EVA

It is the abbreviation of Economic value added. It is calculated by subtracting the cost of capital from the profit after tax. This measure was devised by Stern Stewart & Co. Economic value added attempts to capture the true economic profit of a company. EVA is mainly calculated to estimate the company’s performance with respect to the capital of the company. The primary idea behind calculation of EVA is that the higher the return with respect to the capital the better is the efficiency of the company, better will be the performance of the firm in the future.

Economic value added (EVA) = Net operating profit after tax (NOPAT) – (Cost of capital employed * Weighted average of cost of capital)

EVA to some extend similar to residual income calculation and residual cash flow. There is however a slight deviation in the EVA technique i.e. in the EVA technique slight adjustments in the calculation of net operating profit after tax is made, whereas no such modifications are made in the other two methods. These three are similar in the sense in all the three case the cost of capital is calculated in terms of money rather than in a ratio.

The main advantage of this method being that this method shows the actual financial status of the company. The adjustment that are made in the balance sheet by the companies while reporting profit will have no influence in the calculation of economic value added.  

If we speak commercially the big institutional investor use this technique to identify the financial position of the company before making any investment decisions on these companies.  The main disadvantage in this technique is that its complexity in estimating EVA. The complexity in this method is more in comparison with other methods. The fund manager in order to reduce the complexity split the calculation of the EVA into three parts. They are,

• Calculation of the NOPAT.
• Calculation of the Invested capital.
• Merging of the above two find the end result EVA.

EVA is a latest technology that is emerging in the financial sector. It is considered to be better and advanced than the conventional EBIT or Net income method.

Question

• What are the various advantages of EVA method?
• What are the various stages in the calculation of EVA?