How to Calculate Economic Value Added

Economic Value Added (EVA) is a financial metric that assesses a company’s true economic profit. It goes beyond traditional accounting profit by considering the cost of all capital a business employs. EVA determines if a company generates wealth for its shareholders by highlighting whether operations create value after accounting for the full cost of financing assets.

Understanding Economic Value Added

Economic Value Added provides a deeper understanding of corporate performance than conventional accounting metrics. A company creates value only when its operating profit surpasses the total cost of the capital used to generate that profit. This includes both debt and equity capital, as both have an associated cost that must be covered. A business earning less than its capital cost erodes value, even with positive accounting profit.

This comprehensive view ensures resources are allocated to their most productive uses. EVA aligns management decisions with shareholder interests. By factoring in the cost of all capital, EVA encourages managers to make investments and operational choices that yield returns greater than their financing expense. It promotes efficient capital deployment and discourages investments that increase revenue but fail to cover capital costs.

Breaking Down the EVA Components

Calculating Economic Value Added requires determining its individual components: Net Operating Profit After Tax (NOPAT), Invested Capital, and the Weighted Average Cost of Capital (WACC). Accurately deriving these components is fundamental to performing a meaningful EVA analysis.

Net Operating Profit After Tax (NOPAT)

Net Operating Profit After Tax (NOPAT) represents a company’s profit from core operations after taxes, but before financing costs. To calculate NOPAT, start with earnings before interest and taxes (EBIT) from the income statement. Interest expense is excluded to isolate operational profitability. EBIT is then adjusted for taxes using the company’s effective tax rate. For instance, if a company has an EBIT of $100 million and a tax rate of 21%, its NOPAT would be $79 million ($100 million (1 – 0.21)). This calculation provides a clear picture of core business performance independent of capital structure.

Invested Capital

Invested Capital represents the total money a company has invested in its operating assets. This figure reflects the capital base expected to generate a return. One common approach to calculate Invested Capital is to sum a company’s total debt and total equity from its balance sheet. Alternatively, it can be calculated by taking total assets and subtracting non-interest-bearing current liabilities, such as accounts payable and accrued expenses. The aim is to capture all capital that requires a return, whether financed by lenders or shareholders, to support the company’s operations.

Weighted Average Cost of Capital (WACC)

The Weighted Average Cost of Capital (WACC) is the blended average cost of all capital sources a company uses, including debt and equity. It represents the minimum rate of return a company must earn on its assets to satisfy creditors and shareholders. WACC is a crucial discount rate used in financial valuation and capital budgeting decisions. Its calculation involves determining the cost of each capital component and weighting them by their proportion in the overall capital structure.

##### Cost of Equity (Ke)

The Cost of Equity (Ke) is the return a company’s shareholders require for their investment. The Capital Asset Pricing Model (CAPM) is a widely used method for estimating Ke. The CAPM formula is: Risk-Free Rate + Beta (Market Risk Premium).

The risk-free rate is typically the yield on a long-term U.S. Treasury bond, representing the return on a theoretically risk-free investment. Beta measures the stock’s volatility relative to the overall market; a beta of 1.0 indicates the stock moves with the market, while a beta greater than 1.0 suggests higher volatility. The market risk premium is the expected return of the market minus the risk-free rate, representing the additional return investors demand for investing in the stock market over a risk-free asset.

##### Cost of Debt (Kd)

The Cost of Debt (Kd) is the effective interest rate a company pays on its borrowings. This can be estimated by looking at the yield to maturity on outstanding bonds or by observing current interest rates on new debt issuances with similar risk profiles. Since interest payments are generally tax-deductible, the relevant cost of debt for WACC calculation is after-tax. The after-tax cost of debt is calculated by multiplying the pre-tax cost of debt by (1 minus the corporate tax rate). For example, if a company’s pre-tax cost of debt is 5% and the corporate tax rate is 21%, its after-tax cost would be 3.95% (5% (1 – 0.21)).

##### Capital Structure Weights

Determining capital structure weights involves calculating the proportion of equity and debt in the company’s total capital. These weights are typically based on the market values of equity and debt, as market values reflect current investor perceptions and the true cost of raising new capital. The market value of equity is found by multiplying the current share price by the number of outstanding shares. The market value of debt can be estimated by summing the market values of all outstanding bonds and loans. Once calculated, these market values determine the percentage each component represents of the total capital.

Combining these components, the WACC formula is: (Cost of Equity Weight of Equity) + (After-Tax Cost of Debt Weight of Debt). For instance, if the cost of equity is 10% (60% of capital) and the after-tax cost of debt is 4% (40% of capital), the WACC would be 7.6% (10% 0.60 + 4% 0.40). This percentage represents the average return the company must achieve on investments to satisfy all capital providers.

Performing the EVA Calculation

After determining Net Operating Profit After Tax (NOPAT), Invested Capital, and the Weighted Average Cost of Capital (WACC), the final step is to calculate Economic Value Added (EVA). The formula is: EVA = NOPAT – (Invested Capital WACC). This subtracts the capital charge (cost of using capital) from operating profit after taxes.

Consider a hypothetical company with NOPAT of $150 million, Invested Capital of $1 billion, and WACC of 8%. First, determine the capital charge: $1 billion 0.08 = $80 million. This $80 million is the minimum return required to cover the cost of all employed capital.

Next, subtract this capital charge from NOPAT. EVA = $150 million – $80 million, resulting in an EVA of $70 million. This positive figure indicates the company generated $70 million in economic profit above its capital cost, satisfying debt holders and equity investors.

Conversely, if NOPAT were $70 million with the same Invested Capital and WACC, EVA would be $70 million – ($1 billion 0.08) = -$10 million. This negative EVA signals the company did not generate enough operating profit to cover its cost of capital, indicating economic value destruction.

Interpreting and Applying EVA

The calculated Economic Value Added (EVA) figure indicates a company’s economic performance. A positive EVA signifies the company generated more profit than its capital cost, creating economic value for shareholders. Conversely, a negative EVA indicates operating profit did not cover capital cost, destroying economic value. A zero EVA implies the company earned just enough to cover its capital cost, without creating additional value.

Companies use EVA as a performance measurement tool. Management teams integrate EVA into capital allocation decisions, prioritizing projects projected to generate positive EVA. EVA is also linked to executive compensation structures, incentivizing managers to enhance value creation. By tying incentives to EVA targets, companies encourage efficient resource management and profitable growth. Companies use EVA to communicate their value creation story to investors, demonstrating a commitment to maximizing shareholder returns.