What is Economic Value Added?
Economic Value Added (EVA) or Economic Profit is a measure based on the Residual Income technique that serves as an indicator of the profitability of projects undertaken. Its underlying premise consists of the idea that real profitability occurs when additional wealth is created for shareholders and that projects should create returns above their cost of capital.
EVA adopts almost the same form as residual income and can be expressed as follows:
EVA = NOPAT – (WACC * capital invested)
Where NOPAT = Net Operating Profits After Tax
Capital invested = Equity + long-term debt at the beginning of the period
and (WACC* capital invested) is also known as finance charge
Calculating Net Operating Profits After Tax (NOPAT)
One key consideration for this item is the adjustment of the cost of interest. The cost of interest is included in the finance charge (WACC*capital) that is deducted from NOPAT in the EVA calculation and can be approached in two ways:
- Starting with operating profit, then deducting the adjusted tax charge (because tax charge includes the tax benefit of interest). Therefore, we should multiply the interest by the tax rate and add this to the tax charge; or
- Start with profit after tax and adding back the net cost of interest. Therefore, we should multiply the interest charge by (1-tax rate).
Three main adjustments should be made. Among the most common and important are:
- Expenditures on R&D, promotion, and employee training should be capitalized.
- Depreciation charge 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 debts, deferred tax provisions, and allowances for inventory should be added back to capital implied.
- Non-cash expenses should be added back to profits and to capital employed.
- Operating leases should be capitalized and added back to capital employed.
- Tax charge will be based on cash taxes, rather than the accruals-based methods used in financial reporting and will be calculated as follows:
Tax charge per income statement – increase (or + if reduction) in deferred tax provision + tax benefit of interest = Cash taxes
Calculating the Finance Charge
Finance Charge = Capital invested * WACC
and WACC = Ke*E/ (E+D) + Kd (1-t)*D/ (E+D), where Ke = required return on equity and Kd (1-t) = after tax return on debt
Thus, given the adjusted taxes, we can write the economic value-added formula as follows:
EVA = NOPAT – (WACC * capital invested)
Properties of Economic Value Added
The properties of using economic value added can be compared with other approaches in the following table:
|Valuation model||Measure||Discount Factor||Comments|
|Enterprise discounted cash flow||Free cash flow||WACC||Works best for projects, business units, and companies that manage their capital structure to a target level|
|Discounted economic profit||EVA||WACC||Explicitly highlights when a company creates value|
|Adjusted present value||Free cash flow||Unlevered cost of equity||Highlights changing capital structure more easily than WACC-based models|
Example – Calculating Economic Value Added for a Company
|Capital invested (beginning of year)||$54,236||$50,323||$55,979|
|Economic Value Added||$2,805||$1,187||-$347|
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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 that also uses a residual income approach. Ultimately, the truest measure of value is the cash flow that’s generated by a business, which can only be measured by internal rate of return (IRR). IRR is used in financial modeling to capture all aspects of a business and its economic performance.
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.
In conclusion, economic value added (EVA) highlights when a company creates value (or destroys value) and is helpful to understand 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: