Historical background on the EVA (Economic Value Added) Calculation
The Economic Value Added Calculation was born out of investors frustrations with companies who produced high profit numbers, but who had large costs of capital. The EVA calculation has been intended to help provide the investor with a more rounded measure of a company’s performance. It is often quoted that EVA purports to measure the true economic profit produced by an organization. The reality however is that the Economic Value Added calculation does not represent a “silver bullet” to the investor and there continues to be the need for detailed assessment of a variety of ratios in order to gain a complete understanding before embarking on finalizing an investment decision.
What is the EVA Calculation?
Although quoted as one of the most important investment calculations, it is in fact relatively easy to define. One definition is as follows:
Economic Value Added (EVA) = Net Operating Profit less applicable taxes – Cost of Capital
The EVA is quoted in currency created. For example US$10 million. It is therefore not a ratio.
An alternative definition for Economic Value Added may be defined as:
Economic Value Added (EVA) = (% Return on invested capital - % Cost of Capital) x original capital invested
What Does the Economic Value Added (EVA) Calculation Mean to Investors?
Investors, industry and other stakeholders will look at the relative size of the Economic Value Added calculation. This is because a high EVA calculation implies that a company is generating profits in excess of their cost of capital. This is often interpreted as the company is adding value, which is usually interpreted as good news. If the Economic Value Added calculation produces a negative number then this is usually deemed to be bad news, since it implies that the shareholders may have received a better return elsewhere.
Why Do Investors See the EVA Calculation as Important?
As briefly mentioned, the fundamental use of the Economic Value Added calculation is to indicate to the investor if the company appears to be “adding value” to the shareholders or if they are deemed to be “destroying value”. This is obviously a key calculation, but it must be noted that there are a few challenges with EVA which are discussed below.
What Are the Key Problems with Economic Value Added Analysis of a company?
Three possible key problems with the EVA calculation are the following:
- Investors & industry place too much emphasis on the EVA calculation. The investor must seek to carry out other ratio analysis to gain a more in-depth understanding of the company.
- Investors must understand that EVA gives an absolute value and is not a ratio which can be easily compared to other companies. For example an Economic Value Added of US$ 10 million for a 10,000 person multinational would be viewed very differently to an EVA of US$ 10 million created by a 2 person organization.
- Investors & industry often find it difficult to get compare EVAs or gain an understanding of industry benchmark EVAs due to the Economic Value Added calculation giving an absolute value.
How Else Can the Economic Value Added Calculation be Used?
The EVA calculation can also be used to help assess smaller investment decisions. For example is a business unit within a multi-national “adding value” by creating a positive Economic Value Add. Similarly smaller investments may be assessed using EVA such as investment in a new satellite office. Again the investor or stakeholder needs to carry out a broader base of ratio analysis in order to gain an in-depth knowledge before making any decisions.