Economic Value Added (EVA) is a business performance indicator. It is a measure of economic profit.
One finds EVA is by subtracting the cost of capital from operating profit, adjusted for taxes on a cash basis.
Knowing economic value created can help investors to judge whether the firm is building the worth of their investment or not.
Economic Value Added is one of a few corporate financial performance metrics in use among larger businesses in recent decades.
Stern Stewart & Co with World Headquarters in New York, pioneered the use of EVA. They have encouraged EVA as a tool to link firm performance and executive compensation.
Economic Value Added =
Net Operating Profit after Taxes (NOPAT) - (Capital * Cost of Capital)
In choosing corporate performance metrics, focus on the Intended Beneficiary of the enterprise. For publically traded companies, the Intended Beneficiaries are the shareholders. The intended and expected benefit is wealth creation. The firm must measure the value of the shareholders investment in the firm.
Measuring this benefit to the shareholders is completely different to the use of performance metrics by managers of the corporation’s operations. These are Management Performance Indicators (MPI), or Management Performance Metrics (MPM). I refer to the higher order corporate performance indicators, such as Economic Value Added, as Beneficiary Performance Indicators (BPI). This avoids the more commonly used Key Performance Indicators (KPI). The label ‘key’ is vague or even meaningless, when applied to metrics for almost all firm activities. Few of these activities are ‘key’, in the sense of measuring benefits to the investors.
It is unhelpful to use an MPI as the top financial target for any organization. These top targets must always be BPIs to reflect what the Intended Beneficiaries expect from their organization. To use any of the performance measures that managers use – however important these are to them – focuses the firm on the wrong thing.
This eliminates indicators such as sales revenues, market share, or 'margin', as pointers to the overall company performance. These do not indicate delivering benefits to shareholders. Also ruled out are the usual accounting measures such as ‘profit before tax’, ‘profit after tax’, ‘earnings before interest and tax’ (or ‘EBIT’). However useful for accountants and tax authorities, they do not tell the facts the shareholders need to hear.
Each firm’s management must make its own choice of the top financial metric. I believe the most helpful measures are those that align well with the purpose of creating wealth for investors. Also the simpler they are to calculate and communicate the better.
There are two popular candidates: Total Shareholder Return, and Economic Value Added.
TSR is the return to shareholders from dividends, plus any other cash distributions, plus capital gains or losses on their shares.
The problem with it as a measure of performance is that a company's share price, and related capital gains or losses, is a function of not just earnings per share performance. It also reflects the current state of the market. Managers do not directly influence this. It seems unreasonable to rely on such measures to judge overall performance.
In setting targets for any company, investors need to be able to make comparison with alternative uses of their funds. In the case of TSR, accessing the relevant data for the TSR of comparable investments may be difficult.
In addition, in strategic planning, where we use multi-year targets and forecasts, we would usually discount the cash flows. This further complicates the establishment of the performance information.
Joel M. Stern, Chairman and CEO of SSCP, pioneered the widespread application of EVA as a measure of business performance measurement.
EVA is the cash flow earned by a business less the cost of the firm's capital.
a business creates $16 of after-tax cash on invested capital of $100
and if its cost of capital is 10%, then its Economic Value Added is
$16-$10, that is $6.
For most small to medium firms, this is not an ideal BPI. This is because of the difficulty of working out average cost of capital. As with TSR mentioned above, the complication of having to discount cash flows over multi-year planning horizons may limit its usefulness in many situations.
Smaller overworked accounting departments may resist using the EVA approach, because it usually requires quite a few adjustments to the financial accounts.
Businesses finance assets through debt, equity, or a mix of the two. One indicator is the Weighted Average Cost of Capital or WACC. It is the average of the costs of these two sources of finance. The proportion or weight goes into an average for the whole. By taking this weighted average, we can see how much interest the company has to pay for every dollar it finances.
A firm's WACC is the overall required return on the firm as a whole. Sometimes managers use it to assess the economic feasibility of growth opportunities and structural change like mergers.
Go here for a fuller explanation with worked examples.
Return from Economic Value Added to Corporate Objectives.
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