What it means
Ordinary profit does not charge a company for the use of shareholders' money. A business can report a profit and still be a poor investment if the profit is lower than what investors could earn elsewhere.
EVA fixes this by deducting a capital charge, which is the return investors expect on the funds supplied. The capital charge is the amount of invested capital multiplied by the weighted average cost of capital (WACC), which is the blended cost of debt and equity funding.
For example, a company with $10 million of capital and a 9% cost of capital must earn $900,000 after tax before it creates any extra value. Anything above that is EVA.
The measure was popularised by a consulting firm in the 1980s and 1990s and has been used by many companies to set targets and bonuses. It encourages managers to think about the cost of the assets they use, such as stock, equipment and property.
A manager might decide to sell an underused asset if the capital charge exceeds the profit it earns. EVA can also guide investment decisions.
A project that earns more than its capital charge adds value, while one that earns less does not. This is similar to net present value, but EVA is measured year by year and can be tracked within normal reporting.
There are drawbacks. The calculation requires judgement about what counts as invested capital and which accounting adjustments to make.
Also, it can encourage short-term thinking if bonuses reward EVA in the current year and discourage spending that pays off later. Do not confuse EVA with the many other uses of the same letters in other fields.
In finance, it nearly always refers to Economic Value Added. Some firms use a similar measure under a different name, such as economic profit or residual income.
In practice
Real-world examples.
Example
A retail chain reviews its stores and finds that one store earns an after-tax profit of $150,000 on $2,000,000 of capital. At a 9% cost of capital, the charge is $180,000, so the store has a negative EVA of $30,000. Management uses the result to decide whether to improve the store or close it.
Example
A manufacturing group links part of its executive bonuses to EVA. Managers become more careful about holding excess stock and buying equipment that sits idle. Within a year, the group frees up cash by selling surplus machines.
Example
A technology company evaluates a new product line. The projected after-tax profit of $500,000 on $3,000,000 of capital exceeds the 10% charge of $300,000, so the line adds $200,000 of EVA. The board approves the launch and asks for the result to be reviewed after two years.
Formula
Calculation
EVA = net operating profit after tax (NOPAT) - (WACC x invested capital)
Worked example: a division earns NOPAT of $1,200,000. It uses invested capital of $8,000,000, and the company's WACC is 10%.
Step 1: Capital charge = 10% x $8,000,000 = $800,000.
Step 2: EVA = $1,200,000 - $800,000 = $400,000.
Step 3: The division has created $400,000 of value above the return that investors require.
If the division's NOPAT had been only $700,000, EVA would be $700,000 - $800,000 = -$100,000. It would show a profit but still destroy value.Case study
Seen in the real world.
Brightpath Printing is a fictional company that reported steady profits of $2 million a year. Its board felt satisfied until the new CFO calculated EVA for each business unit.
The analysis showed that the commercial printing unit earned $500,000 after tax on $9 million of capital. At a 10% cost of capital, the charge was $900,000, leaving a negative EVA of $400,000.
In this illustrative case, the board agreed to sell part of the unit's equipment and refocus on higher-margin work. Capital employed fell to $6 million and margins improved, lifting after-tax profit to $700,000 against a charge of $600,000. The unit therefore moved to a positive EVA of $100,000 the following year.
Watch out
Common mistakes.
- Treating accounting profit as proof that value is created, without deducting the cost of capital.
- Using pre-tax profit instead of NOPAT, which overstates the result.
- Choosing an unrealistic cost of capital, which can make EVA look better or worse than it is.
Questions
People also ask.
Is EVA the same as net profit?
No. EVA subtracts a charge for the capital used, whereas net profit does not. That extra charge is what makes EVA a stricter test of performance.
Who uses EVA?
Boards, CFOs and analysts who want to judge whether business units and projects earn more than their cost of capital. It is also used in some bonus schemes.
Can EVA be negative while profit is positive?
Yes, and this is exactly the situation it is designed to reveal.
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