Economic Value Added (EVA) basically implies to financial gain in exceeding the expected figures of profit. In other words, EVA evaluates the additional profit yield of a firm after deducting the cost of capital like dividends to shareholders, etc. However, the acronym EVA applies to multiple fields, with varying interpretations, yet its importance in finance is specific. Furthermore, the utilization of EVA sometimes alluded to the late 1980s as a proprietary variant of the estimations as business advisory company Stern Stewart & Co reportedly made.
Pros And Cons Of Economic Value-Added
Uses of the Economic Value-Added metric
The EVA metric is mainly utilized as a business valuation tool. Some of the EVA supporters such as P.C. Narayan from the Indian Institute of Management (IIM), Bangalore defends EVA over other measures of profitability because it illustrates possible earnings in the future. According to Narayan, this is so because metrics like Earnings Per Share (EPS) only depict how well a company is meeting the past financial expectations of the stock-holder and does not show the possibility for capital reinvestment.
Calculation of Economic Value-Added
According to Stern, Stewart & Co. formula, EVA is the outcome of deducting taxes and the weighted average cost of debt and equity capital from the net operating profit. Although, this is not the sole way to find out EVA as the cost of capital calculation differs from business to business. For example, the version of EVA as per the United States Postal Service (USPS) indexes the operating cost of EVA to inflation to reflect costs after rate extensions bit more precisely. Other companies may not require to adjust costs as per inflation based on accounting methods and corporate policies. The formula of EVA for Stern Stewart & Co EVA reads as:
EVA= (Net Operating Profit-Tax)- (Weighted Average Cost of Equity and Debt)
Advantages of Economic Value-Added
The advantages of EVA include but not limited to:
- EVA complements financial data from various other methods of business valuation and assessment.
- It shows the cost management of businesses and illustrates working capital availability after the deduction of its actual opportunity cost.
- Another advantage of EVA is that it is also used as a management incentive that ensures a company’s continuity of operations.
- According to Aswath Damodaran, a Finance Professor at the New York Stern School of Business, EVA also helps to escape from problems related to percentage calculations by making use of specific values.
Disadvantages of Economic Value-Added
Economic value added cannot determine how effectively capital asset holders utilize the retained profits through project management and other company ventures. Furthermore, capital asset managers may instead of elevating the future return on capital with efficiency, reinvest it to minimize the operational costs by profitability, and misuse the liquid reserves. Economic Value-Added also cannot calculate the return on expenses like research and development.
Rather than simply becoming an operational cost of the income statement, the potential of research and development to produce future profits that are not predicted by EVA is quite significant.