ECONOMIC VALUE ADDED ( EVA) Economic value added (EVA) is an internal management performance measure that compares net

operating profit to total cost of capital. Stern Stewart & Co. is credited with devising this trademarked concept In corporate finance, Economic Value Added or EVA, a registered trademark of Stern Stewart & Co., is an estimate of a firm's economic profit being the value created in excess of the required return of the company's investors (being shareholders and debt holders). Quite simply, EVA is the profit earned by the firm less the cost of financing the firm's capital. The idea is that value is created when the return on the firm's economic capital employed is greater than the cost of that capital. From a commercial standpoint, EVA is the most successful performance metric used by companies and their consultants. The metric is justified by financial theory and consistent with valuation principles, which are important to any investor's analysis of a company. CALCULATING ECONOMIC VALUE ADDED The formula for EVA is: EVA = Net Operating Profit After Tax - (Capital Invested x WACC) As shown in the formula, there are three components necessary to solve EVA: net operating profit after tax (NOPAT), invested capital, and the weighted average cost of capital (WACC) operating profit after taxes (NOPAT) can be calculated, but can usually be easily found on the corporation's income statement. The next component, capital invested, is the amount of money used to fund a particular project. We will also need to calculate the weighted-average cost of capital(WACC) if the information is not provided. The idea behind multiplying WACC and capital investment is to assess a charge for using the invested capital. This charge is the amount that investors as a group need to make their investment worthwhile.

EVA is net operating profit after taxes (or NOPAT) less a capital charge, the latter being the product of the cost of capital and the economic capital. The basic formula is:

Where:

, is the Return on Invested Capital (ROIC); is the weighted average cost of capital (WACC); is the economic capital employed; NOPAT is the net operating profit after tax, with adjustments and translations, generally for the amortization of goodwill, the capitalization of brand advertising and others noncash items.

NOPAT is profits derived from a companys operations after cash taxes but before financing costs and non-cash bookkeeping entries. It is the total pool of profits available to provide a cash return to those who provide capital to the firm. Capital is the amount of cash invested in the business, net of depreciation. It can be calculated as the sum of interest-bearing debt and equity or as the sum of net assets less non-interest-bearing current liabilities (NIBCLs). The capital charge is the cash flow required to compensate investors for the riskiness of the business given the amount of economic capital invested. The cost of capital is the minimum rate of return on capital required to compensate investors (debt and equity) for bearing risk, their opportunity cost. Another perspective on EVA can be gained by looking at a firms return on net assets (RONA). RONA is a ratio that is calculated by dividing a firms NOPAT by the amount of capital it employs (RONA = NOPAT/Capital) after making the necessary adjustments of the data reported by a conventional financial accounting system. EVA = (RONA required minimum return) net investments If RONA is above the threshold rate, EVA is positive.

RELATION SHIP OF MARKET VALUE ADDED( MVA) TO EVA The firm's market value added, or MVA, is the discounted sum (present value) of all future expected economic value added:

Note that MVA = PV of EVA. Examining the components of economic profit and studying the finer points of its calculation require an understanding of its underlying principles. Here we look at how it matters as a performance measure - which is distinct from a wealth metric - and how it is closely related to market value added (MVA). Finally, in establishing an overall picture of economic profit, we help you undo any perceived complexity by showing how all of the calculations surrounding economic profit originate from three main ideas.

To understand economic profit, it helps to distinguish between a performance metric and a wealth metric. A performance metric refers to a measure under company control, such as earnings or return on capital. A wealth metric, on the other hand, is a measure of value that such as equity market capitalization or the price-to-earnings (P/E) multiple -depends on the stock market's collective and forward-looking view. Every performance metric has a corresponding wealth metric. In theory, over the long run, a performance metric can be expected to impact its corresponding wealth metric. For example, consider the matching pair of earnings per share (EPS), a fundamental performance metric, and the P/E multiple, its corresponding wealth metric. The variables that determine EPS - earnings and shares outstanding - are numbers affected only by the company's actions and decisions. On the other hand, the P/E multiple, which is determined by the company's stock price, depends on the value of these actions and decisions assigned by the stock market. The company therefore influences the P/E ratio but cannot fully control it. Here is another way to think about the

difference between the two: EPS is a current (or historical) fact but P/E is a forward-looking and collective opinion. The key criterion for the pairing of a performance and wealth metric is consistency: each half of the pair should reference the same group of capital holders and their respective claims' on company assets. For example, EPS by definition concerns the allocation of earnings to common shareholders; the P/E multiple refers to equity market capitalization, which is the value held by shareholders. Consider another example: return on capital (ROC) is a performance metric that represents the return both to debt and stockholders, and its corresponding wealth metric is the EBITDA multiple - the value of total debt, plus equity market capitalization (also known as the "enterprise value" or "entity value"), divided by earnings before interest, taxes, depreciation and amortization (EBITDA). This is also called the "price-to-EBIDTA multiple", or "the enterprise multiple". Note how ROC and the EBITDA multiple meet the consistency test. Like ROC, EBITDA captures earnings that accrue to both holders of stock and debt. The EBITDA multiple, therefore, reveals how the market values the company in light of earnings to stockholders and debt-holders. DIFFERENCE OF EVA FROM TRADITIONAL APPROACH The only difference is that, under economic profit, the intrinsic value of the firm is broken into two parts: invested capital, plus the present value of future economic profits. Here is the comparison:

Traditional Approach Intrinsic Value = Present Value of Future Free Cash Flows

Economic Profit Intrinsic Value = Invested Capital + Present Value of Future Economic Profits As it breaks intrinsic value into parts, you can see why economic profit is often called "residual profit" or "excess earnings". Let's see how this works in Figure 2 below. We are using the same hypothetical assumptions, and the value of the firm's equity remains $40. In this case, however,

the green bars in years one through five represent future economic profits, which represent a part of the future free cash flows will therefore always be less than the free cash flows. Later in this chapter we explain the economic calculation of the economic profits, but for now, it's enough to understand that they represent profits earned above the cost of capital. Now of course the market does not predict future cash flows (or economic profits) perfectly, so we can speak of MVA in two different ways: the MVA as set by the market and the intrinsic (or theoretical) MVA as set by expected future economic profits. But, just as, according to the traditional valuation model, the firm's market valuation is expected to converge with its discounted free cash flow, the observed MVA is expected to converge with its discounted economic profit value. And here, by "observed MVA" we mean the equity market capitalization, minus the invested capital. These relationships are illustrated as follows (where is a symbol for "moves toward becoming the same as"):

Traditional Valuation Equity Market Capitalization Discounted [Free Cash Flows] = Intrinsic Value of Firm Equity

Economic Profit Valuation Equity Market Capitalization Invested Capital + Discounted [Economic Profit] = Invested Capital + Market Value Added (MVA) You can now see why economic profit and MVA are a matched pair: discounted economic profits are equal to intrinsic MVA. And the observed MVA (equity market capitalization, minus invested capital) should move toward becoming intrinsic MVA.

Economic Profit: Three Big Steps Let's now look at the overall calculation, which can be broken down into three sets of calculations. Each of these is the mathematical implication of one of the three main ideas supporting the entire economic profit system:

Idea

Implication

1. Cash flows are the best indicators 1. Translate accrual-based operating profit of performance. The accounting (EBIT) into cash-bashed net operating profit distortions must therefore be fixed. after taxes (NOPAT). 2. Some expenses are really 2. Reclassify some current expenses as balanceinvestments and should be capitalized sheet (equity or debt) items. on the balance sheet. True investments must therefore be recognized. 3. Equity capital is expensive (or, at 3. Deduct a capital charge for invested capital. the very least, not free). This expense must therefore be accounted for.

IMPORTANCE OF EVA Economic Value Added (EVA) is important because it is used as an indicator of how profitable company projects are and it therefore serves as a reflection of management performance.The idea behind EVA is that businesses are only truly profitable when they create wealth for their shareholders, and the measure of this goes beyond calculating net income. Economic value added asserts that businesses should create returns at a rate above their cost of capitalThe economic value calculation has many advantages. It succinctly summarizes how much and from where a company created wealth. It includes the balance sheet in the calculation and encourages managers to think about assets as well as expenses in their decisions.However, the seemingly infinite cash adjustments associated with calculating economic value can be time-consuming. And accrual distortions can still affect the measure, particularly when it comes to depreciation and amortization differences. Also, economic value added only applies to the period measured; it is not predictive of future performance, especially for companies in the midst of reorganization and/or about to make large capital investments. The EVA calculation depends heavily on invested capital, and it is therefore most applicable to asset-intensive companies that are generally stable. Thus, EVA is more useful for auto manufacturers, for example, than software companies or service companies with a lot of intangible assets.