Economic Value Added, or simple EVA is the measure of the financial performance of the company that is based on calculation related to residual wealth and deduction capital cost from its operating profit (taxes adjustment on a cash basis) (Investopedia, 2013).
This is the best tool to be used that can show shareholders how the companies perform. One of the EVA’s advantages is that it makes gap correction, which means that it is done by gauging in regular GAAP accounting, where it is important. It has an ability to give shareholders an overview whether they are really getting returns superior in comparison to what they put money in, such as index fund or equally risky stock. According to EVA , if the return, which the market is expecting from similar stocks, is exceeded this means that the company is truly enriching the investors. Money is made only when that margin is reached. In case of coming short, it is definitely a loss, even if the official numbers of earnings are looking good (Tully, 2013).
It provides an opportunity to have a look at a hidden cost so that investors would know how to compensate them for losing their own cash. It can be told that EVA is charging the rent from the company for tying up cash of the shareholders in order to support operations. EVA shows this hidden capital cost, which is ignored by conventional measures (McClure, 2009).
The analysis of the recovery process that started in 2009 is showing the companies in USA managed to deliver great EVA increases, which has taken the number from extremely low to the highest in the recent fifteen years. Two numbers, where first one is the return on capital and is the earnings’ ratio to total capital, determine EVA. (EVA has a specific earnings definition, which includes restructuring costs and capitalizing R&D.) The better company is doing in restraining costs and driving sales higher, without new investment deployment loads, the better will be the return on its capital. This has happened in the early recovery part. The return on capital of nation for non-financial companies increased from 7% in the last quarter of 2009 to almost 10% by the beginning of 2012. This an example of good performance (Tully, 2013).
There are two well-known problems with EVA
Capital budgeting can not get benefit from EVA, as the later mentioned has focus on current earnings. For instance, net present value analyses is able to use projections of all potential future cash flows, which might differ from year to year, which means that NPV possesses the richness not present in EVA. Despite the fact that EVA can correctly incorporate the weighted average capital cost, it is still a pitfall. The other significant problem with EVA is that it might increase the managers’ shortsightedness. If the earnings are high today, a reward will be given to the manager today. However, the loses in future are not taken into account as with great results on EVA a promotion of change of job position might follow. This makes the manager’s decisions not visionary taking into considerations not long-term, but short-term value. If the prices cut was achieved through cutting quality, the earnings might definitely increase at one moment, but with time the customer might lose trust into a product that would definitely mean fall in future profits (Economic Value Added and the Measurement of Financial Performance).
EVA is used in many companies
The most common example is Coca-Cola Company that have been using EVA as a main financial measuring tool. There are also many consultants who offer their services on EVA calculation, the most famous are Bennett Stewart of the Stern-Stewart (Stuenkel). The more general approach would say that EVA is used within the companies and the businesses, which follow generally accepted accounting principles (GAAP) (Fraker, 2006).
To conclude this is important to say that EVA serves as a key source of information for the investors about the company’s profits, but is it important to be aware that it is related only to short period and manager must never forget to overview the future situation.
- Investopedia. (2013). Economic Value Added - EVA. Investopedia US, A Division of ValueClick, Inc.. Retrieved from http://www.investopedia.com/terms/e/eva.asp
- Tully, S. (2013). A sobering gut check for the market. CNN Money. Retrieved from http://finance.fortune.cnn.com/tag/economic-value-added/
- McClure, B. (2009). All About EVA. Investopedia US, A Division of ValueClick, Inc., 2013.
- Retrieved from http://www.investopedia.com/articles/fundamental/03/031203.asp
- Economic Value Added and the Measurement of Financial Performance (n.d.). Chapter 12. Retrieved from http://finance.wharton.upenn.edu/~acmack/Chapter_12_app.pdf
- Stuenkel, W.E. (n.d.). Economic Value Added for a Life Insurance Company.
- Retrieved from http://www.soa.org/library/monographs/other/m-as99-1_xvi.pdf
- Fraker, G.T. (2006). Using Economic Value Added (EVA) to Measure and Improve Bank Performance. Retrieved from http://www.rmaaz.org/pictures/measuringbankperformance.pdf