Economic Value Added (EVA): Meaning, advantages and disadvantages

The general aim of establishing businesses is to make profitable returns on them. Investors thrive reduce risks and leverage on skills to allow for increased profits by businesses.

In this article, we will explore the meaning, advantages, disadvantages and other aspects of EVA. Whether you’re an investor or a manager, understanding EVA can give valuable insights into a company’s financial performance.

What is Economic Value Added (EVA)?

Economic Value Added (EVA) is a financial metric that measures the true economic performance of a company by considering the cost of capital and comparing it to the return on invested capital. It provides a more comprehensive view of a company’s financial performance compared to traditional metrics such as net income and earnings per share (EPS). EVA was first introduced by Stern Stewart & Co., a management consultancy firm, in the 1990s.

EVA is calculated by subtracting the cost of capital from the company’s net operating profit after taxes (NOPAT). The cost of capital represents the opportunity cost of the resources invested in the company and includes the cost of equity and the cost of debt. The cost of equity represents the return that investors expect for the risk they are taking, while the cost of debt represents the cost of borrowing funds.

EVA is a useful tool for investors, as it provides insight into the company’s ability to generate returns that are greater than the cost of capital. It also helps managers to identify areas of the business that are underperforming and need improvement. By focusing on creating value, companies can optimize their resources and improve their financial performance over the long term.

How is EVA calculated?

Economic Value Added (EVA) is calculated by subtracting the cost of capital from the company’s net operating profit after taxes (NOPAT). The formula for EVA can be expressed as follows:

EVA = NOPAT – (Cost of Equity + Cost of Debt) * Capital Employed

Where;

NOPAT is the net operating profit after taxes, Cost of Equity is the return that investors expect for the risk they are taking, Cost of Debt is the cost of borrowing funds, and Capital Employed is the total amount of capital invested in the company.

To calculate NOPAT, you need to determine the company’s net operating profit before taxes and then adjust for taxes. The cost of equity can be estimated using the Capital Asset Pricing Model (CAPM), which considers the risk-free rate, the expected market return, and the company’s beta. The cost of debt can be estimated by taking the average interest rate on the company’s debt.

Once you have determined the NOPAT, cost of equity, and cost of debt, you can calculate the EVA by multiplying the capital employed by the cost of capital and subtracting it from the NOPAT. A positive EVA indicates that the company is generating returns that are greater than the cost of capital, while a negative EVA indicates that the company is not generating returns that are sufficient to cover the cost of capital.

Advantages of using EVA as a performance metric 

Economic Value Added (EVA) is a useful metric for measuring the true economic performance of a company. There are several advantages of using EVA as a performance metric, including:

1. Aligns interests of management and investors: EVA incentivizes managers to focus on creating value for the company and aligns their interests with those of the investors. When managers focus on creating positive EVA, they are also improving the financial performance of the company and increasing the value of the shares.
2. Provides a more comprehensive view of performance: Unlike traditional metrics such as net income and earnings per share (EPS), EVA takes into account the cost of capital and provides a more comprehensive view of a company’s financial performance. This allows managers and investors to make informed decisions about the company’s future.
3. Improves resource allocation: By focusing on creating positive EVA, managers are incentivized to optimize the use of the company’s resources and improve its financial performance over the long term. This can lead to better decision-making and improved resource allocation.
4. Encourages long-term thinking: EVA is a long-term metric and encourages managers to focus on creating value over the long term, rather than just maximizing short-term profits. This can lead to more sustainable growth and improved financial performance over the long term.

Disadvantages of using EVA as a performance metric

Economic Value Added (EVA) is a widely used performance metric, but it also has its limitations and criticisms. Some of the key limitations and criticisms of EVA include:

1. Complexity: EVA is a complex metric that requires a deep understanding of finance and accounting principles to be calculated accurately. This can make it difficult for non-financial managers and investors to understand and interpret the results.
2. Subjectivity: The calculation of EVA involves making several assumptions and estimates, such as the cost of equity and the cost of debt. These estimates can be subjective and can lead to varying results depending on the assumptions used.
3. Short-term focus: EVA is a short-term metric that focuses on the current period and does not take into account future expected performance. This can result in managers making decisions that are not in the best interests of the company in the long term.
4. Ignores qualitative factors: EVA is a financial metric that focuses on the financial performance of a company and ignores qualitative factors such as customer satisfaction and employee morale. These qualitative factors can have a significant impact on a company’s performance over the long term.
5. Discourages investment in intangible assets: EVA only considers tangible assets and may discourage investment in intangible assets such as research and development, which can have a significant impact on a company’s future performance.

Applications of EVA in corporate finance and investment analysis 

Economic Value Added (EVA) is a widely used performance metric in corporate finance and investment analysis. Some of the key applications of EVA in these fields include:

1. Corporate finance

EVA is used by companies to measure the true economic performance of their operations and to make informed decisions about resource allocation, capital expenditures, and other financial decisions.

EVA can also help companies evaluate the performance of their divisions and make informed decisions about divestitures or investments in new business ventures.

2. Investment analysis

EVA is used by investors to evaluate the financial performance of a company and to make informed investment decisions.

EVA provides a comprehensive view of a company’s financial performance and helps investors identify undervalued companies that have the potential to generate high returns.

3. Performance evaluation

EVA is used by companies to evaluate the performance of their managers and executives. By focusing on the creation of positive EVA, companies can incentivize their managers to focus on creating value for the company and improving its financial performance over the long term.

4. Mergers and acquisitions

EVA is used in mergers and acquisitions to evaluate the financial performance of potential acquisition targets.

EVA provides a comprehensive view of a company’s financial performance and helps investors identify undervalued companies that have the potential to generate high returns.

Conclusion 

EVA is a widely used performance metric in corporate finance and investment analysis. It provides a comprehensive view of a company’s financial performance and helps companies and investors make informed decisions about resource allocation, investment decisions, and performance evaluation. EVA is a useful tool for improving the financial performance of companies and generating high returns for investors.

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