The economic value added (EVA) is a tool to measure the financial performance of an entity. It comes with several advantages as compared to the traditional profit-based metrics.
Let us discuss what is EVA and its pros and cons as compared to other financial performance measurement tools.
What is Economic Value Added (EVA)?
Economic value added (EVA) is the return above the cost of capital of a business. It is the economic profit of a business that is calculated by subtracting the total cost of capital from operating profits.
EVA is also closely linked with the residual income concept. EVA focuses on the value created by an entity for its shareholders.
The EVA concept evaluates the financial performance of an entity. It evaluates how an entity utilizes its resources (or destroys) to create value for its shareholders.
Unlike the common profitability measures, EVA considers the full cost of capital. It means it includes the cost of equity in its calculations as well.
Components of Economic Value Added
We can analyze the pros and cons of EVA only when we fully understand its components. The EVA formula is:
EVA = NOPAT – (WACC × Invested Capital)
There are three main components of EVA.
NOPAT is the profit of a company net of interest cost, tax savings, adjustments for non-recurring gains (and losses), and accounting measures like depreciation.
NOPAT is a refined measure of profitability that further considers the cash flow impacts and the impact of leverage on the profits of an entity.
The weighted average cost of capital (WACC) considers the total cost of capital including debt and equity. Although it is subject to some theoretical adjustments, it is still a good measure to consider as the required rate of return of a business.
Finally, EVA considers the invested capital. The invested capital includes debt, equity, leases, and other types of investments made by investors of an entity.
Interpretation of Economic Value Added (EVA)
The calculated economic value added (EVA) of a business can either be positive or negative.
If the EVA figure is positive, it means the entity is generating positive returns. It means it is adding to the wealth of its shareholders.
Conversely, a negative EVA figure means the entity is destroying its available resources. It means even if it’s generating profits, the net wealth of shareholders is decreasing.
However, like any other absolute measure, EVA also needs to be interpreted carefully. Analysts must compare the resulting figures with similar entities in the same industry and of the same size.
Also, it is better to analyze the trends of EVA figures rather than considering the absolute figure for a year.
Analysts evaluating the EVA of an entity must also consider the reasons for changes in the EVA. As mentioned above, there are three components of EVA that can affect the outcome.
Advantages of Economic Value Added
Economic value added (EVA) is a performance measurement metric that overcomes the flaws of profitability measures. EVA closely follows the main objective of a commercial entity which is maximizing the wealth of shareholders.
Let us discuss the advantages of EVA as compared to other performance measurement tools.
Considers Value over Profits
EVA is a performance measure that takes net profits one step ahead. It evaluates the value created (or destroyed) by an entity.
Since gross and net profits are subject to accounting manipulations, they do not reflect the value created (or lost) by an entity.
EVA considers any returns generated above and beyond the total cost of capital. It means EVA is a rate of return higher than the cost of capital employed in an entity.
Considers Cost of Equity
Traditional accounting practices like net profits consider only the cost of debt. The income statement of a company would reflect profits generated by considering only the debt expenses. It does not include the cost of equity.
EVA uses the full cost of capital of a business. Therefore, it also considers the cost of equity. Hence, it will only be a positive figure when an entity is generating sufficient returns on its available resources.
EVA as a Divisional Performance Measure
The EVA concept can be applied in decentralized organizations where the head office works as a hub. The EVA can be used to analyze and compare the performance of divisions.
Applying the EVA concept would also motivate the divisional managers and staff to maximize the wealth of each division. It will encourage managers to choose projects where the return exceeds the total cost of capital (or WACC).
EVA as an Organizational Performance Measure
EVA is one of the best tools available to evaluate the performance of the directors of an entity. Unlike other metrics, it does not only consider net profits.
The use of EVA can help improve the organizational performance by:
- Investing in projects with returns that exceed the cost of capital
- Improving the NOPAT of all divisions and the organization collectively
- Closing down the divisions with negative EVA
- Managing the gearing level of the organization and hence the WACC
A Consistent Approach with NPV
The Net Present Value (NPV) is a widely used measure for financial performance. The EVA takes a consistent approach with the NPV.
Both these metrics consider the returns generated above the cost of capital. NPV is used to appraise projects and the EVA can be used for the organization as a whole.
Thus, when an entity invests in projects with positive NPV, it will accumulate more wealth and end with positive EVA for its shareholders.
Avoids Accounting Manipulations
Accounting standards can be adjusted for certain input metrics used in the calculations of net profits. For example, an entity may use accelerated depreciation methods to increase its net profits artificially in a financial year.
The EVA method aims to eliminate such accounting distortions used by accountants. It also motivates managers to improve the total value created by a business so that the EVA results in a positive figure.
Disadvantages of Economic Value Added
The EVA method is not flawless. It also comes with some limitations and disadvantages.
Complex Formula – When Discussed in Detail
The EVA formula has three components only; NOPAT, WACC, and Invested Capital. However, all three components require a lot of calculations.
Each component of EVA comes with some estimates and assumptions. Therefore, it becomes a complex formula when we break down each of these components further.
Difficult to Calculate
A complex formula means the calculations are difficult. It cannot be applied uniformly as not all managers would be skilled to calculate EVA.
The accounting adjustments required to calculate NOPAT and Invested capital can be complex. These tasks can be further complicated when used several times during a financial year.
Also, the accounting practices of an entity may change over the years which would further make it difficult to calculate NOPAT, WACC, Capital, and eventually EVA.
Depends on Several Estimates
A complex formula with some assumptions and estimates means it is difficult to calculate. For example, the calculation of NOPAT is still subject to some accounting manipulations when we adjust the one-time gains or losses incurred by an entity.
Similarly, calculating a suitable WACC rate is always a complex and subjective task. Also, WACC considers the market value of capital when the finance charge used in EVA considers the book value.
Absolute Not Relative Measure
EVA is an absolute measure and not a relative one. It means it is difficult to analyze the performance of entities with different sizes and input components.
An absolute measure is also difficult to analyze when using trend analysis. Analysts must convert the absolute figures of EVA over the years to set performance trend indicators.
How to Improve the Economic Value Added?
Managers can use two approaches to improve the EVA of an entity despite all its pros and cons.
Increase Revenue – NOPAT
It is the conventional way of improving profits for any business. NOPAT will eventually increase when the revenue of an entity increases.
An increase in revenue can either be obtained through an increase in prices or by selling more units. Increasing prices can pose pricing challenges as customers may not accept a sudden increase without improving the product/service quality.
Similarly, increased production output would require more capital resources. It means the WACC of the business would further increase. Therefore, an entity must ensure that increased output facilities generate sufficient returns to cover the total cost of capital.
Decrease the Cost of Capital
As mentioned above, when an entity deploys more capital resources, its total cost of capital increases. Therefore, one way of improving the EVA is to decrease the cost of capital.
An entity can reduce its operating expenses to minimize its cost of capital. It means increasing operational efficiency can improve the cost of capital.
Also, when an entity improves its revenue and liquidity, it will decrease the interest rates. Lenders would be interested in offering lower interest rates to entities generating sufficient cash flows.
Collectively, both these tactics work in tandem. Managers must carefully manage both these strategies so that a change in one measure does not affect the other. The goal should be to maximize the EVA in the long run.