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What is EVA?The economic value added formula - How to calculate EVA?Importance and Limitations of EVA

The economic value added calculator is a tool to help you measure economic value added (EVA), a metric that estimates the real economic performance of a company. Investors use EVA to evaluate how much value their capital investment in a company has created compared to other investments. The economic value-added calculation accounts for the company's operating earnings and capital use efficiency when analyzing the value created for shareholders. So, you can estimate the actual economic profit beyond just the numbers on a balance sheet. To learn more about economic profit, visit our economic profit calculator.

If you want to assess an investment's value to your portfolio or measure how efficiently a company uses the capital at its disposal to create value, then this economic value-added calculator is an ideal tool. Otherwise, you can check out the profitability index calculator, which assesses the potential profitability of an investment using the net present value of an investment. This article explains the concept of economic value, how to calculate EVA, the economic value-added formula, and the importance and limitations of using EVA as a performance measure.

## What is EVA?

EVA is short for economic value added. It is a measure of the actual financial performance of a company by comparing the cost or charge for raising its capital by its net operating profit.

• The charge for raising capital refers to the cost incurred by the company for having to pay the return on employed capital to its investors or shareholders. Learn more by visiting our return on capital employed calculator.
• At the same time, the company's net operating profit is the profit remaining after subtracting operating expenses, cost of goods sold, interest, and taxes.

The difference between these two measures is "economic profit" or "economic value added." Thus, a company creates value when it makes enough profit that exceeds the cost of the capital used. Investors use EVA to estimate how well a company performed compared to other investments. On the other hand, company management uses EVA to assess how efficiently they have utilized the capital they raised to meet their shareholders' expectations.

The concept of EVA goes beyond the surface numbers of accounting profit to analyze wealth creation. It is based on the principle that real profitability only occurs when companies generate a return above the return required by their financiers. Therefore, analysts using EVA to measure performance expect that projects make surplus returns above their cost of capital. This premise is what differentiates EVA from similar profit indicators, which do not account for the cost of equity capital and are prone to accounting manipulations. It is also what makes EVA particularly important to keep track of by capital-intensive businesses.

Essentially, EVA quantifies the rate of return on invested capital with the opportunity cost of investing elsewhere. The higher the EVA, the better the profitability to make the investment worthwhile.

## The economic value added formula - How to calculate EVA?

The EVA formula is:

EVA = NOPAT – (Invested capital × WACC)

where:

• NOPAT — is the net operating profit after tax. NOPAT is generally listed on a company's income statement, or you can calculate it to assess the operating efficiency of the company,

• (Invested capital × WACC) – is the finance charge, representing the minimum return required by finance providers (investors and shareholders) on the capital they provided.

• WACC — the firm's weighted average cost of capital. Generally provided as a public record, it is the average rate of return a company expects to pay its investors. The weights are a fraction of each financial source in a company's capital structure. Visit our WACC calculator to learn more.

• Invested capital — funds invested by shareholders for equity, bondholders, and lenders at the beginning of the investment period. There are different variations in the formula to measure invested capital. However, it is mostly determined by the difference between a company's total assets and liabilities during the course of its business operation.

You can also compute the amount of Invested capital if it is not provided by opening the "Calculate invested capital" section of the calculator and inputting the company's Total assets and Current liabilities provided on the balance sheet.

Accordingly, the EVA formula can be modified as follows:

EVA = NOPAT – ((Total assets - Current liabilities) × WACC)

A positive EVA shows a company is generating returns above the required minimum return. In contrast, a negative EVA means that the company does not generate value from the funds invested in the business. Thus, the company should invest the capital elsewhere.

Example:

Steph is an analyst for a VC firm in Silicon Valley. She wants to assess whether a 2019 investment the firm made in a startup created value for its portfolio.

The startup's NOPAT is $750,000, the cost of invested capital is 17%, and the expended capital is $1,600,000.

Using the EVA formula:

EVA = NOPAT – (Invested capital × WACC)

EVA = $750,000 – (1,600,000 × 17%) =$478,000

The result is a positive added value amount of \$478,000, which means that the company more than covered its cost of capital in 2019.

## Importance and Limitations of EVA

Importance of EVA:

• Businesses can use economic value added to assess managerial performance as it serves as a measure of value creation for shareholders.

• EVA indicates how profitable company projects are, which is essential in decision-making for economic profit.

• EVA considers all costs, including the cost of equity capital, which standard accounting ignores.

• It ensures businesses focus on wealth creation through economic surplus rather than net income.

• EVA calculation can pinpoint where and how much wealth is created by including essential items from the balance sheet.

Limitations of EVA:

EVA is not suitable for all kinds of companies. It best evaluates performance in capital and asset-intensive companies, such as automotive companies. It is not as useful for service companies with many intangible assets, such as software companies.

• Comparing the performance of disproportionately sized companies or projects will likely favor the more prominent candidate since the economic value-added calculation heavily relies on invested capital. Thus, EVA may not always reflect the efficiency of smaller firms that manage better ROI comparably.
• An EVA evaluation only applies to the investment period measured and can not be relied upon to predict future performances. Therefore, it is unreliable for companies looking to make significant capital investments or reorganize their production.