What is Economic Value Added

EconomicValueAdded (EVA) is a measure of business performance that focuses on the value that a company creates for its shareholders.EVA is calculated as NetOperatingProfitAfterTaxes (NOPAT, NetOperatingProfitAfterTaxes) minus the cost of capital (WACC. WeightedAverageCostofCapital).

EVA formula: EVA = NOPAT - (WACC x Capital Inputs)

Where:

NOPAT=OperatingProfitAfterTaxes×(1-TaxRate)

WACC=(MarketValueEquityRatio×CostofEquity)+(MarketValueDebtRatio×CostofDebt×(1-TaxRate))

Capital Input = total invested capital (equity + debt)

The implication of this formula is that economic value added to shareholders is created only when the profitability of a firm exceeds the cost of capital.EVA encourages firms to invest efficiently and to avoid mindless expansion, which improves the overall efficiency of their operations.

Advantages of EVA:

1. Considering the cost of capital: traditional financial indicators (such as net profit, return on net assets, etc.) do not take into account the cost of capital, which may lead to the enterprise's blind pursuit of scale expansion, ignoring the efficiency of the use of capital.EVA, on the other hand, emphasizes that only earnings in excess of the cost of capital are the real value creation.

2. Incentivize long-term value creation: EVA focuses on long-term value creation and encourages sustainable development rather than short-term profits.

3. Can be used for performance appraisal: EVA can be used as a kind of performance appraisal index, linking the remuneration of executives to the economic value added of the enterprise, and incentivizing the management to focus on the value creation of the enterprise.

Disadvantages of EVA:

1. Complexity of calculation: the calculation of EVA involves a number of financial indicators, and the process of calculation is relatively complex, which may lead to difficulties for some users to understand and apply.

2. Subjective factors: The process of calculating EVA involves some subjective factors, such as the determination of the cost of capital, which may be influenced by different evaluators, thus affecting the accuracy of EVA.

In short, EVA is a financial indicator that focuses on corporate value creation and incentivizes effective investment and long-term value creation by measuring the return over the cost of capital. Despite its limitations in calculation and application, EVA is still a valuable performance appraisal and management tool.