Economic value added (EVA)

Economic value added (EVA), also called “economic profit,” is a measurement of a company’s financial performance. EVA is based on residual income and measures the value a company receives from a particular investment. EVA is most common among large companies, partly because companies require detailed information to calculate EVA, and many larger companies already generate the data needed to perform the calculation. Supporters of EVA believe it is an important tool for understanding the sectors and projects of a company that are creating the most value. When a company understands which of its parts creates the most value, it can focus on investing in those parts to maximize its overall economic profit. EVA was created by a consulting company in the 1980s and is still used by many large companies in the twenty-first century.

Background

The concept of EVA was first developed in the early 1980s. In 1983, Stern Stewart & Co.—an independent consulting company that would eventually become Stern Value Management (SVM)—worked on strategies to help companies understand their success and profitability. Management teams at the company developed and copyrighted the term Economic Value Added (EVA). By 1989, SVM helped Briggs & Stratton and other large companies use EVA to determine financial performance at the company. EVA gained popularity among some businesses in the United States in the early 1990s. In 1993, Fortune magazine highlighted EVA in an article, which helped make the measurement even more popular. SVM also used marketing tactics to increase the tool’s popularity. By the mid-1990s, some large, well-known businesses had adopted the measurement. EVA is still used by some companies, though it tends to be more popular among larger companies, which have the data and resources needed to calculate the measurement.

Overview

EVA is a measurement that businesses calculate to understand their success, and especially their residual profit. EVA measures residual profit after subtracting the cost of capital. EVA helps companies understand whether they or their projects are creating value. If a company or project is not creating value, it is destroying value. EVA helps businesses understand whether the funds and resources they are investing in certain projects or methods are helpful to the company and its shareholders. EVA is good for determining whether shareholders are obtaining value from their investments.

In the simplest terms, EVA is the difference between operating profits and the cost of the capital required to make those profits. The equation for EVA is commonly written as EVA = NOPAT - (Invested Capital * WACC). In this equation, NOPAT stands for “net operating profit after taxes.” The invested capital is made mostly of the shareholders’ equity and debt the company takes on. WACC stands for a “weighted average cost of capital,” which a company determines through another formula. Although the formula for EVA may appear simple, companies have to spend a great deal of time calculating each value. It can take time and resources to fully understand the metrics required to determine EVA.

People and companies that support using EVA often do so because they believe this measurement is an important tool to use to maximize shareholder value. Supporters of EVA say that it holds managers and other business leaders accountable. If the EVA indicates that a particular section of a company or a particular project does not create value, the manager or other business leaders can be held accountable. EVA is also an important tool for company planning. EVA helps companies understand whether their resources are being allocated in the best way to increase profit. Companies can change projects, invest capital in other places, and otherwise change their operations so that they can improve economic profit in the future.

Large companies that determine EVA at different levels of the company can also use EVA to help set and provide incentives to various parts of the company. Determining EVA can help reward people and parts of the company that generate the most economic profit. When EVA indicates that certain sectors or projects are not creating value, the company can make decisions about how to shift capital investments to increase shareholder value.

Although EVA is popular among some companies, especially large companies, it is not a useful measurement for all companies to use. The basis of EVA is that it determines the value that shareholders receive from their investments in a company. Therefore, EVA is useful only if the company believes that it creates value only when shareholders receive profits for their investments. Some companies are less focused on creating value for shareholders, and these companies would not find EVA to be useful for understanding overall value. Another reason that some companies do not use EVA is the calculation is based on the amount of invested capital. Therefore, companies that are asset-rich are most likely to find EVA to be useful. Because some sectors are less likely to have asset-rich companies, EVA can be more useful in some sectors than in others. Companies that have many intangible assets, such as technology companies, would not benefit as much from EVA calculations as other companies.

A final reason that some companies might avoid calculating EVA is that the formula can be difficult to calculate. The values needed to calculate EVA can themselves be costly or difficult to determine. Large companies that already track the details needed to calculate EVA are usually best suited to use the measurement. Other companies often use other factors, such as company growth and profit margins, to determine the amount of value they create.

In the twenty-first century, some companies began using EVA methods in combination with other performance metrics, such as process-based costing (PBC). This EVA-PBC approach can be applied to lower management levels in a company to evaluate financial performance and costs for shareholders. Incorporating strategy, this approach can help identify projects that generate profits or losses and plan future operations accordingly.

Bibliography

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