EVA: A Definition
EVA is a measure of profit. Not the accounting profit we are accustomed to seeing in a corporate income statement, but profit as economists define it. Both are measured net of operating expenses; they differ only in the treatment of capital costs. While income statements recognize only the interest paid to bankers and bondholders, EVA recognizes all capital costs, including the opportunity cost of shareholder funds.
The difference between accounting profit and economic profit can be seen in Figure 1. On the left side is profit as it appears on the typical income statement, where EBIT is earnings before interest and tax (a popular term for pre-tax operating income), I is interest expense, T is income taxes, and IC is invested capital. Net income is simply operating income, with interest and taxes removed. Note that the only capital cost included in the profit measure is interest expense (the amount of debt multiplied by the interest rate).
EVA, or economic profit, also starts with EBIT. Income taxes are subtracted to produce net operating profit after tax, or NOPAT. But instead of subtracting interest, EVA charges for the use of all capital, including equity finance. While accounting profit charges only for the cost of debt, capital charges for the calculation of EVA equal the product of invested capital and the cost of capital (COC). The cost of capital, popularly known as the weighted-average cost of capital (WACC), is a function of the cost of debt and equity weighted for their relative proportions in the company’s capital structure.
Economic profit is based on an idea generated by the English economist Alfred Marshall in the late 19th century: for investors to earn true economic profits, sales must be sufficient to cover all costs, including operating expenses (such as labor and materials) and capital charges. Such economic profits are the basis of value creation. Indeed, as management guru Peter Drucker has written, “EVA is based on something we have known for a long time: what we generally call profits, the money left to service equity, is usually not profit at all. Until a business returns a profit that is greater than its cost of capital, it operates at a loss.”2
It can be mathematically proven that the worth of a business must equal invested capital—the sum of fixed assets, cash, and working capital—plus the present (or discounted) value of future EVA. Value determined in this way is mathematically equivalent to the value estimates produced by discounted cash flow models. The upshot: as capital market expectations of corporate EVA increase, so do share prices. Companies can thus use EVA targets to motivate managers to deliver the financial results that capital markets want. This approach is especially useful for executives one or two levels below top management, managers who have little direct influence over share price and for whom stock options are less effective.