Economic Value Added

Accounting profit charges a company for the debt it uses and nothing for the equity. That is the flaw EVA exists to fix.

Shareholders' money is not free. It has a required return, and a company that earns less than that return is destroying value even while its profit and loss account shows a profit. EVA makes the charge explicit: take the after-tax operating profit, subtract the cost of all the capital tied up in the business, and see what is left.

The workbook calls this the true economic profit produced by a company, and also refers to it simply as economic profit. It is a measure of a company's economic success over a period of time, useful to investors who want to know how well the company has produced value for them.

The construction is in three parts.

Net after-tax operating profit is the earnings the operations generate, struck before the cost of financing but after tax — so it belongs to everyone who funded the business, lenders and shareholders alike.

Invested capital is what those funders have put in and left in.

Percentage cost of capital is the blended return the funders require, weighted between debt and equity.

Multiply the last two and you get the rupee amount the business must earn just to stand still. Subtract it from the first and you have EVA.

The sign is what matters. Positive EVA means the business earned more than the capital cost, and value was created. Negative EVA means the opposite — and a company can post a large accounting profit and a negative EVA at the same time, which is precisely the situation the measure is built to expose.

EVA = Net after-tax operating profit - (Invested capital x Cost of capital %)

The second term is the capital charge — the rupee return the providers of capital required for the year.

A listed capital goods company, for the year:

Capital charge = 3,400 x 11%  = Rs 374 crore
EVA            = 390 - 374    = Rs  16 crore

The company earned Rs 390 crore and the market told it that Rs 374 crore of that was simply rent on the money. Rs 16 crore is the genuine surplus — on a business of Rs 3,600 crore of revenue, a margin of value creation of less than half a per cent.

Now grow it. Suppose the board funds a Rs 600 crore expansion at the same 11% cost of capital, and it lifts after-tax operating profit by Rs 54 crore:

New NOPAT          = 390 + 54           = Rs 444 crore
New invested capital = 3,400 + 600      = Rs 4,000 crore
New capital charge = 4,000 x 11%        = Rs 440 crore
New EVA            = 444 - 440          = Rs   4 crore

Profit rose 14% and EVA fell by three-quarters. The expansion earns 9% on capital costing 11%, so every rupee of it destroys value. Nothing in the profit and loss account says so. EVA says so immediately.

Chapter 8 (Investing in Stocks), section 8.5.5.5, which pairs EVA with MVA as "the most common metrics used to determine a company's value", immediately before the EBIT/EV and EV/EBITDA multiples at 8.5.5.6. Questions are definitional and directional: what is subtracted from what, what a positive or negative EVA signifies, and how EVA differs from MVA.

• EVA is a flow, MVA is a stock. EVA measures economic success over a period of time; MVA compares a market value today with capital contributed historically. They are not two names for one thing.
• The capital charge covers equity too. That is the entire point. A company with no debt still has a cost of capital and still faces a charge.
• Positive accounting profit and negative EVA coexist routinely. A question that offers "the company is profitable, therefore EVA is positive" is offering a false inference.
• Start from after-tax operating profit, not profit after tax. PAT is already after interest; using it would charge the debt cost twice, once through interest and again through the capital charge.
• Growth is not automatically value-creating. Adding capital adds to the capital charge. Only a project earning above the cost of capital raises EVA.
• EVA is also called economic profit. Both names appear in the workbook, and a question may use either.