The economic value added method (EVA) for stock, simply means the amount of profit the company makes that exceeds the investor’s minimum required returns.
Given these terms, every business begins operations with the notion that it will be profitable.
However, comparing the success of the business, you should also look at how well the company’s management exceeds the minimum expectations of a shareholder.
Thus, what EVA seeks to do is develop a rationale for exploring how successful a business is in exceeding the expectations of its shareholders.
If a company is successful, the economic value added as high, and the management of the company would be considered a success in operation of the company.
The equation for working out EVA is straightforward.
EVA simply equals the net operating profits after taxes minus the product of the required rate of return times the net assets of the business, or simply put, its invested capital.
Economic Value Added (EVA) = NOPAT – (WACC x Capital Invested)
- The net operating profits after taxes (NOPAT) are simply the total profits of the company after it has paid all of its income taxes.
- The WACC in this situation is the required rate of return demanded by the investors, which is usually represented as a percentage.
- The capital invested is the total capital employed by the company over a particular period of time.
In 2015, company A reported a net operating profit of $16 million, and the company achieved an effective tax rate of 29.50%.
Company A’s capital structure was developed as follows:
- 65% of the company’s capital was raised through equity financing, with a cost of equity being at 6.5%
- 35% of the company’s capital was financed by debt financing, with an after-tax cost of 4.2% of debt
In the given year, the company employed a total capital of $84 million to implement new expansion projects and maintain its current operations.
In order to find this company’s EVA, we must first calculate the NOPAT and the WACC, like so:
NOPAT = Net Operating Profit x (1 – Effective Tax Rate) = $11.28 million
WACC = 65% x 0.065 + 35% x 0.042 = 5.695%
After calculating the NOPAT and the WACC, we simply plug the figures into the EVA formula:
Economic Value Added (EVA) = $11.28 – 5.695% x $84 = $6.50 million
In order for the EVA to give an accurate representation of the economic value of a company, there are certain adjustments that have to be made in order to represent the success of that company.
There are several common adjustments that investors and businesses may want to consider.
One of the largest adjustments is research and development. R&D can be looked upon as both a current expense, as well as in amortized expense, as it has a longer life than other expenses related to the business.
R&D, in essence, is an investment in a company’s future and, as such, needs to have its expenses properly adjusted in the net operating profits.
Other items that need to factor into the adjustments are long-term assets that may be intangibles, such as brand names or company investments.
All of these items will affect the net operating profits of the company and must be accounted for in EVA analysis.
The analysis of EVA is simply one measure or yardstick if you will of how successful company is operated by its management.
Corporate finance is often difficult to know with certainty whether a specific management group is successful or not a meeting the challenges and needs of businesses or shareholders.
To overcome any potential bias towards a particular management team, the EVA gives a simple indication as to how successful the business’ management team has been in creating wealth and exceeding the expected returns of investors.