Economic Value Added (EVA) - Concepts

Economic Value Added is the financial performance measure that comes closer than any other to capturing the true economic profit of an enterprise. EVA (concept was developed by Stern Stewart & Co.) is the performance measure most directly linked to the creation of shareholder wealth over time.
EVA is net operating profit minus an appropriate charge for the opportunity cost of total capital invested in an enterprise. As such, EVA is an estimate of true "economic" profit, or the amount by which earnings exceed or fall short of the required minimum rate of return that shareholders and lenderscould get by investing in other securities of comparable risk.

EVA = Net Operating Profit After Taxes (NOPAT) - Capital * Cost of Equity

The capital charge is the most distinctive and important aspect of EVA. Under the EVA concept a business is profitable only once its profit is greater than its cost of equity. Until that moment it does not create wealth, it destroys it. By taking all equity costs into account, including the cost of equity, EVA shows the amount of wealth a business has created or destroyed in each reporting period.

The primary financial objective of any company should be to maximise the wealth of its shareholders; the value of a company depends on the extent to which investors expect future profits to exceed or fall short of the cost of equity.

Defining EVA and its components

Adjustments in net income and book capital
NOPAT represent the after-tax operating profit before financing costs and non-cash expenses of a company.

NOPAT
= Net Income to Common Shareholders
+ Goodwill Amortization+ Extraordinary Losses (minus gains) After Taxes+ Loan Loss Provision- Charge-Offs+(-) Deferred income tax created by increasing/reducing deferred tax asset

Invested capital
Invested capital can be defined as the total cash payments invested in the company without regard to form of financing or accounting adjustments. This represents the economic base on which capital investors require a minimum return based on the risk profile of the assets and operating characteristics of the company. Invested Capital is calculated by adding the following components: the book value of common equity, cumulative goodwill amortization, cumulative extraordinary gains/ losses, the after tax loan loss reserve.Invested Capital = Book Value of Common Equity
+ Cumulative Goodwill Amortization+ Cumulative Extraordinary Losses (gain)+ After-Tax Loan Loss Reserve- Cumulative Chare-Offs+(-) Deferred income tax created by increas-ing/reducing deferred tax asset

Cost of equity
The cost of equity (CoE) represents the minimum return an investor should require from an investment of similar risk. As part of EVA the cost of equity represents the benchmark by which to judge the adequacy of the rate of return earned on Invested Capital.