 ## 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 Value Added (EVA).

### Economic Value Added (EVA) concept

Economic value added (EVA) is the 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)

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).

ABC Company

Abstract of the Revenue Statement

#### #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 .

#### #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:

• RD =
• Tc = Tax Rate
• D = Capital invested in the organization through Debt.
• V = Total Value of the firm simply calculated as Debt + Equity.
• RE =
• E = Capital invested in the organization through Equity

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

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:

### Colgate Economic Value Added Example EVA

#### #1 – Calculating Colgate’s NOPAT

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

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, , 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’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.

source: Colgate SEC Filings

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

• (2016) = \$1,152/\$3,738 = 30.82%

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

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

#### #2 – Colgate’s Invested Capital

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

source: Colgate SEC Filings

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

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

source: Colgate SEC Filings

Adjusted Equity = Colgate + 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

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

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
• Ke = Rf + (Rm – Rf) x Beta

source – bankrate.com

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

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

source: ycharts

• Cost of Equity = 2.17% + 6.25% x 0.805
• Cost of Equity of Colgate = 7.2%
• Interest Expense (2016) = \$99
• Total Debt (2016) = \$13 + \$0 + \$6,520 = \$6,533 million
• (2016) = \$99/6533 = 1.52%

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.

• Wealth maximization is more important as compared to profit maximization. There is a difference between the two. Wealth Maximization aims to accelerate the worth of the organization as a whole. Maximizing profit can be said to be a subset of maximizing wealth. EVA focuses on wealth creation.
• Economic Value Added (EVA) takes into account the Weighted Average Cost of Capital. It goes with the logic that it is important to cover the cost of equity and not just the interest portion of the debt.
• Organizations tend to focus on profits and ignore the cash flow. This often leads to a liquidity crunch and can also lead to bankruptcy. Economic Value Added (EVA) focuses on more than profits.
• By taking the Weighted Average Cost of Capital, it takes into account both short-term as well as long-term perspectives.

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.

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.