Economic Value Added (EVA)

What is Economic Value Added?

Economic value added (EVA) is a measure of surplus value created on a given investment. When a person is investing his funds, he does this only because he expects to earn a profit from the investment. Let us say, gold seems to be a good instrument to invest with a high-profit margin.

  • Total investment (i.e., price at which gold is purchased) = $ 1000
  • Brokerage paid to the dealer for the purchase of gold = $ 15

In a year, I would like to sell off the gold on account of a liquidity crunch.

  • The selling price of gold = $ 1200
  • Brokerage paid to the dealer on sale of gold = $ 10

In the above Economic Value Added example,

  • Economic Value Added = Selling price – Expenses associated with selling the asset – Purchase price – Expenses associated with buying the asset
  • Economic Value Added = $ 1200 – $ 10 – $ 1000 – $ 15 = $ 175

If we just see the profit, then the profit on selling gold was $ 1200 – $ 1000, i.e., $ 200. But the actual creation of wealth is only $ 175 on account of expenses incurred. This is a very crude example of EconomicExample Of EconomicEconomic examples will help you gain insight into the various economic theories and factors and their impact on the overall economy. Some of these factors illustrated are opportunity cost, demand and supply, sunk cost, the law of diminishing marginal utility and the trade war.read more Value Added (EVA).

In this article, we discuss Economic Value added in detail –

Economic Value Added (EVA) concept

Economic value added (EVA) is the economic profitEconomic ProfitEconomic profit refers to the income acquired after deducting the opportunity and explicit costs from the business revenue (i.e., total income minus overall expenses). It is an internal analysis metric used by the organizations along with the accounting profits.read more by the company in a given period. It measures the 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.

It helps to capture the true economic profit of a company like we calculated the Economic Value Added of investing gold in the above. Economic Value Added example was developed and trademarked by Stern Stewart and Co. as an internal financial performance measure.

EVA Formula

The three main components of Economic Value Added (EVA) are:

  1. Net Operating Profit After Tax
  2. Capital Invested
  3. WACC, i.e., the Weighted Average Cost of Capital

Economic Value Added can be calculated with the help of the following formula:

Economic Value Added EVA formula= Net Operating Profit After Tax – (Capital Invested x WACC)

Economic-Value-Added

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For eg:
Source: Economic Value Added (EVA) (wallstreetmojo.com)

Here, Capital Invested x WACC stands for the cost of capital. This cost is deducted from the Net Operating Profit After Tax to arrive at the economic profit or the residual wealth created by the organization.

Economic Value Added Example (Basic)

#1 – EVA Formula – Net Operating Profit After Tax (NOPAT)

This represents how much will be the company’s potential cash earnings without its capital cost. It is important to deduct tax from the Operating Profit to arrive at the true operating inflow that a company will earn.

NOPAT = Operating Income x (1 – Tax Rate).

EVA Example for calculating Net Operating IncomeNet Operating IncomeNet Operating Income (NOI) is a measure of profitability representing the amount earned from its core operations by deducting operating expenses from operating revenue. It excludes non-operating costs such as loss on sale of a capital asset, interest, tax expenses.read more After Tax is as follows:

ABC Company

Abstract of the Revenue Statement

Particulars20162015
Revenue:
Project Advisory Fees$ 2,00,000$ 1,86,000
Total Revenue (A)$ 2,00,000$ 1,86,000
Expenses:
Direct Expenses$ 1,00,000$ 95,000
Total Operating Expenses (B)$ 1,00,000$ 95,000
Operating Income (C = A minus B)$ 1,00,000$ 91,000
Tax Rate30%30%
Tax on operating income (D = C * Tax Rate)$ 30,000$ 27,300
Net Operating Income After Tax (C minus D)$ 70,000$ 63,700

#2 – EVA Formula – Capital Invested

This represents the total capital invested through equity or debt in a given company.

Continuing with the above EVA example of ABC Company, let us say the company has a total invested capital of $ 30,000. Of this, $ 20,000 is through equity funding, and the rest ($ 10,000) is by means of long term debtTerm DebtLong-term debt is the debt taken by the company that gets due or is payable after one year on the date of the balance sheet. It is recorded on the liabilities side of the company's balance sheet as the non-current liability.read more.

Also, have a look at Return on Invested Capital RatioReturn On Invested Capital RatioReturn on Invested Capital (ROIC) is a profitability ratio that shows how a company uses its invested capital, such as equity and debt, to generate profit. The reason this ratio is so crucial for investors before making an investment is that it helps them decide which firm to invest in.read more

#3 – EVA Formula – WACC

The weighted Average Cost of Capital is the cost the company incurs for sourcing its funds. The importance of deducting the cost of capital from the Net Operating Profit is to deduct the opportunity cost of the capital invested. The formula to calculate the same is as follows:

WACC = RD (1- Tc )*( D / V )+ RE *( E / V )

The formula looks complicated, scary, but if understood, it is fairly simple. It is much easier if the formula is put in words as follows:

Weighted Average Cost of Capital = (Cost of Debt) * (1 – Tax Rate) * (Proportion of debt) + (Cost of Equity) * (Proportion of equity)

This makes the formula easier to understand and also self-explanatory.

Now, understanding the notations of the formula:

An important point to note about this formula is that the Cost of Debt is multiplied by (1 – Tax Rate) as there is tax saving on interest paid on debt. On the other hand, there is no tax saving on the cost of equity, and hence the tax rate is not taken into account.

Let us now look at how WACC is calculated.

ABC Company

Balance Sheet of the Company

Particulars20162015
Equity$20,000$17,000
Debt$10,000$ 7,000
Sources of Funds (A)$30,000$24,000
Fixed AssetsFixed AssetsFixed assets are assets that are held for the long term and are not expected to be converted into cash in a short period of time. Plant and machinery, land and buildings, furniture, computers, copyright, and vehicles are all examples.read more$20,000$18,000
Current AssetsCurrent AssetsCurrent assets refer to those short-term assets which can be efficiently utilized for business operations, sold for immediate cash or liquidated within a year. It comprises inventory, cash, cash equivalents, marketable securities, accounts receivable, etc.read more$20,000$16,000
Less: Current Liabilities$10,000$10,000
Uses of Funds (B)$30,000$24,000
Cost of Debt8%8%
Cost of Equity10%12%

WACC for the year 2016

  • = 8% * (1- 30%) * ($ 10,000 / $ 30,000) + 10% * ($ 20,000 / $ 30,000)
  • = (8% * 70% * 1/3) + (10% * 2/3) = 1.867% + 6.667% = = 8.53%

WACC for the year 2015

  • = 8% * (1- 30%) * ($ 7,000 / $ 24,000) + 12% * ($ 17,000 / $ 24,000)
  • = (8% * 70% * 7/24) + (10% * 17/24) = 1.63% + 8.50% = 10.13%

#4 – Economic Value Added EVA Calculation

From the above, we have all three factors ready for Economic Value Added calculation for the year 2016 and 2015.

Economic Value Added (EVA) for the year 2016 = Net Operating Profit After Tax – (Capital Invested * WACC)

  • = $ 70,000 – ($ 30,000 * 8.53%)
  • = $ 70,000 – $ 2,559 = = $ 67,441

Economic Value Added (EVA) for the year 2015 = Net Operating Profit After Tax – (Capital Invested * WACC)

  • = $ 63,700 – ($ 24,000 * 10.13%)
  • = $ 63,700 – $ 2,432 = = $ 61,268

Accounting adjustments for EVA Calculation

Now since we have understood the basics of EVA calculation, let us go a bit further to understand what can be some of the real-life accounting adjustments involved especially at the Operating Profit level:

Sr. No.AdjustmentExplanationChanges to Net Operating ProfitChanges to Capital EmployedCapital EmployedCapital employed indicates the company's investment in the business, i.e., the total amount of funds used for expansion or acquisition and the entire value of assets engaged in business operations. "Capital Employed = Total Assets - Current Liabilities" or "Capital Employed = Non-Current Assets + Working Capital."read more
1Long-term expensesThere are certain expenses that can be classified as long-term expenses such as research and development, branding of a new product, re-branding of old products. These expenses may be incurred in a given period of time but generally have an effect over and above a given year.
These expenses should be capitalized while EVA calculation as they generate wealth over a period of time and not just reduce profit in a given year.
Add to Net Operating ProfitAdd to Capital Employed.
Also, check out Return on Capital EmployedReturn On Capital EmployedReturn on Capital Employed (ROCE) is a metric that analyses how effectively a company uses its capital and, as a result, indicates long-term profitability. ROCE=EBIT/Capital Employed.read more
2DepreciationLet us categorize depreciation as accounting depreciation and economic depreciation for the purpose of understanding. Accounting depreciation is one which is calculated as per Accounting policies and procedures. In contrast, economic depreciation is one that takes into account the true wear and tear of the assets and should be calculated as per the usage of assets rather than a fixed useful life.Add accounting depreciation
Reduce economic depreciation
The difference in the value of accounting depreciation and economic depreciation should be adjusted from the capital employed
3Non-cash expensesThese are expenses that do not affect the cash flow of a given period.
EVA Example: Foreign exchange contracts are reported at fair value as on the reporting date. Any loss incurred is charged to the Income Statement. This loss does not lead to any cash outflow and should be added back to the Net Operating Profit.
Add to Net Operating ProfitAdd to capital employed by adding it to Retained EarningsRetained EarningsRetained Earnings are defined as the cumulative earnings earned by the company till the date after adjusting for the distribution of the dividend or the other distributions to the investors of the company. It is shown as the part of owner’s equity in the liability side of the balance sheet of the company.read more
4Non-cash incomesSimilar to non-cash expenses, there are non-cash incomes which do not affect the cash flow of a given period. These should be subtracted from the Net Operating Profit.Subtract from Net Operating ProfitSubtract from capital employed by subtracting it from Retained Earnings
5ProvisionsTo arrive at accounting profits, numerous provisions are created, such as deferred taxDeferred TaxDeferred Tax is the effect that occurs in a firm as a result of timing differences between the date when taxes are actually paid to tax authorities by the company and the date when such tax is accrued. Simply put, it is the difference in taxes that arises when taxes due in one of the accounting period are either not paid or overpaid.read more provisions, provision for doubtful debts, provision for expenses, allowance for obsolete inventory, etc. These are provisional figures and do not actually affect the economic profit. In fact, these provisions are generally reversed on the first day of the next reporting period.Add to Net Operating ProfitAdd to capital employed
6TaxesTax should also be calculated on actual cash outflow rather than the mercantile system where all accruals are taken into account, and only then tax is deducted.Tax is supposed to be deducted after calculating Net Operating Profit. So it is directly deducted, and no other adjustments are required.

Colgate Economic Value Added Example EVA

#1 – Calculating Colgate’s NOPAT

Let us have a look at the Income Statement of Colgate.

Colgate EVA NOPAT

source: Colgate SEC Filings

  • The operating Profit of Colgate in 2016 is $3,837 million

The operating profit above does contain noncash items like Depreciation and Amortization, Restructuring costsRestructuring CostsRestructuring Cost is the one-time expense incurred by the company in the process of reorganizing its business operations. It is done to improve the long term profitability and working efficiency. This expenditure is treated as the non-operating expenses in the financial statements.read more, etc.

In our EVA example, we assume that the book depreciation and economic depreciation are the same for Colgate, and hence, no adjustment is needed when we calculated NOPAT.

However, restructuring cost needs to be adjusted for. Below is the snapshot of Colgate’s restructuring costs from its Form 10K.

Colgate EVA NOPAT Step 2
  • Colgate’s restructuring charges in 2016 = $228 million

Adjusted Operating Profit = Operating Profit + Restrucutring Expenses

  • Adjusted Operating Profit (2016) =  $3,837 million + $228 million = $4,065 million

For calculating NOPAT, we required the tax rates.

We can calculate the effective tax rates from the income statement below.

Colgate WACC Calculation - Step 5

source: Colgate SEC Filings

Effective Tax rate = Provision for Income Taxes / Income Before income taxes

NOPAT = Adjusted Operating Profit x (1-tax rate)

  • NOPAT (2016) = $4,065 million x (1-0.3082) = $2,812 million

Also, check out an article on Non-recurring itemsNon-recurring ItemsNon-recurring items are income statement entries that are unusual and unexpected during regular business operations; examples include profits or losses from sale of asset, impairment costs, restructuring costs, and losses in lawsuits, and inventory write-off.read more

#2 – Colgate’s Invested Capital

Let us now calculate the second item required for calculating Economic Value Added, i.e., Invested Capital.

Colgate EVA Invested Capital

source: Colgate SEC Filings

Invested capital represents the actual debt and equity invested in the company.

Total Debt = Notes and Loan Payable + Current Portion of Long-Term DebtCurrent Portion Of Long-Term DebtCurrent Portion of Long-Term Debt (CPLTD) is payable within the next year from the date of the balance sheet, and are separated from the long-term debt as they are to be paid within next year using the company’s cash flows or by utilizing its current assets.read more + Long Term Debt

  • Total Debt (2016) = $13 + $0 + $6,520 = $6,533 million
Colgate EVA Net Deferred Taxes

source: Colgate SEC Filings

Adjusted Equity = Colgate Shareholders EquityShareholders EquityShareholder’s equity is the residual interest of the shareholders in the company and is calculated as the difference between Assets and Liabilities. The Shareholders' Equity Statement on the balance sheet details the change in the value of shareholder's equity from the beginning to the end of an accounting period.read more + Net Deferred tax + Non Controlling Interest + Accumulated Other comprehensive (income) loss

  • Adjusted Equity (2016) = -$243 + $55 + $260 + $4,180 = $4,252 million

Colgate’s Invested Capital (2016) = Debt (2016) + Adjusted Equity (2016)

  • Colgate’s Invested Capital (2016) = $6,533 million + $4,252 million = $10,785 million

#3 – Find WACC of Colgate

Colgate WACC Calculation - Step 1

We note from above that Colgate’s number of shares = 882.85 million

Current Market Price of Colgate = $72.48 (as of closing 15th September 2017)

Market value of equity of Colgate = 72.48 x 882.85 = $63,989 million

Colgate WACC Calculation - Step 2

As we have earlier noted,

Total Debt = Notes and Loan Payable + Current Portion of Long-Term Debt + Long Term Debt

  • Total Debt (2016) = $13 + $0 + $6,520 = $6,533 million

Let us now find the cost of equity of Colgate using CAPM modelCAPM ModelThe Capital Asset Pricing Model (CAPM) defines the expected return from a portfolio of various securities with varying degrees of risk. It also considers the volatility of a particular security in relation to the market.read more

  • Ke = Rf + (Rm – Rf) x Beta

We note from below that the risk-free rateRisk-free RateA risk-free rate is the minimum rate of return expected on investment with zero risks by the investor. It is the government bonds of well-developed countries, either US treasury bonds or German government bonds. Although, it does not exist because every investment has a certain amount of risk.read more is 2.17%

Colgate WACC Calculation - Step 3

source – bankrate.com

For the United States, Equity Risk Premium is 6.25%.

us-risk-premium-wacc

source – stern.nyu.edu

Let us look at the Beta of Colgate. We note that Colgate’s  Beta has increased over the years. It is currently 0.805

Colgate-WACC-Calculation-Step-4

source: ycharts

Also, check out the article on CAPM Beta CalculationCAPM Beta CalculationCAPM Beta is an essential theoretical measure of how a single stock moves with respect to the market. In this method, we determine the cost of equity by summing up the beta and risk premium product with the risk-free rate.read more

  • Cost of Equity = 2.17% + 6.25% x 0.805
  • Cost of Equity of Colgate = 7.2%
Colgate WACC Calculation - Step 6

Let us now calculate WACC

  • Market Value of Equity = $63,989 million
  • Value of Debt = $6,533 million
  • Cost of Equity = 7.20%
  • Cost of Debt = 1.52%
  • Tax rate = 30.82%

WACC = E/V * Ke + D/V * Kd * (1 – Tax Rate)

WACC = (63,989/(63,989+6,533)) x 7.20% + (6,533 /(63,989+6,533)) x 1.52% x (1-0.3082)

WACC = 6.63%

#4 – Colgate’s Economic Value Added EVA Calculation

Economic Value Added formula= Net Operating Profit After Tax – (Capital Invested x WACC)

  • Colgate’s NOPAT (2016) = $4,065 million x (1-0.3082) = $2,812 million
  • Colgate’s Invested Capital (2016) = $6,533 million + $4,252 million = $10,785 million
  • Economic Value Added (Colgate) = $2,812 million – $10,785 million x 6.63%
  • Economic value added = $2097 million

What is the importance of EVA?

The very basic objective of every business is to maximize shareholder value. The investor is the key stakeholder around which all business activities are focused.

The key factors which are important while maximizing shareholder valueShareholder ValueShareholder's value is the value that company shareholders receive as dividends and stock price appreciation due to better decision-making by the management that ultimately results in a company's growth in sales and profit.read more are:

Advantages and disadvantages

Like any other financial ratio/indicator, even Economic Value Added (EVA) has its own sets of advantages and disadvantages. Let us have a look at the basic pointers for the same.

Advantages of using Economic Value Added (EVA):

  1. As discussed above, it helps to give a clear picture of wealth creation as compared to other financial measures used for analysis. It takes into account all costs, including the opportunity cost of equity, and it does not stick to accounting profits.
  2. It is comparatively simple to understand.
  3. EVA can also be calculated for different divisions, projects, etc. and the appropriate investment decisions can be taken for the same
  4. It also helps to develop a relationship between the use of capital and Net Operating Profit. This can be analyzed to make the most out of opportunities and also make appropriate improvements wherever necessary.

Disadvantages of using Economic Value Added (EVA):

  1. There are a lot of assumptions involved in calculating the Weighted Average Cost of Capital. It is not easy to calculate the cost of equity, which is a key aspect of WACC. On account of this, there are chances that EVA itself can be perceived to be different for the same organization, and for the same period as well. In the above Economic Value Added example, the cost of equity has changed from the year 2015 to the year 2016. This can be one of the major factors due to a decrease in EVA.
  2. Apart from the WACC, there are other adjustments also which are required to the Net Operating Profit After Tax. All non-cash expenses need to be adjusted. This becomes difficult in case of an organization with multiple business units and subsidiaries.
  3. A comparative analysis is difficult with Economic Value Added (EVA) on account of the underlying assumptions of WACC.
  4. EVA is calculated on historical data, and future predictions are difficult.

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