How to Calculate Economic Value Added(EVA)
Economic value added (EVA™) concept was created by Stern Stewart & Co and they own its trademark.It is an estimate of a firm’s economic profit and is quite useful inthe hands of analysts.It is an effective method that helps to measure the quality of management decisions and is considered as reliable indicator of future growth of a firm.Cost of capital can be understood as the rate of return required for shareholders or the persons who have put their money for business operations.When the revenue generated exceeds cost of capital and business then the company creates wealth for shareholders.
Positive EVA shows the increase in companies value over a period of time while negative shows a decrease.It helps managers to make better investment decisions and identify the opportunities.
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There are two methods through which you can calculate the EVA™
1. Residual Income Method (Spread Method)
It involves computation of difference between two returns of same risk level : (NOPLAT/TotalCapital – WACC) * Total Capital
*NOPAT = Net operating profit after taxes this can be found by deducting interest and taxes from EBIT
*WACC = weighted average cost of capital
This method is also called spread method.
EVA™ number should be +ive. -ive value is not good for investor to choose the security.
2. Refined Earnings Method
Under this method EVA = (Sales – Operating expenses) – (WACC) (Net assets).
Besides practising this formula you can also try this spreadsheet that i have found on net.Here is the example excel sheet that will help you to create your own.
How managers can increase EVA™
Basically there are 3 major tactics to increase the EVA™ for any firm,it includes greater return with minimal capital employement,minimize capital and invest the capital in high return investments and projects.
EVA cannot be considered as fully reliable as there are a bit chances that it can be manipulated though they are rare but it might happen as it is just a financial figure that relies on financial accounting methods of revenue realization and expense recognition.You can read this story here to find out how can managers manipulate this tool
