Economic value added (EVA) is a financial measurement of the return earned by a firm that is in excess of the amount that the company needs to earn to appease shareholders. In other words, it is a measure of an organization’s economic profit that takes into account the opportunity cost of invested capital and ultimately measures whether organizational value was created or lost.
EVA compares the rate of return on invested capital with the opportunity cost of investing elsewhere. This is important for businesses to keep track of, particularly those businesses that are capital intensive. When calculating economic value added, a positive outcome means that the company is creating value with its capital investments.
Conversely, a negative outcome would mean that the company is destroying value with its capital investments and the capital would be better spent elsewhere. Businesses can use economic value added to assess managerial performance as it serves as a measure of value creation for shareholders.
The EVA formula is calculated using the following equation:
EVA = NOPAT – ( capital x cost of capital )
EVA = NOPAT – (WACC * capital invested)
Where NOPAT = Net Operating Profits After Tax
WACC = Weighted Average Cost of Capital
Capital invested = Equity + long-term debt at the beginning of the period
and (WACC* capital invested) is also known as finance charge
Let’s look at an example.
Paul is the CFO of an organization in Boston. In order to assess the organization’s value creation or destruction, Paul would like to calculate economic value added for 2015. The organization’s NOPAT is $3,500,000, cost of capital is 5%, and the organization employed 1,000,000 in capital in 2015.
By plugging the values into the EVA calculation above, we can compute the value that Paul needs:
$3,500,000 – ( 1,000,000 x 5% ) = $3,450,000
Paul’s organization had a total added value amount of $3,450,000 in 2015.