Economic Value Added Formula: Calculating True Business Value

The Economic Value Added (EVA) formula is a powerful tool for calculating a company's true economic value. It helps businesses understand their financial performance beyond just profits and losses.

EVA is calculated by subtracting the cost of capital from net operating profit after taxes (NOPAT). This is where the magic happens, and you get a clear picture of a company's true value.

The EVA formula is EVA = NOPAT - (Capital x Cost of Capital). This formula is straightforward, yet it provides a wealth of information about a company's financial health.

The economic value added (EVA) is a financial metric that measures the surplus profit generated by a project or company beyond the total cost of funding the project. It's the excess profit generated beyond the capital cost of a project.

EVA is calculated by subtracting the capital costs from the operating profit. This can be represented by the formula: EVA = Net Operating Profit after Taxes (NOPAT) - Capital Charge. The capital charge is the cost of all capital employed to generate those profits.

The cost of capital (WACC) is inclusive of the cost of debt (kd) and the cost of equity (ke), so all stakeholders in the capital structure are represented in the metric. This makes EVA a comprehensive measure of a company's economic performance.

In 1989, the New York consulting firm Stern Stewart & Co. introduced and trademarked EVA, a variation or modification of what was previously called "residual income or profit". This marked the beginning of EVA's widespread adoption as a financial performance metric.

Here's a breakdown of the EVA formula:

By understanding the EVA formula and its components, you can better evaluate a company's financial performance and make informed decisions about investments or resource allocation.

Calculating EVA involves determining the difference between the actual rate of return on assets and the cost of capital, and multiplying this difference by the net investment in the business.

The net investment in the business should be the net book value of all fixed assets, assuming straight-line depreciation is used. The expenses for training and R&D should be considered part of the investment in the business.

To calculate EVA, you can use the following formula: (Net investment) x (Actual return on investment – Percentage cost of capital). This calculation yields more reliable results when the targeted organization has a large asset base.

The actual return on investment is typically calculated by dividing net income by net investment. The percentage cost of capital is the weighted average cost of capital, or WACC, which includes the cost of debt and the cost of equity.

For example, in the case of the Hegemony Toy Company, the financial analyst calculated the economic value added as ($3,632,000 Net investment) x (17.8% Actual return – 12.5% Cost of capital) = $192,496 Economic value added.

Here's a summary of the EVA calculation:

The economic value added formula is made up of several key components, each playing a crucial role in calculating EVA.

NOPAT is the net operating profit after taxes, which is calculated by deducting income taxes from operating income.

The cost of capital, also known as WACC, is the cost of debt (kd) and the cost of equity (ke) combined, representing the minimum return required by all stakeholders in the capital structure.

The invested capital is the total amount of capital invested in the business, consisting of shareholders' equity and beginning long-term debt.

To calculate EVA, you'll need to know the tax rate, cost of equity, after-tax cost of debt, and the equity and debt weights.

Here's a breakdown of the components involved in calculating EVA:

These components work together to give you a clear picture of a company's economic value added.

Accountants typically find all the necessary adjustments by hypothetically asking themselves if they would accept their remuneration having to depend on the resulting profit. This helps eliminate non-operating and accounting-related positions in profits that dilute the economic picture of performance.

The necessary adjustments quickly become apparent when considering goodwill and intangible assets, non-operating positions, volatile cost components, and large investments. These adjustments are crucial to get an accurate picture of a company's economic performance.

The guiding principle is to only adjust profits in a way that is discounted cash flow neutral: costs can be capitalized but not eliminated, while depreciation can be omitted but the associated assets remain on the balance sheet.

Here are some key adjustments to consider:

NOPAT (Net Operating Profit After Taxes) is the input for EVA, and it's essential to keep it close to the official profit declaration, as every change requires an explanation.

Tax in EVA can be a complex topic, but it's essential to understand its impact on your company's financials.

Calculating NOPAT for EVA requires assessing the impact of taxes, which can be done by calculating actual taxes for the period under observation from paid taxes and changes in the tax positions on the balance sheet.

This approach ensures that you're accounting for all taxes due, regardless of when they're paid.

A flat tax rate can be used if the tax situation is too complicated for non-financial managers.

Tax adjustments focus operating management on operating issues and define EVA as a purely operating performance metric.

If the tax situation changes, the tax rate is adjusted in advance.

Here's a summary of the tax treatment in EVA:

EVA adjustments are a crucial step in calculating the true economic value added by a project or company. They eliminate non-operating and accounting-related positions in profits that dilute the economic picture of performance.

The necessary adjustments become apparent when accountants ask themselves if they would accept their remuneration having to depend on the resulting profit. This thought experiment helps identify the adjustments needed to accurately reflect the company's economic performance.

Adjusted items include goodwill and intangible assets, non-operating positions, volatile cost components, and large investments. These items can distort the company's profitability and need to be removed to get an accurate picture of its economic value added.

Accountants typically follow a guiding principle of only adjusting profits in a way that is discounted cash flow neutral. This means costs can be capitalized but not eliminated, while depreciation can be omitted but the associated assets remain on the balance sheet.

Here's a list of the types of adjustments that can be made:

The goal of EVA adjustments is to ensure that the resulting NOPAT (net operating profit after taxes) stays close to the official profit declaration. Any changes require an explanation to maintain transparency and accuracy.

EVA can be split into its value sources by the value driver tree, using financial metrics indexed by the method of indexing operating performance.

Operating Rank, Operating Radar, and Operating Contribution are the most important tools for this, as they help split Economic Value Added into its components without external effects diluting operating performance measurement.

A list of all indexing tools is available, which can be useful for reference.

EVA is a powerful tool that can be broken down into its value sources using the value driver tree. This involves indexing financial metrics by operating performance, which can be done with tools like Operating Rank, Operating Radar, and Operating Contribution.

These tools help split Economic Value Added into its components without external effects diluting the measurement of operating performance. A list of all indexing tools is available for reference.

Capital Charge is used to calculate EVA, which is a key aspect of understanding its value sources.

EVA for Game Products, Inc is a great example of how this metric can be used to evaluate a company's performance.

The company's financial analyst calculated the EVA by starting with the net income from the income statement, which was $645,000.

The return on investment for Game Products, Inc was 17.8%, using the information from the balance sheet and income statement.

To calculate the EVA, the financial analyst used the following formula: ($3,632,000 Net investment) x (17.8% Actual return – 12.5% Cost of capital).

The result was $192,496 in economic value added, indicating that the company is generating a healthy economic value on the funds invested in it.

Here's a breakdown of the EVA calculation for Game Products, Inc:

This calculation shows how EVA can be used to evaluate a company's performance and identify areas for improvement.