Economic Value Added (EVA)

The Importance of Economic Value Added (EVA) in Financial Analysis

When it comes to evaluating the financial performance of a company, there are several metrics and ratios that analysts use. One such metric that has gained significant popularity in recent years is Economic Value Added (EVA). EVA provides a comprehensive measure of a company's profitability by taking into account both its operating income and the cost of capital. In this article, we will explore the concept of EVA, its calculation, and its significance in financial analysis.

What is Economic Value Added (EVA)?

Economic Value Added (EVA) is a financial performance measure that aims to determine the true economic profit generated by a company. It was developed by Stern Stewart & Co., a consulting firm, in the late 1980s. EVA goes beyond traditional accounting measures, such as net income or earnings per share, by considering the cost of capital employed in generating those earnings.

At its core, EVA measures the residual income that remains after deducting the cost of capital from a company's operating profit. It provides a more accurate picture of a company's profitability by considering the opportunity cost of the capital invested in the business.

Calculating Economic Value Added (EVA)

The calculation of EVA involves a few key components:

• Net Operating Profit After Tax (NOPAT): This is the operating profit of a company after deducting taxes. It represents the profit generated from the core operations of the business.
• Capital Employed: This refers to the total capital invested in a company, including both equity and debt. It represents the funds used to generate the company's profits.
• Cost of Capital: This is the weighted average cost of the company's debt and equity. It represents the return that investors expect to earn on their investment in the company.

The formula for calculating EVA is as follows:

EVA = NOPAT – (Capital Employed x Cost of Capital)

By subtracting the cost of capital from the operating profit, EVA provides a measure of the value created by a company above and beyond the expectations of its investors.

The Significance of Economic Value Added (EVA)

EVA offers several advantages over traditional financial metrics, making it a valuable tool for financial analysis:

• Focus on Long-Term Value Creation: EVA encourages companies to focus on generating sustainable profits that exceed the cost of capital. By considering the cost of capital, EVA aligns the interests of shareholders and management towards long-term value creation.
• Comparison Across Companies: EVA allows for meaningful comparisons of companies operating in different industries and with varying capital structures. It provides a standardized measure of profitability that is not influenced by accounting practices.
• Identification of Value Drivers: EVA helps identify the key drivers of value creation within a company. By analyzing the components of EVA, such as NOPAT and capital employed, management can identify areas for improvement and make informed decisions to enhance profitability.

Case Study: Coca-Cola's Use of EVA

A notable example of a company that has successfully implemented EVA is The Coca-Cola Company. In the late 1990s, Coca-Cola adopted EVA as a key performance metric to align its management team with shareholder value creation.

By focusing on EVA, Coca-Cola aimed to improve its profitability and enhance shareholder returns. The company implemented various initiatives to increase its NOPAT, reduce its capital employed, and optimize its cost of capital. These efforts resulted in significant improvements in EVA over time.

Through the use of EVA, Coca-Cola was able to identify areas of inefficiency and take corrective actions to enhance its financial performance. The company's success with EVA demonstrates the value of this metric in driving long-term value creation.

Conclusion

Economic Value Added (EVA) is a powerful financial metric that provides a comprehensive measure of a company's profitability. By considering the cost of capital, EVA goes beyond traditional accounting measures and offers valuable insights into a company's true economic profit.

EVA enables companies to focus on long-term value creation, compare their performance with industry peers, and identify key drivers of profitability. It helps align the interests of shareholders and management towards sustainable value creation.

As demonstrated by Coca-Cola's successful implementation of EVA, this metric can drive significant improvements in financial performance when used effectively. By incorporating EVA into their financial analysis, investors and analysts can gain a deeper understanding of a company's profitability and make more informed investment decisions.