Economic Value Added (EVA)

Overview

Economic Value Added (EVA) is a financial performance metric that calculates the economic profit of a company by deducting the cost of capital from its operating profit. Developed by Stern Stewart & Co., EVA measures the value a company generates from funds invested in it. Unlike traditional accounting measures, EVA recognizes that capital has a cost and that true value creation occurs only when a company earns returns above this cost.

Core Concepts

EVA Formula

EVA = NOPAT - (Capital × WACC)

Where:
- NOPAT = Net Operating Profit After Tax
- Capital = Total capital employed
- WACC = Weighted Average Cost of Capital

Alternative Formula:
EVA = (ROIC - WACC) × Capital
Where ROIC = Return on Invested Capital

Key Components

1. NOPAT (Net Operating Profit After Tax)

NOPAT Calculation:
Operating Income (EBIT)
- Cash Operating Taxes
+ Tax Shield on Interest
= NOPAT

Adjustments:
+ R&D Expenses (capitalized)
+ Marketing Investments
- Non-cash charges
± Other economic adjustments

2. Capital Employed

Capital = Equity + Debt - Non-interest bearing liabilities

Or:
Capital = Fixed Assets 
         + Net Working Capital
         + Other Operating Assets
         - Non-interest bearing current liabilities

3. WACC (Weighted Average Cost of Capital)

WACC = (E/V × Re) + (D/V × Rd × (1-T))

Where:
E = Market value of equity
D = Market value of debt
V = E + D (Total value)
Re = Cost of equity
Rd = Cost of debt
T = Tax rate

EVA Adjustments

Common Accounting Adjustments

1. R&D Capitalization

Traditional: R&D expensed immediately
EVA: R&D capitalized and amortized

Impact:
Year 1: +$10M R&D to capital
Years 2-5: -$2M amortization/year
Result: Better reflects economic reality

2. Operating Leases

Traditional: Off-balance sheet
EVA: Capitalize as debt

Adjustment:
+ PV of lease obligations to capital
+ Imputed interest to NOPAT
Result: Comparable across own/lease decisions

3. Goodwill Treatment

Options:
1. Leave goodwill on books (no amortization)
2. Write off immediately
3. Amortize over economic life

EVA Approach: Based on economic substance

Comprehensive Adjustment List

Common EVA Adjustments:
├── Income Statement
│   ├── R&D capitalization
│   ├── Marketing investments
│   ├── Restructuring charges
│   └── Unusual gains/losses
├── Balance Sheet
│   ├── Operating leases
│   ├── LIFO reserve
│   ├── Bad debt reserves
│   └── Deferred taxes
└── Other
    ├── Off-balance sheet items
    ├── Pension adjustments
    └── Stock compensation

Strategic Applications

Performance Measurement

Business Unit Evaluation

Business Unit EVA Analysis:
┌─────────────┬────────┬────────┬────────┬────────┐
│ Unit        │ NOPAT  │Capital │ WACC % │  EVA   │
├─────────────┼────────┼────────┼────────┼────────┤
│Division A   │ $50M   │ $200M  │  10%   │ +$30M  │
│Division B   │ $30M   │ $400M  │  10%   │ -$10M  │
│Division C   │ $20M   │ $100M  │  10%   │ +$10M  │
│Total        │ $100M  │ $700M  │  10%   │ +$30M  │
└─────────────┴────────┴────────┴────────┴────────┘

Value Driver Analysis

EVA Improvement Levers:
1. Increase NOPAT
   ├── Revenue growth
   ├── Margin improvement
   └── Operating efficiency

2. Reduce Capital
   ├── Asset optimization
   ├── Working capital mgmt
   └── Divestments

3. Optimize WACC
   ├── Capital structure
   ├── Risk management
   └── Tax optimization

Capital Allocation

Investment Decision Framework

EVA-Based Investment Criteria:
                    Expected EVA Impact
                           ↑
    Definitely     │    Strongly
    Invest         │    Consider
    ───────────────┼────────────────
    Maybe          │    Definitely
    Later          │    Not
                           →
                   Capital Required

Portfolio Management

Strategic Options by EVA:
┌─────────────────────┬─────────────────────┐
│  High Current EVA   │  Low Current EVA    │
├─────────────────────┼─────────────────────┤
│High Growth:         │High Growth:         │
│• Invest heavily     │• Selective invest   │
│• Protect position   │• Fix or exit        │
├─────────────────────┼─────────────────────┤
│Low Growth:          │Low Growth:          │
│• Harvest cash       │• Divest/Liquidate   │
│• Optimize capital   │• Minimize capital   │
└─────────────────────┴─────────────────────┘

Implementation Framework

Phase 1: Foundation

1. Define Measurement System

Implementation Steps:
Identify necessary adjustments
Establish data sources
Create calculation templates
Define reporting hierarchy
Set review cadence

2. Calculate Baseline

Baseline EVA Calculation:
┌─────────────────────────────┐
│ Historical EVA (3-5 years)  │
├─────────────────────────────┤
│ Year -2: $(10M)             │
│ Year -1: $5M                │
│ Year 0:  $20M               │
│ Trend:   Improving          │
└─────────────────────────────┘

Phase 2: Integration

Link to Management Processes

EVA Integration Points:
Strategic Planning ←→ EVA Targets
       ↓                    ↑
Capital Budgeting ←→ EVA Analysis
       ↓                    ↑
Performance Mgmt  ←→ EVA Metrics
       ↓                    ↑
Compensation     ←→ EVA Incentives

Cascade Through Organization

EVA Cascade:
Corporate EVA Target: $100M
         ↓
Division Targets: A:$50M, B:$30M, C:$20M
         ↓
Department Targets: Specific contribution
         ↓
Individual Goals: EVA-linked objectives

Phase 3: Incentive Alignment

EVA Bonus System

Bonus Bank Mechanism:
Annual EVA Performance → Bonus Earned
         ↓
┌────────────────────┐
│    Bonus Bank      │
├────────────────────┤
│ 1/3 Paid Out       │
│ 2/3 At Risk        │
└────────────────────┘
         ↓
Multi-year alignment

Compensation Formula

Target Bonus = Base × Target %
Actual Bonus = Target × (Actual EVA / Target EVA)

With modifiers:
- Floor: 0% (no negative bonus)
- Cap: 200% (prevent excess risk)
- Carry forward/back provisions

Advanced EVA Concepts

Market Value Added (MVA)

MVA = Market Value - Capital Invested
    = PV of Future EVAs

Relationship:
MVA = Σ [EVAt / (1+WACC)^t]

EVA Momentum

EVA Momentum = (EVAt - EVAt-1) / Salest-1

Interpretation:
> 0: Value creation accelerating
= 0: Steady state
< 0: Value creation decelerating

Sector-Specific Considerations

Technology Companies

Adjustments:
- Heavy R&D capitalization
- Stock compensation
- Acquisition accounting
- Intangible assets

Challenges:
- High growth/negative EVA early
- Changing business models
- Option value considerations

Financial Services

Modifications:
- Risk-adjusted capital
- Regulatory capital requirements
- Trading book adjustments
- Credit loss provisions

Formula variant:
EVA = Net Income - (Equity × Cost of Equity)

Comparative Analysis

EVA vs Traditional Metrics

Metric Comparison:
┌──────────────┬────────────┬──────────────┬─────────────┐
│   Metric     │ Considers  │  Incentive   │ Complexity  │
│              │  Capital?  │  Alignment   │             │
├──────────────┼────────────┼──────────────┼─────────────┤
│Net Income    │     No     │     Low      │    Low      │
│ROE           │   Partial  │   Medium     │    Low      │
│ROIC          │     Yes    │   Medium     │   Medium    │
│EVA           │     Yes    │    High      │    High     │
│Cash Flow     │     No     │   Medium     │   Medium    │
└──────────────┴────────────┴──────────────┴─────────────┘

Advantages and Limitations

Advantages

True Economic Profit
- Considers cost of capital
- Aligns with shareholder value
- Reduces earnings manipulation
Better Decision Making
- Clear value creation focus
- Consistent measurement
- Long-term orientation
Incentive Alignment
- Management thinks like owners
- Reduces agency costs
- Encourages efficiency

Limitations

Complexity
- Multiple adjustments needed
- Requires expertise
- Data intensive
Short-term Pressure
- Can discourage investment
- May reduce R&D
- Asset reduction focus
Implementation Challenges
- Culture change required
- System modifications
- Training needs

Case Studies

Coca-Cola Implementation

Timeline: 1980s-1990s
Approach:
- CEO Roberto Goizueta champion
- Comprehensive implementation
- All decisions EVA-based

Results:
- Stock price: 10x increase
- Market cap: $150B added
- ROIC: Doubled
- Culture: Value-focused

Best Buy Transformation

Challenge: Declining profitability
EVA Implementation:
- Store-level EVA tracking
- Capital allocation reform
- Incentive realignment

Outcomes:
- Closed unprofitable stores
- Improved capital efficiency
- Stock price recovery
- Sustainable profitability

Implementation Tools

EVA Calculation Template

EVA Calculation Worksheet:
─────────────────────────────────
Operating Income (EBIT):         $___
- Cash Taxes:                    $___
= NOPAT:                        $___

Beginning Capital:               $___
+ Adjustments:                   $___
= Adjusted Capital:             $___

WACC:                           ___%
Capital Charge:                 $___

EVA = NOPAT - Capital Charge =  $___
─────────────────────────────────

EVA Improvement Toolkit

Value Creation Strategies:
┌─────────────────┬────────────────┐
│ Revenue Growth  │ Cost Reduction │
├─────────────────┼────────────────┤
│• Market share   │• Process opt.  │
│• Pricing power  │• Automation    │
│• New products   │• Outsourcing   │
├─────────────────┼────────────────┤
│ Asset Efficiency│ Capital Struct.│
├─────────────────┼────────────────┤
│• Inventory turns│• Debt/equity   │
│• Asset sales    │• Cost of debt  │
│• Lease vs buy   │• Dividends     │
└─────────────────┴────────────────┘

Software and Systems

EVA Software Solutions

Stern Stewart EVA
- Official methodology
- Comprehensive adjustments
- Training included
Oracle Hyperion
- Integrated planning
- EVA calculations
- Performance management
SAP BPC
- Business planning
- Consolidation
- EVA reporting

Integration Requirements

System Architecture:
ERP Systems → Data Warehouse → EVA Engine → Reporting
     ↓              ↓              ↓           ↓
Transactions    Adjustments    Calculations  Dashboards

Best Practices

Implementation Success Factors

Executive Sponsorship
- CEO commitment
- Board support
- Visible use
Comprehensive Training
- All management levels
- Finance deep dive
- Ongoing education
Gradual Rollout
- Pilot programs
- Learn and adjust
- Scale success
Cultural Integration
- Link to values
- Communication plan
- Success stories

Common Implementation Mistakes

Over-complexity in calculations
Insufficient training
Weak link to incentives
Ignoring behavioral impacts
Poor communication

Future Considerations

Evolution of EVA

Real-time EVA
- Dynamic calculations
- Predictive analytics
- Scenario modeling
Sustainability Integration
- ESG adjustments
- Long-term value
- Stakeholder considerations
AI Enhancement
- Automated adjustments
- Pattern recognition
- Optimization algorithms

Action Steps

Quick Start Guide

Week 1-2: Education and Planning
□ Executive workshop
□ Select pilot unit
□ Identify adjustments

Week 3-4: Baseline Calculation
□ Gather historical data
□ Calculate EVA
□ Validate results

Week 5-8: Pilot Implementation
□ Set targets
□ Track performance
□ Refine process

Week 9-12: Expand and Scale
□ Roll to more units
□ Link to incentives
□ Measure impact

Conclusion

Economic Value Added represents a powerful framework for aligning business decisions with shareholder value creation. While implementation requires significant effort and organizational change, the benefits of improved capital allocation, better decision-making, and aligned incentives make it worthwhile for many organizations. Success with EVA requires commitment to the methodology, investment in systems and training, and patience to allow the cultural transformation to take hold. When properly implemented, EVA transforms organizations from accounting profit focus to true economic value creation.