Economic Value Added Formula Example How To Calculate Eva

What is Economic Value Added?

Economic value added (EVA) measures the surplus value created on a given investment. When a person is investing his funds, he does this only because he expects to earn a profit from the investment. So, let us say, gold seems to be a good instrument to invest in with a high-profit margin.

Total investment (i.e., price at which gold is purchased) = $ 1000Brokerage paid to the dealer for the purchase of gold = $ 15

I want to sell off the gold during a liquidity crunch in a year.

The selling price of gold = $ 1200Brokerage paid to the dealer on sale of gold = $ 10

In the above Economic Value Added example,

Economic Value Added = Selling price – Expenses associated with selling the asset – Purchase price – Expenses associated with buying the assetEconomic Value Added = $ 1200 – $ 10 – $ 1000 – $ 15 = $ 175

If we see the profit, then the profit on selling gold was $ 1200 – $ 1000, i.e., $ 200. But the actual creation of wealth is only $ 175 on account of expenses incurred. So this is a very crude example of EconomicExample Of EconomicEconomic examples will help you gain insight into the various economic theories and factors and their impact on the overall economy. Some of these factors illustrated are opportunity cost, demand and supply, sunk cost, the law of diminishing marginal utility and the trade war.read more Value Added (EVA).

In this article, we discuss Economic Value added in detail –

Economic Value Added (EVA) concept

Economic value added (EVA) is the economic profitEconomic ProfitEconomic profit refers to the income acquired after deducting the opportunity and explicit costs from the business revenue (i.e., total income minus overall expenses). It is an internal analysis metric used by the organizations along with the accounting profits.read more by the company in a given period. It measures the company’s financial performance based on the residual wealth calculated by deducting its cost of capital from its operating profit, adjusted for taxes on a cash basis.

It helps to capture the true economic profit of a company like we calculated the Economic Value Added of investing gold in the above. The Economic Value Added example was developed and trademarked by Stern Stewart and Co. as an internal financial performance measure.

EVA Formula

The three main components of Economic Value Added (EVA) are:

Net Operating Profit After TaxCapital InvestedWACC, i.e., the + [Cost of Debt * % of Debt * (1-Tax Rate)]” url=”https://www.wallstreetmojo.com/weighted-average-cost-capital-wacc/”]Weighted Average Cost of Capital”Weighted”The

Economic Value Added can be calculated with the help of the following formula:

Economic Value Added EVA formula= Net Operating Profit After Tax – (Capital Invested x WACC)

You are free to use this image on you website, templates, etc., Please provide us with an attribution linkHow to Provide Attribution?Article Link to be HyperlinkedFor eg:Source: Economic Value Added (EVA) (wallstreetmojo.com)

Here, Capital Invested x WACC stands for the cost of capital. This cost is deducted from the Net Operating Profit After Tax to arrive at the organization’s economic profit or residual wealth.

Economic Value Added Example (Basic)

#1 – EVA Formula – Net Operating Profit After Tax (NOPAT)

This represents how much the company’s potential cash earnings will be without its capital cost. Therefore, it is important to deduct tax from the Operating Profit to arrive at the true operating inflow that a company will earn.

NOPAT = Operating Income x (1 – Tax Rate).

EVA Example for calculating Net Operating IncomeNet Operating IncomeNet Operating Income (NOI) is a measure of profitability representing the amount earned from its core operations by deducting operating expenses from operating revenue. It excludes non-operating costs such as loss on sale of a capital asset, interest, tax expenses.read more After Tax is as follows:

ABC Company

Abstract of the Revenue Statement

#2 – EVA Formula – Capital Invested

This represents the total capital invested through equity or debt in a company.

Continuing with the above EVA example of ABC Company, let us say the company has invested $ 30,000. $ 20,000 is through equity funding, and the rest ($ 10,000) uses long term debtTerm DebtLong-term debt is the debt taken by the company that gets due or is payable after one year on the date of the balance sheet. It is recorded on the liabilities side of the company’s balance sheet as the non-current liability.read more.

Also, have a look at Return on Invested Capital RatioReturn On Invested Capital RatioReturn on Invested Capital (ROIC) is a profitability ratio that shows how a company uses its invested capital, such as equity and debt, to generate profit. The reason this ratio is so crucial for investors before making an investment is that it helps them decide which firm to invest in.read more

#3 – EVA Formula – WACC

The weighted Average Cost of Capital is the cost the company incurs for sourcing its funds. The importance of deducting the cost of capital from the Net Operating Profit is to deduct the opportunity cost of the capital invested. The formula to calculate the same is as follows:

WACC = RD (1- Tc )*( D / V )+ RE *( E / V )

The formula looks complicated and scary, but it is fairly simple if understood. It is much easier if the formula is put in words as follows:

Weighted Average Cost of Capital = (Cost of Debt) * (1 – Tax Rate) * (Proportion of debt) + (Cost of Equity) * (Proportion of equity)

This makes the formula easier to understand and also self-explanatory.

Now, understanding the notations of the formula:

RD = Cost of DebtCost Of DebtCost of debt is the expected rate of return for the debt holder and is usually calculated as the effective interest rate applicable to a firms liability. It is an integral part of the discounted valuation analysis which calculates the present value of a firm by discounting future cash flows by the expected rate of return to its equity and debt holders.read moreTc = Tax RateD = Capital invested in the organization through Debt.V = Total Value of the firm simply calculated as Debt + Equity.RE = Cost of EquityCost Of EquityCost of equity is the percentage of returns payable by the company to its equity shareholders on their holdings. It is a parameter for the investors to decide whether an investment is rewarding or not; else, they may shift to other opportunities with higher returns.read moreE = Capital invested in the organization through Equity

An important point to note about this formula is that the Cost of Debt is multiplied by (1 – Tax Rate) as there is tax saving on interest paid on debt. On the other hand, there is no tax saving on the cost of equity, and hence the tax rate is not taken into account.

Let us now look at how WACC is calculated.

Balance Sheet of the Company

WACC for the year 2016

= 8% * (1- 30%) * ($ 10,000 / $ 30,000) + 10% * ($ 20,000 / $ 30,000)= (8% * 70% * 1/3) + (10% * 2/3) = 1.867% + 6.667% = = 8.53%

WACC for the year 2015

= 8% * (1- 30%) * ($ 7,000 / $ 24,000) + 12% * ($ 17,000 / $ 24,000)= (8% * 70% * 7/24) + (10% * 17/24) = 1.63% + 8.50% = 10.13%

#4 – Economic Value Added EVA Calculation

From the above, we have all three factors ready for Economic Value Added calculation for 2016 and 2015.

Economic Value Added (EVA) for the year 2016 = Net Operating Profit After Tax – (Capital Invested * WACC)

= $ 70,000 – ($ 30,000 * 8.53%)= $ 70,000 – $ 2,559 = = $ 67,441

Economic Value Added (EVA) for the year 2015 = Net Operating Profit After Tax – (Capital Invested * WACC)

= $ 63,700 – ($ 24,000 * 10.13%)= $ 63,700 – $ 2,432 = = $ 61,268

Accounting adjustments for EVA Calculation

Now since we have understood the basics of EVA calculation, let us go a bit further to understand what can be some of the real-life accounting adjustments involved, especially at the Operating Profit level:

Colgate Economic Value Added Example EVA

#1 – Calculating Colgate’s NOPAT

Let us have a look at the Income Statement of Colgate.

source: Colgate SEC Filings

The operating Profit of Colgate in 2016 is $3,837 million

The operating profit above does contain noncash items like Depreciation and Amortization, Restructuring costsRestructuring CostsRestructuring Cost is the one-time expense incurred by the company in the process of reorganizing its business operations. It is done to improve the long term profitability and working efficiency. This expenditure is treated as the non-operating expenses in the financial statements.read more, etc.

In our EVA example, we aIn our EVA example, we assume that the book depreciation and economic depreciationEconomic DepreciationEconomic depreciation is the wear and tear of an asset beyond its expected capacity or utility. For example, suppose we have an asset and expect the depreciation to run for four years. Still, it becomes obsolete and scraps in only three years it is said to be economically depreciated.read more are the same for Colgate, and hence, no adjustment is needed when calculating NOPAT.

However, restructuring cost needs to be adjusted for. Below is the snapshot of Colgate’s restructuring costs from its Form 10K.

Colgate’s restructuring charges in 2016 = $228 million

Adjusted Operating Profit = Operating Profit + Restrucutring Expenses

Adjusted Operating Profit (2016) = $3,837 million + $228 million = $4,065 million

For calculating NOPAT, we required the tax rates.

We can calculate the effective tax rates from the income statement below.

source: Colgate SEC Filings

Effective Tax rate = Provision for Income Taxes / Income Before income taxes

Effective tax rateEffective Tax RateEffective tax rate determines the average taxation rate for a corporation or an individual. For both, there is a similar formula only with variation in considering variables. The effective tax rate formula for corporation = Total tax expense / EBTread more (2016) = $1,152/$3,738 = 30.82%

NOPAT = Adjusted Operating Profit x (1-tax rate)

NOPAT (2016) = $4,065 million x (1-0.3082) = $2,812 million

Also, check out an article on Non-recurring itemsNon-recurring ItemsNon-recurring items are income statement entries that are unusual and unexpected during regular business operations; examples include profits or losses from sale of asset, impairment costs, restructuring costs, and losses in lawsuits, and inventory write-off.read more

#2 – Colgate’s Invested Capital

Let us now calculate the second item required for calculating Economic Value Added, i.e., Invested Capital.

Invested capital represents the actual debt and equity invested in the company.

Total Debt = Notes and Loan Payable + Current Portion of Long-Term DebtCurrent Portion Of Long-Term DebtCurrent Portion of Long-Term Debt (CPLTD) is payable within the next year from the date of the balance sheet, and are separated from the long-term debt as they are to be paid within next year using the company’s cash flows or by utilizing its current assets.read more + Long Term Debt

Total Debt (2016) = $13 + $0 + $6,520 = $6,533 million

Adjusted Equity = Colgate Shareholders EquityShareholders EquityShareholder’s equity is the residual interest of the shareholders in the company and is calculated as the difference between Assets and Liabilities. The Shareholders’ Equity Statement on the balance sheet details the change in the value of shareholder’s equity from the beginning to the end of an accounting period.read more + Net Deferred tax + Non Controlling Interest + Accumulated Other comprehensive (income) loss

Adjusted Equity (2016) = -$243 + $55 + $260 + $4,180 = $4,252 million

Colgate’s Invested Capital (2016) = Debt (2016) + Adjusted Equity (2016)

Colgate’s Invested Capital (2016) = $6,533 million + $4,252 million = $10,785 million

#3 – Find WACC of Colgate

We note above that Colgate’s number of shares = 882.85 million

Current Market Price of Colgate = $72.48 (as of closing 15th September 2017)

Market value of equity of Colgate = 72.48 x 882.85 = $63,989 million

As we have earlier noted,

Total Debt = Notes and Loan Payable + Current Portion of Long-Term Debt + Long Term Debt

Let us now find the cost of equity of Colgate using CAPM modelCAPM ModelThe Capital Asset Pricing Model (CAPM) defines the expected return from a portfolio of various securities with varying degrees of risk. It also considers the volatility of a particular security in relation to the market.read more

Ke = Rf + (Rm – Rf) x Beta

We note from below that the risk-free rateRisk-free RateA risk-free rate is the minimum rate of return expected on investment with zero risks by the investor. It is the government bonds of well-developed countries, either US treasury bonds or German government bonds. Although, it does not exist because every investment has a certain amount of risk.read more is 2.17%

source – bankrate.com

For the United States, Equity Risk Premium is 6.25%.

source – stern.nyu.edu

Let us look at the Beta of Colgate. We note that Colgate’s Beta has increased over the years. It is currently 0.805.

source: ycharts

Also, check out the article on CAPM Beta CalculationCAPM Beta CalculationCAPM Beta is an essential theoretical measure of how a single stock moves with respect to the market. In this method, we determine the cost of equity by summing up the beta and risk premium product with the risk-free rate.read more

Cost of Equity = 2.17% + 6.25% x 0.805Cost of Equity of Colgate = 7.2%
Interest Expense (2016) = $99Total Debt (2016) = $13 + $0 + $6,520 = $6,533 millionEffective Interest RateEffective Interest RateEffective Interest Rate, also called Annual Equivalent Rate, is the actual rate of interest that a person pays or earns on a financial instrument by considering the compounding interest over a given period.read more (2016) = $99/6533 = 1.52%

Let us now calculate WACC

Market Value of Equity = $63,989 millionValue of Debt = $6,533 millionCost of Equity = 7.20%Cost of Debt = 1.52%Tax rate = 30.82%

WACC = E/V * Ke + D/V * Kd * (1 – Tax Rate)

WACC = (63,989/(63,989+6,533)) x 7.20% + (6,533 /(63,989+6,533)) x 1.52% x (1-0.3082)

WACC = 6.63%

#4 – Colgate’s Economic Value Added EVA Calculation

Economic Value Added formula= Net Operating Profit After Tax – (Capital Invested x WACC)

Colgate’s NOPAT (2016) = $4,065 million x (1-0.3082) = $2,812 millionColgate’s Invested Capital (2016) = $6,533 million + $4,252 million = $10,785 millionEconomic Value Added (Colgate) = $2,812 million – $10,785 million x 6.63%Economic value added = $2097 million

What is the importance of EVA?

The very basic objective of every business is to maximize shareholder value. Therefore, the investor is the key stakeholder around which all business activities are focused.

The key factors which are important while maximizing shareholder valueShareholder ValueShareholder’s value is the value that company shareholders receive as dividends and stock price appreciation due to better decision-making by the management that ultimately results in a company’s growth in sales and profit.read more are:

Wealth maximization is more important as compared to profit maximization. There is a difference between the two. Wealth Maximization aims to accelerate the worth of the organization as a whole. Maximizing profit can be said to be a subset of maximizing wealth. EVA focuses on wealth creation.Economic Value Added (EVA) considers the Weighted Average Cost of Capital. It goes with the logic that it is important to cover the cost of equity and not just the interest portion of the debt.Organizations tend to focus on profits and ignore the cash flow. This often leads to a liquidity crunch and can also lead to bankruptcy. Economic Value Added (EVA) focuses on cash flowsCash FlowsCash Flow is the amount of cash or cash equivalent generated & consumed by a Company over a given period. It proves to be a prerequisite for analyzing the business’s strength, profitability, & scope for betterment. read more more than profits.Taking the Weighted Average Cost of Capital takes into account both short-term as well as long-term perspectives.

Advantages and disadvantages

Like any other financial ratio/indicator, even Economic Value Added (EVA) has advantages and disadvantages. So let us have a look at the basic pointers for the same.

Advantages of using Economic Value Added (EVA):

As discussed above, it helps to give a clear picture of wealth creation compared to other financial measures used for analysis. It considers all costs, including the opportunity cost of equity, and it does not stick to accounting profits.It is comparatively simple to understand.EVA can also be calculated for different divisions, projects, etc., and the appropriate investment decisions can be taken for the sameIt also helps to develop a relationship between the use of capital and Net Operating Profit. This can be analyzed to make the most out of opportunities and make appropriate improvements wherever necessary.

Disadvantages of using Economic Value Added (EVA):

There are a lot of assumptions involved in calculating the Weighted Average Cost of Capital. It is not easy to calculate the cost of equity, which is a key aspect of WACC. On account of this, there are chances that EVA itself can be perceived as different for the same organization and the same period. In the above Economic Value Added example, the cost of equity has changed from the year 2015 to the year 2016. This can be one of the major factors due to a decrease in EVA.Apart from the WACC, other adjustments are also required to the Net Operating Profit After Tax. All noncash expenses need to be adjusted. This becomes difficult in the case of an organization with multiple business units and subsidiaries.A comparative analysis is difficult with Economic Value Added (EVA) on account of the underlying assumptions of WACC.EVA is calculated on historical data, and future predictions are difficult.

What is Economic Value Added?#

Economic Value Added (EVA) concept#

EVA Formula#

Economic Value Added Example (Basic)#

#1 – EVA Formula – Net Operating Profit After Tax (NOPAT)#

#2 – EVA Formula – Capital Invested#

#3 – EVA Formula – WACC#

#4 – Economic Value Added EVA Calculation#

Accounting adjustments for EVA Calculation#

Colgate Economic Value Added Example EVA#

#1 – Calculating Colgate’s NOPAT#

#2 – Colgate’s Invested Capital#

#3 – Find WACC of Colgate#

#4 – Colgate’s Economic Value Added EVA Calculation#

What is the importance of EVA?#

Advantages and disadvantages#

Advantages of using Economic Value Added (EVA):#

Disadvantages of using Economic Value Added (EVA):#

Recommended Articles#