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Economic Value Added – an introduction
November 18th, 2009
Jakub Skavroň
EVA® is the emerging tool with which to measure
shareholder value
– EVA® introduction–
 Adjusted operating profit less the capital charge
(weighted average cost of capital multiplied by capital invested)
Economic Value Added
(EVA®)
 A company with a positive EVA is earning more than its cost of
capital, and is thus creating wealth
EVA® utilizes cash flows, the capital employed and the
cost of capital to measure the creation of value
– EVA® introduction–
Economic Value Added
(EVA®)
Net Operating
Profit After Tax
(NOPAT)
Capital
Charge
There are two main categories of value drivers
– EVA® value driver categories –
EVA®
=
Drivers for defining the economic results
of management
Economic result
Revenues
Profit margin
Drivers for determining the cost of activities
used to reach economic results
–
Invested capital
Costs
Assets
Working capital
x
Capital charge
Cost of debt
Cost of equity
EVA® compares the return on invested capital with the
cost of capital
EVA = ECONOMIC RESULT - COST OF INVESTED CAPITAL
EVA = NOPAT - (WACC * INVESTED CAPITAL)
.
EVA = (
NOPAT
* INVESTED CAPITAL ) - (WACC * INVESTED CAPITAL)
INVESTED CAPITAL
EVA = ( ROIC * IC) - (WACC * IC)
EVA = (ROIC - WACC) * IC
Value driven by ROIC and Invested Capital
– Value matrix –
+
Creating
Value
Destroying
Value
Disinvesting
Invested
Capital
Investing
-
Limiting
Value
Releasing
Value
Negative
(ROIC – WACC)
Positive
The calculation of EVA starts with calculation of NOPAT
– Calculation of EVA –
SALES
Cost of Sales
-2 500
Depreciation
-600
Other Costs
-300
EBIT
Taxes on EBIT1
NOPAT
1At
4 000
tax rate of 33,3%
600
-200
400
NOPAT is then compared with Cost of Invested Capital,
and the result represents Economic Value Added
– Calculation of EVA –
Invested Capital
Weighted Average Cost of Capital (WACC)1
15%
COST OF INVESTED CAPITAL
150
NOPAT
400
COST OF INVESTED CAPITAL
ECONOMIC VALUE ADDED
1An
1 000
explanation of how to calculate WACC will follow later
-150
250
The other approach described earlier is to compare
ROIC with WACC
– Calculation of EVA –
NOPAT
Invested Capital
400
1 000
RETURN ON INVESTED CAPITAL (ROIC)
40%
ROIC
40%
WACC
-15%
ECONOMIC VALUE ADDED (%)
25%
Use of EVA® remains a controversial subject which
presents its pros and cons
Pros

Cons

Fails to look forward, due to difficulties with calculations of
terminal value

Shifts the focus from achieving growth to achieving
profitable growth, thus enabling the firm to evaluate better
where the firm should tie up its capital
Does not recognize the potential future value of investment
expenses such as R&D, investment in human resources

The lack of financial knowledge in many companies

Risks reduce management strategy to a mere formula

Enables manager bonuses to be linked to the real
performance of the business unit

Copyright by Stern Stewart & Co.

Permits to evaluate company performance in every single
period

Recognizes the fact that business units have different risk
profiles and should therefore be charged with different costs
of capital
The general rule is to use Economic Value Added (EVA®)
for the past and Discounted Cash Flow (DCF) for the
future
EVA is a great tool for measuring how well you have done and whether you have:
EVA®

Exceeded the cost of capital (or not)
By how much and during which years

It can highlight strategic insights and motivate action
What caused the yearly fluctuations, what can we do about it

Remember that EVA was developed as a compensation tool
Stern Stewart’s focus is on issues of corporate governance
DCF is superior when projecting the future, unless the company has installed an EVA  based accounting system,
and data is easily available
DCF


In all cases much easier to calculate
While discounted EVA (calculated correctly) is mathematically equivalent to discounted cash flow,
it is difficult to make sure you have made all the adjustments correctly, and you are almost guaranteed
to make a mistake
Back up
WACC calculation requires inputs from several outside
sources
– Steps to Calculation of WACC –
Risk Free Rate
6,0%
Market Risk Premium
4,0%
Stock Beta
Cost of Equity
Cost of Debt
Tax Rate
Effective Cost of Debt
1.1
10,4%

Current Treasury Bond Rate (Source: Fed, CNB)

Represents the premium required to compensate for extra risk
associated with investing in equities

Represents “non-diversifiable risk” or risk due to general market shifts
(Source: Bloomberg, Value Line)
 Cost of Equity = Risk Free Rate + Beta x Market Risk Premium
5,0%

Each rating level has associated debt cost (eg. BBB+ in 2006 is 5%)
30,0%

Interest expense is tax deductible
3,5%
 Effective cost of debt = Tax shield * Cost of Debt
Weight of Equity
40,0%

Ratio of Equity on Total Capital
Weight of Debt
60,0%

Ratio of Debt on Total Capital
WACC
6,3%
 Weighted Average Cost of Capital