Economic Value Added
Economic value added (EVA) is a measure of a company's financial performance based on the residual wealth calculated by deducting its cost of capital from its operating profit, adjusted for taxes on a cash basis. EVA can also be referred to as economic profit, as it attempts to capture the true economic profit of a company. This measure was devised by management consulting firm Stern Value Management, originally incorporated as Stern Stewart & Co.
Economic Value Added (EVA)
Definition
Economic Value Added (EVA) is a financial performance metric based on a company's net asset value. It is calculated by subtracting the cost of capital from the operating profit before tax and then adjusting it to a cash basis after-tax amount. EVA aims to capture the true economic profit of a company, hence it is also known as economic profit.
Origin
EVA was conceived by the management consulting firm Stern Value Management, originally known as Stern Stewart & Co. The metric gained popularity in the late 1980s and early 1990s, becoming an important tool for measuring corporate financial performance.
Categories and Characteristics
EVA has the following key characteristics:
- True Reflection of Economic Profit: By deducting the cost of capital, EVA provides a more accurate reflection of a company's economic profit, not just its accounting profit.
- Focus on Capital Efficiency: By considering the cost of capital, EVA encourages companies to use capital more efficiently and improve investment returns.
- Long-term Perspective: EVA emphasizes long-term value creation, discouraging short-term behavior.
Specific Cases
Case 1: A company has an operating profit before tax of 5 million yuan in a given year, a capital cost of 2 million yuan, and a tax rate of 30%. The EVA calculation for this company is as follows:
After-tax operating profit = 5 million yuan × (1 - 30%) = 3.5 million yuan
EVA = 3.5 million yuan - 2 million yuan = 1.5 million yuan
The company created an economic value added of 1.5 million yuan in that year.
Case 2: Another company has an operating profit before tax of 10 million yuan in a given year, a capital cost of 8 million yuan, and a tax rate of 25%. The EVA calculation for this company is as follows:
After-tax operating profit = 10 million yuan × (1 - 25%) = 7.5 million yuan
EVA = 7.5 million yuan - 8 million yuan = -0.5 million yuan
The company did not create economic value added in that year, instead, it incurred a loss of 0.5 million yuan.
Common Questions
Question 1: Why does EVA reflect a company's economic performance better than net profit?
Answer: Because EVA takes into account the cost of capital, whereas net profit does not. EVA provides a more accurate reflection of the economic value created for shareholders.
Question 2: How can a company improve its EVA?
Answer: A company can improve its EVA by increasing operating profit, reducing the cost of capital, or using capital more efficiently.
