Economic Value Added (EVA)

What is Economic Value Added (EVA)?

Economic Value Added (EVA), sometimes known as Economic Profit, is a measure based on the Residual Income technique, which measures the return generated over and above investors’ required rate of return (hurdle rate).

EVA serves as an indicator of the profitability of projects in which a company invests. Its underlying premise consists of the idea that 1) real profitability occurs when additional wealth is created for investors and 2) that projects should generate returns above their cost of capital.

EVA Formula

EVA adopts almost the same form as residual income, and the EVA formula can be expressed as follows:

EVA = NOPAT – (WACC * Invested Capital)  

Where:

• NOPAT = Net Operating Profit After Tax
• WACC = Weighted Average Cost of Capital
• Invested Capital = Shareholders’ Equity + Net Debt at the beginning of the period (Alternatively, Invested Capital can be calculated by taking Total Assets minus Cash minus Non-interest Bearing Liabilities)

(WACC * Invested Capital) is also known as the Finance Charge

Calculating Net Operating Profits After Tax (NOPAT)

One key consideration for this item is the adjustment of the cost of debt. The cost of debt is implicitly included in the Finance Charge (WACC * Invested Capital) since WACC includes the cost of debt. Therefore, we need to make sure that we do not deduct interest expense when calculating NOPAT. We can adjust for this in two ways:

1. Start with operating income (EBIT) and multiply operating income by (1 – tax rate); or
2. Start with profit after tax (net income) and add back the after-tax cost of interest. Therefore, we should multiply the interest expense by (1 – tax rate) before adding back to profit after tax.

Accounting Adjustments

When calculating EVA, the typical practice is to make several accounting adjustments. Among the most common and important are:

• Expenditures on R&D, promotion, and employee training should be capitalized instead of expensed.
• Depreciation expense is added back to profit, and instead, a charge for economic depreciation is made. This reflects the true change in the value of assets during the period, unlike accounting depreciation.
• Accounts such as provisions, allowances for doubtful accounts, deferred tax provisions, and allowances for inventory should be added back to invested capital, which is also known as capital employed.
• Non-cash expenses should be added back to profits and to invested capital.
• Operating leases should be capitalized and added back to invested capital.
• Tax charge will be based on cash taxes, rather than the accruals-based methods used in financial reporting and will be calculated as follows:

Cash Taxes = Tax Charge per Income Statement – Increase (or + if Reduction) in Deferred Tax Provision + Tax Benefit of Interest Charge

Calculating the Finance Charge

Finance Charge = WACC * Invested Capital

WACC = [Ke * E / (E+D)] + [Kd * (1-t) * D / (E+D)]

Where: Ke = Cost of Equity and Kd * (1-t) = After-Tax Cost of Debt

Thus, given the adjusted taxes, we can write the economic value-added formula as follows:

EVA = NOPAT – (WACC * Invested Capital)

When EVA is a positive value, the company is creating value for investors. If EVA is a negative value, the company is destroying value.    

Properties of Economic Value Added

The properties of using economic value added can be compared with other approaches in the following table:

Example – Calculating Economic Value Added for a Company

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Alternative Measures of Value

Financial analysts typically rely on various different methods of measuring value. Return on invested capital (ROIC) is a common method.

Ultimately, the truest measure of value is the cash flow that’s generated by a business, which can be measured by the internal rate of return (IRR). IRR is used in financial modeling and valuation to determine whether a company is creating value in its investments.

If the IRR is greater than the cost of capital, the company is usually adding value. If IRR is less than the cost of capital, the company is destroying value.

Video Explanation of Economic Value Added (EVA)

Watch this short video to quickly understand the main concepts covered in this guide, including the definition of Economic Value Added, the formula for EVA, and an example of EVA calculation.

Additional Resources

In conclusion, economic value added (EVA) highlights when a company creates value (or destroys value) and is helpful in understanding the company’s performance in a given year. For more resources to help advance your corporate finance career as a Financial Modeling & Valuation Analyst (FMVA), these additional resources will be helpful:

• Return on Equity
• Return on Assets
• Valuation Methods
• Financial Modeling Guide
• See all valuation resources