The economic profit of a company tells us the true economic value of a company, which is why EVA has become popular among investors and owners of companies.
It helps to show the financial performance of a business by taking into account both its costs of capital and taxes.
Companies that generate higher EVAs are considered to have better economic profits compared to their peers, as they have been able to generate higher revenues than their costs of capital and taxes.
EVA can be used to compare the performance of different companies in the same industry, or even against competitors in other industries.
What is Economic Value Added or EVA?
EVA is the difference between a company’s operating profit and its cost of capital, adjusted for taxes on a cash basis. It is an indication of the true economic value added by that company to its shareholders.
A company with a higher EVA than its peers indicates that it has been able to generate more revenue than what was used to finance its operations and pay taxes.
This creates value for shareholders, which is why EVA is an important metric to consider when evaluating a company’s financial performance.
In addition to providing investors with insight into the true economic profit of a company, EVA can also be used as a metric to motivate management to make better decisions that maximize the value of their business.
By setting EVA targets, companies can create incentives for managers to drive more profitable decisions and strive for higher levels of value generation.
How EVA Works
EVA (Economic Value Added) is a metric used to assess the added value generated by a company due to investments made.
It measures the incremental difference between a firm’s rate of return on its invested capital and its cost of capital, thus providing insight into how well an organization manages and utilizes funds for growth.
When a company’s EVA is negative, it means the investment funds are not being utilized to their fullest potential. A positive EVA, on the other hand, proves that those same investments are driving value into the business and generating profit.
It gives an accurate indication of the company’s true economic performance.
EVA is not only a helpful metric for investors but it can also be used to motivate management and reward employees for driving value into their business.
By setting EVA targets, companies can create incentives for managers to drive more profitable decisions and strive for higher levels of value generation.
How to Calculate EVA
Here is the formula for calculating EVA
EVA = NOPAT – (Invested Capital * WACC)
Where,
NOPAT or Net Operating Profit After Tax: This is the company’s operating profit after taxes are taken into account.
Invested Capital: This is the total amount of capital invested in the business, including equity and debt financing.
WACC or Weighted Average Cost of Capital: This is the rate of return that a company must earn to compensate its investors for their investments in the firm. It is the average of the cost of equity and debt financing, weighted by their respective proportions in the capital structure.
Example of EVA
Let’s take the example of ABC Company. The company has an operating profit (NOPAT) of $100 million and invested capital of $500 million with a weighted average cost of capital (WACC) of 8%.
The EVA for ABC Company would be calculated as follows
EVA = 100 – (500 * 0.08)
= 100 – 40
= $60 million
Therefore, the EVA for ABC Company is $60 million. This indicates that the company has generated an economic profit of $60 million above and beyond its cost of capital.
Conclusion
In conclusion, Economic Value Added (EVA) is a useful metric for investors as it provides an accurate indication of a company’s true economic performance. It measures the difference between a firm’s rate of return on its invested capital and its cost of capital, thus providing insight into how well an organization manages and utilizes funds for growth.
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