Economic Value Addition

Economic Value Added (EVA) is a financial performance method to calculate the true
economic profit of a corporation. EVA can be calculated as net operating after taxes profit
minus a charge for the opportunity cost of the capital invested.

EVA is an estimate of the amount by which earning exceed or fall short of the required
minimum rate of return for shareholders or lenders at comparable risk.

Unlike market based measures, such as MVA, EVA can be calculated at divisional (Strategic
Business Unit) level.

Unlike stock measures, EVA is a flow and can be used for performance evaluation overtime.

Unlike accounting profit, such as EBIT, net income and EPS, EVA is economic and is based on
the idea that the business must cover both the operating costs and the capital costs.

In corporate finance, Economic Value Added or EVA is an estimate of a firm's

economic profit - being the value created in excess of the required return of the company's
shareholders - where EVA is the profit earned by the firm less the cost of financing the firm's
capital. The idea is that shareholders gain when the return from the capital employed is
greater than the cost of that capital; see corporate finance: working capital management.
This amount can be determined, among other ways, by making adjustments to GAAP
accounting, including deducting the opportunity cost of equity capital. The formula was
developed by Joel Stern, and is a registered trademark of Stern Stewart & Co.

Calculation of EVA

EVA is Net Operating Profit After Taxes (or NOPAT) less the money cost of capital. Any value
obtained by employees of the company or by product users is not included in the
calculations. The basic formula is:

where:

, is the Return on Invested Capital (ROIC);

‘c’ is the Weighted Average Cost of Capital (WACC);

‘K’ is capital employed;

NOPAT is the Net Operating Profit After Tax, with adjustments and translations for the
amortization of goodwill, the capitalization of brand advertising and others.

USAGE OF EVA METHOD

Eva was developed to help managers to incorporate two basic principles of finance into
their decision-making:

 The primary financial objective of any company should be to maximize the wealth of
its shareholders.
 The value of a company depends on the extent to which investors expect the future
will differ from the cost of capital. By definition, a sustained increase in EVA will
result in an increase in the market value of a company. This approach has proved
valid and effective for many types of organizations. This is because the level of EVA
isn’t what really matters. Current performance already is reflected in share prices. It
is the (continuous) improvement in EVA that brings (continuous) increases in
shareholder wealth.

Some specific usages of EVA include:

 To set organizational goals.

 Performance measurement.
 Determining of bonuses.
 Communication with shareholders and investors
 Motivation of managers
 Capital budgeting
 Corporate valuation
 Analyzing equities

The EVA Concept of Profitability

EVA is based on the concept that a successful firm should earn at least its cost of capital.
Firms that earn higher returns than financing costs benefit shareholders and account for
increased shareholder value. In its simplest form, EVA can be expressed as the following
equation:

EVA = Net Operating Profit After Tax (NOPAT) - Cost of Capital

NOPAT is calculated as net operating income after depreciation, adjusted for items that
move the profit measure closer to an economic measure of profitability. Adjustments
include such items as: additions for interest expense after-taxes (including any implied
interest expense on operating leases); increases in net capitalized R&D expenses; increases
in the LIFO reserve; and goodwill amortization. Adjustments made to operating earnings for
these items reflect the investments made by the firm or capital employed to achieve those
profits. Stern Stewart has identified as many as 164 items for potential adjustment, but
often only a few adjustments are necessary to provide a good measure of EVA.[1]
Measurement of EVA

Measurement of EVA can be made using either an operating or financing approach. Under
the operating approach, NOPAT is derived by deducting cash operating expenses and
depreciation from sales. Interest expense is excluded because it is considered as a financing
charge. Adjustments, which are referred to as equity equivalent adjustments, are designed
to reflect economic reality and move income and capital to a more economically-based
value. These adjustments are considered with cash taxes deducted to arrive at NOPAT. EVA
is then measured by deducting the company's cost of capital from the NOPAT value. The
amount of capital to be used in the EVA calculations is the same under either the operating
or financing approach, but is calculated differently.

The operating approach starts with assets and builds up to invested capital, including
adjustments for economically derived equity equivalent values. The financing approach, on
the other hand, starts with debt and adds all equity and equity equivalents to arrive at
invested capital. Finally, the weighted average cost of capital, based on the relative values of
debt and equity and their respective cost rates, is used to arrive at the cost of capital which
is multiplied by the capital employed and deducted from the NOPAT value. The resulting
amount is the current period's EVA.

Strategies for increasing EVA

 Increase the return on existing projects (improve operating performance)

 Invest in new projects that have a return greater than the cost of capital
 Use less capital to achieve the same return
 Reduce the cost of capital
 Liquidate capital or curtail further investment in sub-standard operations where
inadequate returns are being earned

Advantages of EVA

EVA is more than just performance measurement system and it is also marketed as a
motivational, compensation-based management system that facilitates economic activity
and accountability at all levels in the firm.

Stern Stewart reports that companies that have adopted EVA have outperformed their
competitors when compared on the basis of comparable market capitalization.
 Several advantages claimed for EVA are:

 EVA eliminates economic distortions of GAAP to focus decisions on real economic

results
 EVA provides for better assessment of decisions that affect balance sheet and
income statement or tradeoffs between each through the use of the capital charge
against NOPAT
 EVA decouples bonus plans from budgetary targets
 EVA covers all aspects of the business cycle
 EVA aligns and speeds decision making, and enhances communication and teamwork

Academic researchers have argued for the following additional benefits:

 Goal congruence of managerial and shareholder goals achieved by tying

compensation of managers and other employees to EVA measures (Dierks & Patel,
1997)
 Better goal congruence than ROI (Brewer, Chandra, & Hock, 1999)
 Annual performance measured tied to executive compensation
 Provision of correct incentives for capital allocations (Booth, 1997)
 Long-term performance that is not compromised in favor of short-term results
(Booth, 1997)
 Provision of significant information value beyond traditional accounting measures of
EPS, ROA and ROE (Chen & Dodd, 1997)

Limitations of EVA

EVA also has its critics. The biggest limitation is that the only major publicly-available sample
evidence on the evidence of EVA adoption on firm performance is an in-house study
conducted by Stern Stewart and except that there are only a number of single-firm or
industry field studies.

Brewer, Chandra & Hock (1999) cite the following limitations to EVA:

EVA does not control for size differences across plants or divisions

EVA is based on financial accounting methods that can be manipulated by managers

EVA may focus on immediate results which diminishes innovation

EVA provides information that is obvious but offers no solutions in much the same way as
historical financial statement do

Also, Chandra (2001) identifies the following two limitations of EVA:

Given the emphasis of EVA on improving business-unit performance, it does not encourage
collaborative relationship between business unit managers

EVA although a better measure than EPS, PAT and RONW is still not a perfect measure

Brewer et al (1999) recommend using other performance measures along with EVA and
suggest the balanced scorecard system. Other researchers have noted that EVA does not
correlate as strongly with stock returns as its proponents claim. Chen & Dodd (1997) found
that, while EVA provides significant information value, other accounting profit measures
also provide significant information and should not be discarded in favor of EVA alone.
Biddle, Brown & Wallace (1997) found only marginal information content beyond earnings
and suggest a greater association of earnings with returns and firm values than EVA, residual
income, or cash flow from operations.

Finally, a key criticism of EVA is that it is simply a retreaded model of residual income and
that the large number of "equity adjustments" incorporated in the Stern Stewart system
may not be necessary (Barfield, 1998; Chen & Dodd, 1997; O'Hanlon & Peasnell, 1998;
Young, 1997). The similarity between EVA and residual income is supported by Chen and
Dodd (1997) who note that most of the EVA and residual income variables are highly
correlated and are almost identical in terms of association to stock return.