What it means
Accounting profit can be misleading, because it ignores the cost of the money shareholders have put into the business. A company can report a profit and still leave its owners worse off if that profit is lower than they could have earned elsewhere at similar risk.
SVA fixes this by charging the business for the capital it uses. The idea was popularised by the academic Alfred Rappaport, who argued that managers should aim at increasing the value of the business to shareholders instead of simply raising earnings.
In his approach, the value of a company equals the present value of its future free cash flows (the cash left after running costs and investment), discounted at the cost of capital. SVA is the increase in that value over a period.
A widely used practical version looks at a single year. It takes the profit from operations after tax, called net operating profit after tax or NOPAT, and subtracts a charge for the capital invested at the weighted average cost of capital, or WACC (the blended return that lenders and shareholders require).
What remains is the surplus created beyond the required return. Companies use SVA to compare divisions, to decide which projects to fund and to design incentive plans.
A division with high profit but a heavy capital base may create less value than a smaller one that uses little capital. Managers who are rewarded on SVA tend to release unused assets, manage working capital carefully and avoid investments that earn less than their cost.
The nuance is that SVA depends on estimates, mainly the cost of capital and the definition of invested capital. Small changes to the assumptions can move the result, and short-term SVA can be raised by cutting investment in growth that would pay back later.
It is therefore best read over several years and alongside other measures.
In practice
Real-world examples.
Example
A conglomerate calculates SVA for each of its four divisions. The division with the largest profit turns out to destroy value once the capital charge is applied, so the group considers selling it.
Example
A retail chain links its managers' bonuses to SVA for each region. Regional managers begin to cut slow-moving stock and close poor stores, because both actions reduce the capital charge without hurting profit.
Example
A software firm evaluates a $20,000,000 acquisition by estimating how much SVA it will add each year. The deal is approved only after the analysis shows that the expected profit comfortably exceeds the capital charge.
Formula
Calculation
SVA = NOPAT - (WACC x invested capital)
Suppose a business unit earns NOPAT of $12,000,000 and has invested capital of $100,000,000. The weighted average cost of capital is 9%, so the capital charge is 0.09 x 100,000,000 = $9,000,000. SVA = 12,000,000 - 9,000,000 = $3,000,000. The unit created $3,000,000 of value above the return investors required, which is equal to a return on capital of 12% against a required 9%.Case study
Seen in the real world.
Ashford Industrial is an illustrative, fictional manufacturer with two divisions. The pumps division earns NOPAT of $8,000,000 on invested capital of $50,000,000, while the valves division earns NOPAT of $5,000,000 on invested capital of $70,000,000. The group's cost of capital is 10%.
The pumps division has a capital charge of $5,000,000 and an SVA of $3,000,000. The valves division has a capital charge of $7,000,000 and an SVA of negative $2,000,000, even though it makes a healthy accounting profit.
The board used these figures to ask whether the valves division could improve its returns or whether its capital would be better used elsewhere. The illustrative outcome was a plan to cut the valves division's inventory by $10,000,000, which reduced the capital charge by $1,000,000 a year and moved the division closer to break-even on SVA.
Watch out
Common mistakes.
- Treating accounting profit as value creation, when profit does not include the cost of equity capital.
- Using an out-of-date or arbitrary cost of capital, which can turn a value-creating project into a value-destroying one on paper.
- Boosting short-term SVA by cutting investment in future growth.
Questions
People also ask.
Is SVA the same as economic value added?
They are closely related, since both charge for capital, but SVA is often tied to the Rappaport cash flow approach while EVA is a trademarked method with specific accounting adjustments.
Can SVA be negative?
Yes, a negative SVA means the business earned less than the return required by its investors, so it destroyed value even if it reported an accounting profit.
How is SVA used in pay plans?
Bonuses linked to SVA reward managers for earning more than the cost of capital, and they discourage holding idle assets.
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