Economic Value Added (EVA)

You know how farmers earn a significant profit after selling the produce at the end of the year. However, to truly understand if you’ve made a real return on your investment, you need to factor in all your costs — including the interest on any loans you took to fund your farm. If the money you earned exceeds your total costs, including the opportunity cost of your investment, you’ve truly created value. This is similar to Economic Value Added (EVA) in business.

What is EVA?

Economic Value Added (EVA) is a financial performance metric that calculates the true economic profit of a company. It measures how much value a company has created or destroyed for its shareholders after accounting for the cost of capital. EVA is essentially the profit a company generates above the required return on its capital, which is considered the hurdle rate.

The formula for EVA is:

EVA = Net Operating Profit After Taxes (NOPAT) − (Capital × Cost of Capital)

Where:

• NOPAT = Net Operating Profit After Taxes, which represents the company’s profit from operations after taxes.

• Capital = The amount of capital invested in the business (equity + debt).

• Cost of Capital = The rate of return required by investors (based on the company’s risk).

Example:

Suppose Hindustan Unilever (HUL) has:

• NOPAT = ₹2,000 crore
• Capital = ₹10,000 crore
• Cost of Capital = 12%

Then the EVA would be:

EVA = ₹2,000 crore − (₹10,000 crore × 12%)

EVA = ₹2,000 crore − ₹1,200 crore

EVA = ₹800 crore

This means HUL has created ₹800 crore of value for its shareholders after covering the cost of capital.

Why is EVA Important?

1. Measures True Profitability: EVA takes into account the total cost of capital, ensuring that the company is generating a return above the cost of the resources it uses. It’s a more accurate measure of profitability than net income or operating profit because it adjusts for the cost of capital.

2. Focuses on Value Creation: EVA focuses on how much value a company has truly created, which is critical for shareholders who want to know if their investments are generating real returns.

3. Incentive for Management: Many companies use EVA as part of their performance-based compensation. If the company’s EVA is positive, it means management is effectively creating value, and they are rewarded accordingly.

Limitations of EVA:

• Complex to Calculate: Calculating EVA requires detailed financial data, including NOPAT and capital, which may not always be readily available or easy to determine accurately.

• Short-Term Focus: EVA is a performance measure based on current profitability and capital costs, which may sometimes overlook long-term investments that haven’t yet generated returns.

• Ignores Market Conditions: EVA focuses solely on the internal efficiency of the business and doesn’t factor in changes in market conditions, which could significantly affect the company’s future value.

EVA is often used by companies like Tata Steel, Reliance Industries, and Maruti Suzuki, particularly in evaluating capital-intensive projects. The use of EVA encourages a focus on creating value beyond just generating profits, especially in sectors like manufacturing and energy where capital costs are significant.

Economic Value Added is a powerful tool that shows if a company is truly generating value beyond its cost of capital. By focusing on the return on invested capital, EVA gives a clearer picture of a company’s ability to create long-term shareholder wealth. In the next chapter, we will explore Valuing Startups and High-Growth Companies, a different challenge entirely, where traditional valuation methods often don’t apply.