FREE online courses on Financial Management and Creating Value - Chapter 3 -
Economic Value Added - EVA
Probably the most widely used approach to measuring
value-creation is Economic Value Added or EVA. EVA has been popularized by Stern
Stewart, a major consulting firm which holds the registered trademark for EVA?.
Many large American corporations have adopted EVA: Boise Cascade, Coca-Cola,
Whirlpool, Eli Lilly, Monsanto to name a few. EVA like all value-based metrics
departs from the traditional accounting model. The basic equation for
calculating EVA is:
EVA = NOPAT - Cost of Capital
NOPAT: Net Operating Profits After Taxes. This is Operating
Profits less taxes but before financing costs and non-cash entries (although not
depreciation). NOPAT is the residual income we have generated on the capital
invested.
Cost of Capital: This is the charge for use of capital. It
includes interest on the debt and a charge for the equity capital based on a
cash equivalent equity x cost of equity rate.
The idea behind EVA is rooted in economic income as opposed
to accounting income. As economic income moves up or down, so goes the value of
the business. The problem is that calculating economic income is not easy; it
requires hundreds of adjustments. For example, under traditional accounting we
would expense cash disbursed for research and development (R & D), but in
arriving at economic income we would capitalize R & D since it provides a future
economic benefit. The list of adjustments from accounting to economic is
extensive: depreciation, gains / losses, reserves, deferred taxes, etc. Since
EVA is at the center of Value Based Management, it is important to keep the
number of adjustments to those material items that significantly distort value.
This is important since managers throughout the entire organization will need to
understand how EVA is calculated. Keeping EVA simple will go a long way towards
successful implementation.