EVA: Economic Value Added?
Companies and consultants measure performance using economic value added (EVA), a novel concept.
An activity or business venture’s “value-added” is its incremental value.
EVA is sometimes called economic rent. It is a popular tool for measuring a company’s resource efficiency.
The difference between the return on resources invested and their cost is EVA. Higher EVA means better resource use.
Net operating profit after tax minus capital investment opportunity cost equals EVA. EVA assumes a corporation must cover operating and capital costs.
EVA might be good or bad. Positive is preferred. Negative EVA should prompt managers to improve and adapt it.
EVA helps managers achieve two key financial decision-making goals:
Optimize shareholder value
Earn surplus profit above capital cost to increase firm value.
Given this, company management should focus on improving EVA.
Explaining Economic Value Added
Economic profit or rent is measured by economic value added (EVA).
EVA evaluates a company’s economic profit, not its accounting profit.
Economic profit minus accounting profit is equity capital cost.
Profit is calculated without equity capital costs by a finance manager. They calculate EPS for shareholders.
However, an economist measures earnings by factoring all costs, including equity capital opportunity cost. The financial manager views profits differently from the economist.
In actuality, EVA doesn’t consider corporate profitability. Instead, it considers whether any earnings remain after all resource costs (including equity capital opportunity cost).
Equity capital opportunity cost is the expense of compensating equity stockholders at a market rate.
If the business can satisfy this responsibility and leave some revenue for its own use, that “leftover portion” is called EVA, which is “positive.”
If earnings don’t cover equity shareholders’ opportunity cost, EVA is “negative”.
The firm’s profits are insufficient to compensate equity capital at the market-determined rate of return.
Profitable enterprises may not contribute to EVA when measured.
If EVA is continually negative, investors may leave the company, feeling it cannot create enough profits.
EVA is becoming useful. Every organization wants to understand investor behavior and keep them.
Economic Value Added Calculation
Easy to calculate economic value added (EVA). Standard accounting subtracts debt capital interest from EBIT to get EBT.
From EBT, profit tax is deducted to get EAT. Subtract preference shareholder dividends to get equity shareholder profits.
Subtract the market-determined equity shareholder return on investment from these earnings (profits).
An EVA (positive) balance remains if earnings can fully absorb this charge and some stay in the business.
EVA (negative) is the portion of the market-determined rate of return not fully absorbed by firm profits.
Finance managers must remedy negative Economic Value Added (EVA) to ensure a positive future EVA.
How to create positive EVA from negative
Increase revenue without increasing capital through boosting operating profit margins or asset turnover ratios.
Reduce business capital by selling underutilized assets. This will boost asset turnover and lower capital cost.
Redirect capital to initiatives and activities that perform better.
Change the company’s capital structure to boost leverage.
The last point may involve replacing equity with lower-cost debt in the firm’s financial structure.
It may cut net earnings, but it would boost EVA by lowering debt and equity costs.
Financial Managers Benefit from EVA
Financial managers use EVA to assess firm profitability.
It lets them improve the company’s position if EVA is zero or negative.
Most professional managers are interested in improving EVA if it is favorable.
The premise is simple, so everybody can comprehend it.
EVA conveys business performance well.
It boosts motivation and communication.
EVA’s power comes from its focus on shareholder value and relative performance.
EVA adapters have faster asset dispositions and turnaround.
Stern and Stewart & Co., the creators of EVA, found that equity market prices are more connected with yearly EVA levels than return on equity, cash flow growth, or EPS growth.
Limitations of EVA
EVA’s single-period concentration is its biggest drawback.
EVA cannot capture all long-term decision-making effects.
Using EVA exclusively can distract managers from other challenges.
EVA Works How?
Three elements should be considered while determining EVA:
Net operating profit after tax (NOPAT): The annual cash flow needed to raise all stock and loan capital after taxes.
Economic book value (EBV) capital: This estimates an enterprise’s overall capital use, including debt and equity.
The enterprise’s cost of capital: The risk-adjusted rate for any division or the business.
Adjustments are needed for NOPAT and EBV numbers. Adjustments are needed to produce precise values for calculations.
Stern and Stewart & Co. lists approximately 160 adjustments and others.
What form of modification to employ and where relies on industry, technology, and value generation.
When managers use this tool wisely, decisions are more effective and results-oriented.