What is Economic Value Added?
In short:
Economic Value Added (EVA), also called Economic Profit, shows the surplus profit generated by a project beyond the minimum amount required to cover the cost of funding the project. Ideally, projects companies undertake will result in more income generation than just enough to cover capital cost, when they do those projects add economic value to the company. The amount they add is measured by EVA.
Formula:
Key Points
- Economic Value Added shows the profit being generated above and beyond the company’s or project’s capital cost.
- Companies or projects that add economic value will have a positive EVA whereas companies or projects that do not will have a negative EVA.
In-depth:
Understanding Economic Value Added
When looking at a company or project it may be beneficial to know if and/or how much additional profit is being generated above the cost of capital. If the company or project has a positive EVA this means the company or project is producing a rate of return above the rate being paid for the capital. This additional profit being generated is “value” being added to the company or project.
On the other hand, if the company or project has a negative EVA this means value is not being created, instead, value is being destroyed.
To calculate EVA, the after-tax operating profit is subtracted from the cost of the financing. Essentially, we are comparing the cash being generated by the project or company to the expense to finance the project or company. Since businesses want to make money, we need the profit of the business to exceed the expenses i.e. positive EVA constructive, negative EVA destructive.
*We simplified the last paragraph to illustrate the general idea of EVA.
What is NOPAT
Above, we displayed the formula for calculating EVA which included NOPAT. But what is NOPAT? This represents net operating profit after taxes (NOPAT) and is the earnings of the company or project if there was not debt.
What is WACC
What is WACC? All companies or projects require capital in order to be funded, weighted average cost of capital (WACC) represents the weighted cost of that capital depending on where it is sourced from, i.e. debt or equity.
Think of WACC like this, if 80% of capital comes from equity and 20% comes from debt then WACC will reflect more of the equity cost than the debt cost. The reason this is important is that you must pay your investors, both debt and equity investors. Additionally, this represents the opportunity cost of the project or company.
EVA Example
To make more sense of EVA we can consider a simple example to see how it works. Say we’re looking for a project that will produce $6,000 in NOPAT. We know that this project would also require a $49,000 investment and that our weighted average cost of capital is 11.25%. With this information we can apply the EVA formula:
EVA = $6,000 – ($49,000 x 11.25%)
EVA = $6,000 – $5,512.5
EVA = $487.5
In our very simple example, we can see that the project is constructive with an EVA of $487.5.
Frequently Asked Questions
Economic value added is important because it indicates the profitability of a project or company based on the earnings it is producing vs the cost of the capital to produce those earnings. When a company or project is adding economic value subtracting the operating profits from the capital costs will result in a positive number.
To get EAV you need to subtract NOPAT from the Cost of Capital of the project or company using the formula: EVA = NOPAT – (Invested Capital x WACC). Where NOPAT is net operating profit after tax and Cost of Capital is the result of multiplying the invested capital by the weighted average cost of capital (WACC).
The difference between ROI and EVA is that ROI is the percentage return on the original amount invested whereas EVA is the measure of surplus income a company/project generates above its capital costs.