Economic Value Added (EVA)

                                                                         _____________________
                                                                                 {  Cost of Capital }
                                                                                            
EVA = Net Operating Profit After Taxes – (WACC *  Invested Capital)

EVA = (ROIC – WACC) * Invested Capital

What these equivalent equations say are that EVA measures the profits that are generated in excess of what it costs to earn those profits, i.e., the cost of capital. EVA takes into account the cost of both debt and equity.  By comparison, net income calculations do not include the cost of equity.

Linking Value Creation and EVA
Remembering the formulas that determine value: 

Increasing Firm Value

The firm's value today is the sum of all the future cash flows, discounted by the weighted average cost of capital, "WACC." 

Investing in Value-creating Projects

Value is created with positive NPV projects				Key Concept
Value is destroyed with negative NPV projects

The firm will be able to generate future cash flows only by investing in projects with positive Net Present Value, "NPV," i.e., projects where the present value of future cash flows exceed the initial investment. 

The EVA calculation differs from NPV in that EVA includes the cost of utilizing the initial investment for the project.

Therefore, excess economic profit, or EVA, is created only when the return on invested capital (ROIC) exceeds the firm's WACC.  

EVA is based on the following concept:  Managers will only generate a return on equity capital that exceeds what shareholders otherwise could have earned with the capital, when their annual compensation is based on generating positive EVA.  By doing this, shareholders force managers to only take on projects that have positive NPV and to reject those that don't -- even though these projects sound like such good ideas, at the time.. 

The theory is that this accumulation of good decisions increases a firm's excess profits, or EVA, and ultimately increases firm value.   It makes sense.  The research shows though, that EPS is as effective a predictor of future performanceas EVA and less expense to produce. 

Here's the Practical Turnaround Thinking:  The current research suggests, however, that a portfolio of one to two financial, and three to eight non-financial measures, combined with an employee engagement measure, provides management with an reliable picture of current and future performance.  This portfolio also serves to translate strategy throught the organization.

• EVA
  - WACC analysis
  - ROIC analysis