Economic value added

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In corporate finance, Economic Value Added or EVA is an estimate of economic profit, which can be determined, among other ways, by making corrective adjustments to GAAP accounting, including deducting the opportunity cost of equity capital. The concept of EVA is in a sense nothing more than the traditional, commonsense idea of "profit," however, the utility of having a separate and more precisely defined term such as EVA or Residual Cash Flow is that it makes a clear separation from dubious accounting adjustments that have enabled businesses such as Enron to report profits while in fact being in the final approach to becoming insolvent. EVA can be measured as Net Operating Profit After Taxes(or NOPAT) less the money cost of capital. EVA is similar to Residual Income (RI), although under some definitions there may be minor technical differences between EVA and RI (for example, adjustments that might be made to NOPAT before it is suitable for the formula below). Another, much older term for economic value added is Residual Cash Flow. In all three cases, money cost of capital refers to the amount of money rather than the proportional cost (% cost of capital). The amortization of goodwill or capitalization of brand advertising and other similar adjustments are the translations that can be made to Economic Profit to make it EVA. The EVA is a registered trademark by its developer, Stern Stewart & Co.

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[edit] Calculating EVA

In the field of corporate finance, Economic Value Added is a way to determine the value created, above the required return, for the shareholders of a company.

The basic formula is:

\mathit{EVA} \ = \ ( r - c ) \cdot K \ = \ \mathit{NOPAT} - c \cdot K

where

r = { \mathit{NOPAT} \over K } , called the Return on Invested Capital (ROIC).

is the firm's return on capital, NOPAT is the Net Operating Profit After Tax, c is the Weighted Average Cost of Capital (WACC) and K is capital employed. To put it simply, EVA is the profit earned by the firm less the cost of financing the firm's capital.

Shareholders of the company will receive a positive value added when the return from the capital employed in the business operations is greater than the cost of that capital; see Working capital management. Any value obtained by employees of the company or by product users is not included in the calculations.

[edit] Relationship to Market Value Added

The firm's market value added, or MVA, is the discounted sum of all future expected economic value added:

MVA = V - K_0 = \sum_{t=1}^{\infty} { EVA_t \over (1+c)^t }

Note that MVA = NPV of company.

[edit] Other measures of shareholder value

[edit] See also

[edit] References

  • G. Bennett Stewart III (1991). The Quest for Value. HarperCollins. 
  • Erik Stern. The Value Mindset. Wiley. 
  • Joel Stern and John Shiely. The EVA Challenge. Wiley. 
  • Al Ehrbar. EVA, the Real Key to Creating Wealth. Wiley. 

[edit] External links

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