The EVA principle (Economic Value Added) measures a company's true economic profit by subtracting its cost of capital from its net operating profit after taxes. Developed by Stern Stewart & Co., EVA quantifies whether a business creates value beyond its financing costs.
EVA calculates residual income after accounting for capital costs. The formula:
EVA = NOPAT - (Invested Capital × WACC)
Where NOPAT is net operating profit after taxes, WACC is weighted average cost of capital, and invested capital includes equity and debt. A positive EVA indicates value creation.
| Component | Description |
|---|---|
| NOPAT | Operating profits after taxes, excluding interest and non-operating items |
| Invested Capital | Total capital employed, including equity and debt |
| WACC | Weighted average cost of capital, reflecting financing costs |
EVA aligns executive compensation with shareholder interests by focusing on economic profit rather than accounting profit. Unlike earnings per share, EVA adjusts for capital efficiency. For example, Coca-Cola used EVA to improve capital allocation decisions in the 1990s, increasing market value by $25 billion.
Some argue EVA overcomplicates performance measurement. However, its adjustments for accounting distortions make it more accurate than traditional metrics. Critics also claim EVA discourages long-term investments due to its focus on short-term capital costs. In reality, properly implemented EVA encourages projects that generate long-term value above their cost of capital.
I've seen EVA misused when companies ignore its requirement for consistent capital charge calculations. One client applied different WACC rates to divisions, distorting comparisons. Proper implementation requires standardized capital charges across all business units.
Consider a company with $100 million NOPAT, $500 million invested capital, and 8% WACC. Its EVA would be $60 million ($100M - ($500M × 0.08)). This positive EVA indicates the company generates economic profit after financing costs.
EVA's strength lies in its ability to compare value creation across industries. A software firm with lower NOPAT but higher capital efficiency may show higher EVA than a manufacturing company with higher NOPAT but excessive capital requirements.