Economic Value Added (EVA)
A company may be profitable, but should the company reinvest its earnings in its business to earn more money or should it be distributed to shareholders as dividends? Should an investor purchase more stock in a secondary offering of the company? The answer depends on whether the company can earn more on the additional funds as measured by its return on assets than its opportunity cost, often represented as the aggregate return of the stock market. If it cannot earn more than the general market return with the additional funds, then investors of the company will get a lower return for their money than if they had invested in a market index fund or an exchange-traded fund based on a stock market index.
Economic value added (EVA) is the spread between a firm's return on invested capital (ROIC) and the cost of capital multiplied by the total amount of capital invested, and measures the amount of value added with newly invested funds.
EVA = (ROIC – Cost of Capital) × Average Amount of Invested Capital
ROIC = Net Operating Profit after Taxes
Average Invested Capital
EVA measures the additional value added if more money is invested in the business. If EVA is negative, then the additional investment will lower the overall return of the company. For instance, if a business borrows money at 6% for 1 year and earns 10% on that money, then EVA is positive, so borrowing money increases value of the business. If the business only earns 4% on the money, then EVA is negative, which will decrease the value of the business.
EVA can also be measured in terms of net operating profit after taxes (NOPAT):
EVA = NOPAT – Weighted Average Cost of Capital × Invested Capital
There are several ways to increase EVA:
- operating efficiency can be increased, by increasing the return on existing assets
- additional projects can be undertaken where the business can earn a greater return than its cost of capital or, as it is sometimes called, its hurdle rate
- the business can eliminate activities with a negative EVA
Generally, most businesses will not invest in a project unless the expected return is at least a minimum, called the hurdle rate. If the business is a public company, then it would want to invest in projects that earned at least its return on equity (ROE). If the ROIC for a proposed project is less than the ROE, then ROE will decrease if the project is undertaken, thereby decreasing the value for shareholders.