The general purpose of setting up a business is to make a profitable profit on them. Investors thrive and capitalize on skills to allow business growth profits.
In this article, we will explore the meaning, advantages, disadvantages and other aspects of EVA. Whether you’re an investor or a manager, understanding EVA can provide valuable insight into a company’s financial performance.
What does economic value (EVA) include?
Economic value added (EVA) is a financial metric that measures the actual economic performance of a company by considering the cost of capital and comparing it to the return on invested capital. It provides a more comprehensive view of a company’s financial performance than traditional metrics such as net income and earnings per share (EPS). EVA was first introduced in the 1990s by the management consultancy firm, Stern Stewart & Company.
EVA is calculated by subtracting the cost of capital from the company’s net operating profit after tax (NOPAT). The cost of capital represents the opportunity cost of the resources invested in the company and includes the cost of equity and the cost of debt. The cost of equity represents the return that investors expect for their risk, while the cost of debt represents the cost of borrowing funds.
EVA is a useful tool for investors, as it provides insight into a company’s ability to generate returns that exceed the cost of capital. It also helps managers identify areas of the business that are underperforming and need improvement. By focusing on value creation, companies can optimize their resources and improve their financial performance over the long term.
How is EVA calculated?
Economic Value Added (EVA) is calculated by subtracting the cost of capital from a company’s net operating profit after tax (NOPAT). Eva’s formula can be expressed as:
EVA = NOPT – (Value of Equity + Value of Debt) * Capital Employed
where;
NOPAT is the net operating profit after taxes, cost of equity is the return investors expect to take on their risk, cost of debt is the cost of borrowing funds, and invested capital is the total amount of capital invested in the company.
To calculate NOPAT, you need to determine the company’s net operating profit before taxes and then adjust for taxes. The cost of equity can be estimated using the capital asset pricing model (CAPM), which considers the risk-free rate, the expected market return, and the company’s beta. The cost of debt can be estimated by taking the average interest rate on the company’s debt.
Once you have determined the NOPT, cost of equity, and cost of debt, you can calculate EVA by multiplying the capital employed by the cost of capital and subtracting it from the NOPT. A positive EVA indicates that the company is generating returns that exceed the cost of capital, while a negative EVA indicates that the company is not generating returns that are sufficient to cover the cost of capital.
Advantages of using EVA as a performance metric
Economic value added (EVA) is a useful metric for measuring the true economic performance of a company. There are many advantages to using EVA as a performance metric, including:
- Aligns the interests of management and investors: EVA encourages managers to focus on creating value for the company and align their interests with those of investors. When managers focus on creating positive EVA, they are also improving the company’s financial performance and increasing the share price.
- Provides a more comprehensive view of performance: Unlike traditional metrics such as net income and earnings per share (EPS), EVA takes into account cost of capital and provides a more comprehensive view of a company’s financial performance. This allows managers and investors to make informed decisions about the future of the company.
- Optimizes resource allocation: By focusing on creating positive EVA, managers are motivated to optimize the company’s use of resources and improve its financial performance over the long term. This leads to better decision making and better allocation of resources.
- Encourages long-term thinking: EVA is a long-term metric and encourages managers to focus on creating value in the long term rather than maximizing short-term profits. This can lead to more sustainable growth and improved financial performance over the long term.
Disadvantages of using EVA as a performance metric
Economic value added (EVA) is a widely used performance metric, but it has limitations and criticisms. Some of the main limitations and criticisms of EVA include:
- Complexity: EVA is a complex metric that requires a deep understanding of finance and accounting principles to calculate accurately. This can make it difficult for non-financial managers and investors to understand and interpret the results.
- Subject: Calculating EVA involves making a number of assumptions and estimates, such as cost of equity and cost of debt. These estimates may be subjective and may lead to different results depending on the assumptions used.
- Short term focus: EVA is a short-term metric that focuses on the current period and does not take into account expected future performance. As a result, managers may make decisions that are not in the best interests of the company in the long run.
- Ignores quality factors: EVA is a financial metric that focuses on a company’s financial performance and ignores qualitative factors such as customer satisfaction and employee morale. These qualitative factors can have a significant impact on a company’s performance over the long term.
- Discourage investment in intangible assets: EVA considers only tangible assets and may discourage investment in intangible assets such as research and development, which can significantly impact a company’s future performance.
Applications of EVA in corporate finance and investment analysis
Economic value added (EVA) is a widely used performance metric in corporate finance and investment analysis. Some of the key applications of EVA in these areas include:
1. Corporate Finance
EVA is used by companies to measure the true economic performance of their operations and to make informed decisions about resource allocation, capital expenditures and other financial decisions.
EVA can also help companies assess the performance of their divisions and make informed decisions about diversification or investment in new business ventures.
2. Investment analysis
EVA is used by investors to evaluate a company’s financial performance and make informed investment decisions.
EVA provides a comprehensive view of a company’s financial performance and helps investors identify undervalued companies that have the potential to generate high returns.
3. Performance appraisal
EVA is used by companies to evaluate the performance of their managers and executives. By focusing on creating positive EVA, companies can encourage their managers to focus on creating company value and improving its financial performance over the long term.
4. Mergers and Acquisitions
EVA is used in mergers and acquisitions to evaluate the financial performance of potential acquisition targets.
EVA provides a comprehensive view of a company’s financial performance and helps investors identify undervalued companies that have the potential to generate high returns.
The result
EVA is a widely used performance metric in corporate finance and investment analysis. It provides a comprehensive view of a company’s financial performance and helps companies and investors make informed decisions about resource allocation, investment decisions and performance evaluation. EVA is a useful tool to improve the financial performance of companies and generate higher returns for investors.
Is EVA suitable for analyzing startups?
Most startups are unique, and their value can be difficult to ascertain. To get the actual value of a startup, check out our previous article on startup valuation.
How effective is EVA in business?
EVA offers excellent performance to existing businesses and can in turn uncover indicators of overall business growth.