How to Calculate EVA (Economic Value Added)

Economic Value Added (EVA) is a financial metric that measures a company’s true economic profit. It goes beyond traditional accounting measures by considering the cost of all capital employed, both debt and equity. The purpose of EVA is to determine if a company is generating wealth for its shareholders after accounting for the full cost of the capital used.

A positive EVA indicates the company is creating value, as its operations generate more profit than the cost of funding them. Conversely, a negative EVA suggests the company is destroying value, as profits are insufficient to cover its cost of capital.

Understanding the Core Elements of EVA

Calculating Economic Value Added requires understanding three fundamental components: Net Operating Profit After Tax (NOPAT), Invested Capital, and the Weighted Average Cost of Capital (WACC). These components are interconnected, forming the basis of the EVA calculation.

NOPAT represents the profit a company generates from its core operations after accounting for taxes, but before considering any financing costs. Invested Capital signifies the total amount of money, from both debt and equity sources, that a company has deployed to generate its operating profits. The Weighted Average Cost of Capital (WACC) represents the average rate of return a company must pay to its debt and equity holders for the use of their capital.

Calculating Net Operating Profit After Tax (NOPAT)

Net Operating Profit After Tax (NOPAT) is a measure of a company’s profitability from its operations. It is calculated using the formula: Operating Income (EBIT) multiplied by (1 – Tax Rate).

Operating Income, or Earnings Before Interest and Taxes (EBIT), represents the profit derived from a company’s primary business activities before deducting interest expenses and income taxes. This figure is typically located on a company’s income statement. It includes revenues less the cost of goods sold and operating expenses. For example, if a company reports $500,000 in revenue, $200,000 in cost of goods sold, and $100,000 in operating expenses, its Operating Income is $200,000.

The tax rate used in the NOPAT calculation is the corporate income tax rate. When calculating NOPAT, it is important to consider the effective tax rate applicable to the company’s operating income, which may incorporate both federal and relevant state taxes.

For example, with an Operating Income (EBIT) of $200,000 and an effective tax rate of 25%, the NOPAT calculation is: $200,000 (1 – 0.25) = $150,000. This $150,000 represents the profit generated from the company’s core business activities that is available to both debt and equity capital providers, after all operating costs and taxes have been paid.

Determining Invested Capital

Invested Capital represents the total funds tied up in a business’s operations, encompassing both debt and equity used to generate operating profits. A common approach to calculating Invested Capital is to sum a company’s total assets and then subtract its non-interest-bearing current liabilities. This method focuses on the assets actively used in operations.

Non-interest-bearing current liabilities (NIBCL) are short-term obligations that do not accrue interest. Examples include accounts payable, accrued expenses like wages payable, and current taxes due. These liabilities essentially provide a form of free, short-term financing that reduces the overall capital a company needs to fund its operations.

A company’s balance sheet is the primary source for these figures. For example, if a company has total assets of $1,000,000, and its non-interest-bearing current liabilities (such as $150,000 in accounts payable and $50,000 in accrued taxes) total $200,000, the Invested Capital is $1,000,000 – $200,000 = $800,000. This $800,000 reflects the capital directly invested in the business’s revenue-generating activities.

Calculating the Weighted Average Cost of Capital (WACC)

The Weighted Average Cost of Capital (WACC) is a blended rate representing the average cost of all the capital a company uses, including both equity and debt. The overall WACC formula combines the after-tax cost of debt and the cost of equity, weighted by their respective proportions in the company’s capital structure: WACC = (Cost of Equity % Equity) + (Cost of Debt % Debt (1 – Tax Rate)).

The Cost of Equity represents the return required by a company’s equity investors to compensate them for the risk they undertake. It is frequently calculated using the Capital Asset Pricing Model (CAPM), which considers the risk-free rate, the market risk premium, and the company’s specific risk, measured by its beta. The formula for Cost of Equity is: Risk-Free Rate + Beta (Market Risk Premium). The risk-free rate is typically derived from the yield on long-term U.S. Treasury bonds.

The Market Risk Premium (MRP) is the additional return investors expect for investing in the overall stock market compared to a risk-free asset. Beta measures a company’s stock price volatility relative to the overall market; a beta of 1 means the stock moves with the market, while a beta greater than 1 indicates higher volatility. For instance, if the risk-free rate is 4%, the market risk premium is 5%, and a company’s beta is 1.2, its Cost of Equity is 4% + 1.2 5% = 10%.

The Cost of Debt represents the interest rate a company pays on its borrowed funds. A significant aspect of the cost of debt is its tax deductibility; interest payments reduce a company’s taxable income. Therefore, the effective cost of debt is reduced by the company’s tax rate. For example, if a company’s pre-tax cost of debt is 6% and its corporate tax rate is 21%, the after-tax cost of debt is 6% (1 – 0.21) = 4.74%.

Determining the weights for equity and debt involves calculating their market values. The market value of equity is found by multiplying the current stock price by the number of outstanding shares. For debt, the book value is often used as a practical approximation. These market values are then expressed as percentages of the total capital. If a company has a market value of equity of $600,000 and a market value of debt of $400,000, its total capital is $1,000,000. The weight of equity is 60% and the weight of debt is 40%. Combining these elements, if Cost of Equity is 10%, after-tax Cost of Debt is 4.74%, equity weight is 60%, and debt weight is 40%, the WACC is (10% 0.60) + (4.74% 0.40) = 7.896%.

Assembling the EVA Calculation

With Net Operating Profit After Tax (NOPAT), Invested Capital, and the Weighted Average Cost of Capital (WACC) determined, the final step involves combining these figures to calculate Economic Value Added (EVA). The EVA formula is: EVA = NOPAT – (Invested Capital WACC). This calculation measures the economic profit generated by a company after accounting for the true cost of all the capital it uses.

The term (Invested Capital WACC) represents the total cost of capital, often referred to as the capital charge. This charge signifies the minimum return that a company’s operations must generate to satisfy both its debt and equity investors. If NOPAT exceeds this capital charge, the company has created economic value, indicating efficient capital utilization. If NOPAT falls short, the company has destroyed value.

To illustrate, assume a company’s NOPAT is $150,000, its Invested Capital is $800,000, and its Weighted Average Cost of Capital (WACC) is 7.896%. The capital charge is $800,000 0.07896 = $63,168. The Economic Value Added (EVA) is then $150,000 – $63,168 = $86,832.

A positive EVA, such as $86,832, indicates that the company has generated profits in excess of its capital costs, thereby creating wealth for its shareholders. A negative EVA signals that the company’s operations are not covering the cost of its capital, leading to value destruction.