ECONOMIC VALUE ANALYSIS

Economic Value Analysis is a systematic approach to evaluating the performance attributes of your product in relation to the resource expenditures required to enjoy its benefits. In corporate finance, Economic Value Added or EVA, a registered trademark of Stern Stewart & Co., is an estimate of a firm's economic profit being the value created in excess of the required return of the company's investors (being shareholders and debt holders). EVA is the profit earned by the firm less the cost of financing the firm's capital. The idea is that value is created when the return on the firm's economic capital employed is greater than the cost of that capital. This amount can be determined by making adjustments to GAAP accounting. There are potentially over 160 adjustments that could be made but in practice only five or seven key ones are made, depending on the company and the industry it competes in. From a commercial standpoint, Economic Value Added (EVA) is the most successful performance metric used by companies and their consultants. Although much of its popularity is a result of able marketing and deployment by Stern Stewart, owner of the trademark, the metric is justified by financial theory and consistent with valuation principles, which are important to any investor's analysis of a company.

Calculating EVA
EVA is net operating profit after taxes (or NOPAT) less a capital charge, the latter being the product of the cost of capital and the economic capital. The basic formula is:

where:

, is the Return on Invested Capital (ROIC); is the weighted average cost of capital (WACC); is the economic capital employed; NOPAT is the net operating profit after tax, with adjustments and translations, generally for the amortization of goodwill, the capitalization of brand advertising and others non-cash items.

EVA Calculation: EVA = net operating profit after taxes a capital charge [the residual income method]

Therefore EVA = NOPAT (c capital), or alternatively EVA = (r x capital) (c capital) so that EVA = (r-c) capital where:
r = rate of return, and c = cost of capital, or the Weighted Average Cost of Capital (WACC).

NOPAT is profits derived from a companys operations after cash taxes but before financing costs and non-cash bookkeeping entries. It is the total pool of profits available to provide a cash return to those who provide capital to the firm. Capital is the amount of cash invested in the business, net of depreciation. It can be calculated as the sum of interest-bearing debt and equity or as the sum of net assets less non-interest-bearing current liabilities (NIBCLs). The capital charge is the cash flow required to compensate investors for the riskiness of the business given the amount of economic capital invested. The cost of capital is the minimum rate of return on capital required to compensate investors (debt and equity) for bearing risk, their opportunity cost. Another perspective on EVA can be gained by looking at a firms return on net assets (RONA). RONA is a ratio that is calculated by dividing a firms NOPAT by the amount of capital it employs (RONA = NOPAT/Capital) after making the necessary adjustments of the data reported by a conventional financial accounting system. EVA = (RONA required minimum return) net investments If RONA is above the threshold rate, EVA is positive.

Comparison with other approaches

Other approaches along similar lines include residual income (RI) and residual cash flow. Although EVA is similar to residual income, under some definitions there may be minor technical differences between EVA and RI (for example, adjustments that might be made to NOPAT before it is suitable for the formula below). Residual cash flow is another, much older term for economic profit. In all three cases, money cost of capital refers to the amount of money rather than the proportional cost (% cost of capital); at the same time, the adjustments to NOPAT are unique to EVA. Although in concept, these approaches are in a sense nothing more than the traditional, commonsense idea of "profit", the utility of having a separate and more precisely defined term such as EVA is that it makes a clear separation from dubious accounting

adjustments that have enabled businesses such as Enron to report profits while actually approaching insolvency. Other measures of shareholder value include:
Added value Market value added Total shareholder return.

Relationship to market value added

The firm's market value added, or MVA, is the discounted sum (present value) of all future expected economic value added:

Note that MVA = PV of EVA. More enlightening is that since MVA = NPV of Free cash flow (FCF) it follows therefore that the NPV of FCF = PV of EVA; Since after all, EVA is simply the re-arrangement of the FCF formula. Implementing EVA The key persons (top and middle managers) have to understand and commit to EVA thoroughly without the full support of managers there will not be substantial results, good understanding helps to tailor EVA to the specific need of a company.EVA will be most beneficial if broken down into small parts. Integration to incentive systems for all the employees is a good way to make all the employees to work hard for common goals. EVA is a
method to measure a companys true profitability and to steer the company correctly from the viewpoint of shareholders. EVA helps the operating people to see how they can influence the true profitability (especially if EVA is broken down into parts than can be influenced) It clarifies considerably the concept of profitability.

Conclusion
Economic profit - otherwise known as "Economic Value Added" (EVA) is based on classic financial theory, and, for this reason, is not entirely different from traditional free cash flow measures. Three conceptual pillars support economic profit: Cash flows are more reliable than accruals. Some period expenses are - in economic reality - actually long-term investments.

The company does not create value until a threshold level of return is generated for shareholders. Economic profit boils down to a set of adjustments that translate an accrual-based earnings before interest and taxes (EBIT) into a cash-based net operating profit after taxes (NOPAT). Although the list of potential adjustments is long, it is important not to be seduced into an almost-impossible quest for absolute precision. From an investor's perspective, consistency is more important. That is, an income statement adjustment should always be matched by a balance sheet adjustment. For example, if we add back minority interest to earnings, then we need to add the minority interest balance sheet account to invested capital. We can add neither or both, but there is no truly right answer. In this example, it comes down to whether we prefer our economic profit to have an operational perspective (add both) or a financial perspective (add neither). It avoids seeking precision in the calculation of weighted average cost of capital (WACC), a dubious academic exercise. It is far better to charge the company with an approximate but consistent estimate of WACC than to try to chase down the elusive cost of equity. (Several companies, after trying to explain a precise WACC to employees, have come to abandon a precise WACC in favour of a round number like 10%; e.g. "cost of capital is 10 %".) Finally, it helps to consider whether economic profit is an appropriate performance metric for the company you are evaluating.

Strengths and weaknesses: Strengths If you had to rely on only one single performance number, economic profit is probably the best because it contains so much information (mathematicians would call it "elegant"): economic profit incorporates balance sheet data into an adjusted income statement metric. Economic profit works best for companies whose tangible assets (assets on the balance sheet) correlate with the market value of assets - as is often the case with mature industrial companies. Weaknesses

Although some proponents argue economic profit is "all you need", it is very risky to depend on an single metric. The companies least suited for economic profit are high-growth, new-economy and hightechnology companies, for whom assets are 'off balance sheet' or intangible.