When we talk about measure of a company’s performance, one metric that rarely comes to mind is Economic Value Added (EVA). EVA attempts to capture true economic profit / value added to the company. Economic profit is not a wealth metric, it is a performance metric.
A performance metric refers to a measure which can be controlled by the company, such as earnings or return on capital. A wealth metric, on the other hand, is a measure of value that depends on the stock market’s collective and forward-looking view such as market capitalization. Now, although these two types of metrics are distinct, they are related.
Economic profit when broken into part is nothing but the Invested Capital and Present value of future economic profits. EVA can be measures by subtracting the cost of capital from the Net Operating Profit after Tax (NOPAT). What separated EVA from other performance metrics like EBITDA, EPS etc. is that it takes into account all the cost of running the business.
Let’s understand why EVA is better than the traditional performance metrics; take for e.g. a company ABC, ABC earned $10,000 on a capital base of $100,000. The return on capital is 10%, and it looks that the company is doing well. Now say that this company is in the early stage and the market for its product still has some risks and the debt obligation and the required rate of return that the investors demand add up to 13%. This means that although the company is enjoying profits, the company lost 3% for its shareholders. Alternatively, if the capital was $100mn and ABC earned $20mn net profit, ABC would have added $7mn as EVA.
The below examples further explains the impact of EVA on wealth creation.
The five years cumulative EVA shows that ABC, Inc. has destroyed value for investors. On the other hand the XYZ, Inc. has added value to shareholders wealth.
Hence EVA is a technique to measure whether a company is creating economic value above the cost of capital. Having said that if calculated properly EVA can be a very effective tool to identify best investments to separate wealth generating stocks from wealth depleting ones.
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