The goal of most companies is to create value for the 澳洲幸运5官方开奖结果体彩网:shareholder. But how is value measured? Wouldn't it be nice if👍 there were a simple formꩵula to figure out whether a company is creating wealth?

Like many economic formulas, 澳洲幸运5官方开奖结果体彩网:economic value added (EVA) is intriguingly clever and maddeningly🌺 deceptive. Does EVA simplify the task of finding value-generating companies, or does it muddy the waters?

What Is EVA?

EVA is a performance metric that calculates the creation of 澳洲幸运5官方开奖结果体彩网:shareholder value; however, it distinguishes itself from traditional 澳洲幸运5官方开奖结果体彩网:financial performance metrics, such as 澳洲幸运5官方开奖结果体彩网:net profit and 澳洲幸运5官方开奖结果体彩网:earnings per share (EPS). EVA is the calculation of what profits remain after the 澳洲幸运5官方开奖结果体彩网:costs of a company's capital—debt and equity—are deducted from 澳洲幸运5官方开奖结果体彩网:operating profit. The idea is simple but💛 rigo🎶rous: true profit should account for the cost of capital.

Example EVA Scenario

To understand the difference between EVA and its infamous cousin, 澳洲幸运5官方开奖结果体彩网:net income, let's use an example based on the fictitious company Ray's House of Crockery. Ray's earned $100,000 on a 澳洲幸运5官方开奖结果体彩网:capital base of $1 million thanks to its sales of stew pots. Traditional accounting metrics suggest that Ray is doing a good job. His company offers a return on capital of 10%. However, Ray's has only been operating for a year, and the market for stew pots still carries significant uncertainty and risk. Debt obligations plus the 澳洲幸运5官方开奖结果体彩网:required return that investors demand add up to an investment cost of capital of 13%. That means that, although Ray's is enjoying accounting profits, the company was unable to ♋grant 3% to its shareholders.♐

Conversely, if Ray's capital is $100 million—including debt and 澳洲幸运5官方开奖结果体彩网:shareholder equity—and the cost of using that capital (interest on debt and the cost of 澳洲幸运5官方开奖结果体彩网:underwriting the equity) is $13 million per year, Ray will add 澳洲幸运5官方开奖结果体彩网:economic value for his shareholders only when profits are more than $13 milꦡlion per year. If Ray's earns $20 million, the company's EVA will be $7 million.

In other words, EVA charges the company rent for tying up investors' cash to support operations. There is a hidden 澳洲幸运5官方开奖结果体彩网:opportunity cost that goes to investors to compensate them f꧋or forfeiting the use of their own cash. EVA captures this hidden cost of capital that conventional measures ignore.

Developed by the management consulting firm Stern Stewart, EVA became wildly popular in the 1990s. Big corporations, including Coca-Cola, GE, and AT&T, employ EVA internally to 澳洲幸运5官方开奖结果体彩网:measure wealth creation perꦛformance. In turn, investors and analysts are now scrutinizing companies' EVA just as they previously observed EPS and 澳洲幸运5官方开奖结果体彩网:P/E ratios. Stern Stewart has gone so far as to trademark the concept.

EVA Calculation

There are four steps in the calculation of EVA:

1. Calculate Net Operating Profit After Tax (NOPAT)
2. Calculate Total Invested Capital (TC)
3. Determine the Weighted Average Cost of Capital (WACC)
4. Calculate EVA
   

$\begin{aligned} &\mathit{EVA} = \mathit{NOPAT} - \mathit{WACC}*\mathit{TC}\\ &\textbf{where:}\\ &\mathit{NOPAT} = \text{Net Operating Profit After Tax}\\ &\mathit{WACC} = \text{Weighted Average Cost of Capital}\\ &\mathit{TC} = \text{Total Invested Capital}\\ \end{aligned}$​EVA=NOPAT−WACC∗TCwhere:NOPAT=Net Operating Profit After TꦰaxWACC=Weighted Av𝓡erage Cost of CapitalTC=Total Invested Capital​
The steps appear straightforward and simple, but looks can be deceiving. For starters, NOPAT hardly represents a reliable indicator of shareholder wealth. NOPAT might show profitability according to the 澳洲幸运5官方开奖🉐结果体彩网:generally accepted account🍸ing principles (GAAP), but standard accounting profits rarely reflect the amount of cash left at year-end for shareholders. According to Stern Stewart, dozens of adjustments to earnings and 澳洲幸运5官方开奖结果体彩网:balance sheets—in areas like R&D, inventory, costing, 澳洲幸运5官方开奖结果体彩网:depreciation and 澳洲幸运5官方开奖结果体彩网:amortization of goodwill—must be made before the calculation of standard 澳洲幸运5官方开奖结果体彩网:accounting profit can be used to calculate EVA.

Figuring out the 澳洲幸运5官方开奖结果体彩网:weighted average cost of capital (WACC) is even more difficult. WACC is a complex function of the 澳洲幸运5官方开奖结果体彩网:capital structure (proportion of debt and equity on the balance sheet), the stock's volatility measured by its beta, and the 澳洲幸运5官方开奖结果体彩网:market risk premium.

That said, if carried out consistently, EVA should help identify the best investments—the companies that generate more wealth than their rivals. All other things being equal, firms with high EVAs should, over time, outperform others with lower or negative EVAs.

However, the actual EVA level matters less than the change in the level. According to research conducted by Stern Stewart, EVA is a critical driver of a company's stock performance. If EVA is positive but is expected to become less positive, it is not giving a very good signal. Conversely, if a company suffers negative EVA but is expected to 澳洲幸运5官方开奖结果体彩网:rise into positive territory, a buy signal is given.

Of course, Stern Stewart is hardly unbiased in the assessment of EVA. Some research challenges the close relationship between rising EVA and stock price performance. Still, the popularity of the concept reflects the importance of EVA's basic principle: the cost of capital should not be ignored but kept at the forefront of investors' minds. Best of all, EVA gives analysts and anyone else the chance to look skeptically at EPS reports and forecasts.

The Bottom Line

EVA, or economic value added, accounts for the cost of capital when figuring a company's profits. Positive EVA indicates that a company is generating wealth above the minimum required return for its shareholders; a negative EVA shows that it is not. Calculating EVA is another way to evaluate investments and decide whether they're likely to perform well over time.