC using the available financial figures through its financial statements.
EVA = NOPAT – (WACC × Capital)
We’ll calculate the components of EVA first.
NOPAT = Operating Income × (1 – Tax Rate)
We begin with the gross profit of the company and make adjustments for the interest and tax charges. Then, we adjust for the non-recurring income and expense items if any.
Suppose NOPAT for ABC Company is $ 350,000 for the current financial year. The Company’s calculated WACC is 12% for the same year.
The total capital invested (Debt + Equity) is $ 2 million for ABC company.
Now, we can use these components to calculate the EVA using the formula.
EVA = NOPAT – (WACC × Capital)
EVA = $ 350,000 – (12% × 2,000,000)
EVA = $ 350,000 – 240,000 = $ 110,000.
The economic value added by ABC company is positive. Therefore, we can say that ABC company is positively utilizing its invested capital by generating sufficient EVA.
Economic Value Added and Other Profitability Measures
A conventional way of appraising the performance of a business is to look at its profitability metrics. Analysts use different profitability ratios to analyze and compare the financial performance of a business.
One drawback of using the profitability figure is the exclusion of the cost of equity in its calculations. Net profits do not include the cost of equity. Therefore, if a company does not include debt financing, its net profits will mistakenly increase manifolds.
Also, accounting standards are subject to bias and manipulation by accountants. They can adjust these terms to look profitability figures attractive.
Economic value added eliminates such distortions from the perspective of the shareholders of a business. It calculates a rate of return above WACC. It means a rate of return that is sufficient to generate economic value for the shareholders and not only for the business.
