Economic Value Added (EVA) is a modern performance measurement tool that shows whether a company is truly creating wealth for its shareholders. It measures the value generated after covering the cost of all resources, including the cost of equity and debt. Unlike accounting profit, which only considers explicit costs, EVA also includes the opportunity cost of capital.
In simple terms, EVA = Net Operating Profit After Taxes (NOPAT) – Capital Charge.
If EVA is positive, the firm is creating wealth; if it is negative, the firm is destroying wealth.
Capital Employed = Total capital invested (equity + debt)
WACC = Weighted Average Cost of Capital
---
Key Principles of EVA
1. Wealth Creation Principle: Profit should be measured after deducting the cost of capital, not just accounting costs.
2. Time Value of Money Principle: EVA respects the fact that funds invested must earn more than their cost over time.
3. Cash Flow over Profits: EVA emphasizes economic cash flows rather than mere accounting profits.
4. Shareholder Value Maximization: Positive EVA signals that the company is delivering returns higher than expectations of investors.
---
Steps in Calculating EVA
1. Calculate NOPAT (operating profit after taxes, excluding financing costs).
2. Determine Capital Employed (equity + debt used in business).
3. Calculate WACC (weighted average cost of debt and equity).
4. Compute Capital Charge = Capital Employed × WACC.
5. Subtract Capital Charge from NOPAT → gives EVA.
---
Interpretation
EVA > 0: The company is creating value; returns exceed cost of capital.
EVA = 0: The company is breaking even in terms of wealth creation.
EVA < 0: The company is destroying value; returns are less than cost of capital.
---
Examples
1. Infosys: Generates consistently high EVA as its return on capital employed exceeds cost of capital. Its stable profits, low debt, and strong IT demand ensure value creation for shareholders.
2. Reliance Jio: Initially showed negative EVA due to heavy capital investments and high financing costs, but over time as profits increased, EVA turned positive, showing wealth creation.
3. Tesla: For years, Tesla had negative EVA because investments and costs exceeded profits. However, after scaling and strong performance, its EVA turned positive, driving up shareholder wealth.
---
Advantages of EVA
Focuses on true economic profit rather than accounting profit.
Encourages efficient capital utilization.
Links directly to shareholder wealth maximization.
Helps managers evaluate performance objectively.
---
Limitations of EVA
Complex to calculate compared to simple ratios.
Requires many accounting adjustments (e.g., R&D, provisions).
May not suit small firms with limited capital structure complexities.
---
Conclusion
Economic Value Added (EVA) is a powerful tool that measures real wealth creation by comparing profits with the cost of capital employed. It aligns management goals with shareholder interests by emphasizing efficiency and long-term value. Positive EVA reflects good financial health and strategic success, while negative EVA signals the need for corrective actions.
