Economic Value Added (EVA)
Economic Value Added (EVA) is a comprehensive financial metric. This is one of the reasons why EVA is used for value-based incentives and indexed bonus targets. It is also the basis for indexing operating performance (see Strategy Index).
As we have seen in the metric wars of the 1990s, what is important about EVA, and perhaps what makes it more successful than similar metrics, is not simply what it measures but how it is used. EVA requires that the cost of capital be assessed not only in valuations but also in measuring operating performance. Thus EVA makes possible the use of one metric for three related aspects of value-based performance management: capital allocation, performance assessment, and incentive compensation. EVA is calculated as follows:
Economic Value Added (EVA) = Net Operating Profit after Taxes (NOPAT) - Capital Charge
Net Operating Profit after Taxes = Adjusted Net Operating Profit Before Taxes * (1 - tax rate)
Adjusted Net Operating Profit Before Taxes = Earnings Before Interest and Taxes (EBIT) - Adjustments
Capital Charge = Average Invested Capital * Cost of Capital
Invested Capital = Fixed Assets + Net Working Capital (NWC) (Average Invested Capital is calculated from the beginning and end of the period.)
Net Working Capital = Current Assets - Cash and Cash Equivalents - Current Liabilities + Current Portion of Interest-Bearing Debt (in current assets)
EVA can be split into its value sources by the value driver tree. To do this, the financial metrics have to be indexed by the method of indexing operating performance. The most important tools for this are Operating Rank, Operating Radar, and Operating Contribution. These indexing tools split Economic Value Added into its components without external effects diluting operating performance measurement. A list of all indexing tools is here.
Adjustments eliminate non-operating and accounting-related positions in profits that dilute the economic picture of performance. Adjusted items include:
- Goodwill and intangible assets
- Non-operating positions
- Volatile cost components
- Large investments
Accountants typically find all the necessary adjustments by hypothetically asking themselves if they would accept their remuneration having to depend on the resulting profit. The necessary adjustments quickly become apparent. The guiding principle is only to adjust profits in a way that is discounted cash flow neutral: costs can be capitalized but not eliminated, while depreciation can be omitted but the associated assets remain on the balance sheet. It is important that the resulting NOPAT stays close to the official profit declaration because every change requires an explanation. The resulting NOPAT is the input for EVA.
Tax Treatment in EVA
In order to calculate NOPAT for EVA, one has to assess the impact of taxes. This can be accomplished by calculating actual taxes for the period under observation from paid taxes and changes in the tax positions on the balance sheet. It is important to calculate exactly what taxes are due for that period independent of when those taxes are actually paid. Very often this approach is too complicated for non-financial managers, in which case a flat tax rate may be used. Tax adjustments focus operating management on operating issues and define EVA as a purely operating performance metric. If the tax situation changes, the tax rate is adjusted in advance.
Cost of Capital
In traditional accounting using Generally Accepted Accounting Principles (GAAP), the interest paid on any debt appears as a cost on corporate balance sheets, yet there is no corresponding cost for shareholder's equity. But of course, there is an opportunity cost to equity financing, and shareholders expect a competitive return on their investment every bit as much as creditors do. Including the Cost of Capital in measuring operating performance and economic profit is perhaps the single most important adjustment made to GAAP in EVA and Value-Based management.
There are two general methods for calculating Cost of Capital, the equity method, and the entity method. In the equity method, the Cost of Capital is simply the expected return on all invested equity. In the entity method, the Cost of Capital is a weighted average of the cost of equity and the cost of debt: the weighted-average cost of capital (WACC).
The cost of debt can be identified directly from existing debt obligations or from the house bank. The cost of equity cannot be measured directly and is typically derived from historic equity returns observed in the market. One method of calculating the cost of equity capital is the Capital Asset Pricing Model (CAPM). This model calculates the cost of equity by multiplying a standard market risk premium by a risk factor beta (plus the risk-free-rate). Since beta is difficult to measure for individual companies due to a lack of liquidity and data points, generic industry betas are often used to assess the appropriate beta, though more involved, company-specific calculation methods are possible.
Cost of Capital is used to calculate the Capital Charge in EVA. Click here for more detailed information about calculating Capital Charge, including when to use each of the equity and entity methods.
The Capital Charge is the absolute dollar value that is expected by investors as a book return on the capital provided. This amount is derived by multiplying invested capital with the cost of capital. There are two methods of calculating invested capital:
- The Entity Method: Invested capital is the sum of equity and debt with cash and cash equivalents subtracted. This method is used by companies where financing is not part of business operations (see also the Non-Financials Value Driver Tree).
- The Equity Method: Invested capital equals book equity. This method is used by companies where financing is part of business operations, such as banks, insurance companies, and real estate developers (see also the Financials Value Driver Tree).
Capital Charge is used to calculate EVA.