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What is Economic Value Added?
Have you noticed that the stock prices of many companies (especially internet stocks) seem to rise rapidly despite large reported losses on their Income Statements. How can values go up, up, and up with such low earnings on the Income Statement? This question has raised serious concerns that Net Income has little to do with the values of companies. So why the disconnect? Well, net income is derived from past events on a short-term basis while values of companies are derived from future events over the long-term. Consequently, managers are looking for better measures of financial performance. In recent years, such a measurement has emerged. It's called Economic Value Added or EVA.
The basis of EVA resides in something called Economic Income. Economic Income is a better measure of value-creation since it takes a much longer view of what's going on. Unfortunately, calculating Economic Income isn't easy. For example, suppose you spend $ 10,000 on research and development. This should provide a long-term benefit to your organization. In determining Economic Income we will capitalize Research and Development while under traditional accounting, we deduct the full amount as an expense in arriving at Net Income.
In a much simpler form, EVA is calculated by taking Net Operating Profits After Taxes (NOPAT) and reducing NOPAT by your total cost of capital. Remember that your cost of capital includes both debt and equity. Cost of Capital is the cash flows that you spend to compensate your investors for the risks they incur when they lend you money or buy stock in your company. The resulting amount, NOPAT - Cost of Capital, is called EVA. If it's positive, this indicates that you created x amount of value for the owners of your company. A negative EVA would imply that you destroyed x amount of value for the owners.
Numerous companies, such as Coke Cola, have made EVA their key management program to drive value-creation. So does EVA really work? Well, that depends upon your business. It appears EVA is a good improvement to traditional financial measurement when a company's capital structure is heavily invested in real assets with relatively low debt loads (such as utilities). However, if your business is based on intangibles such as intellectual capital in a fast growth environment (such as technology companies), than EVA will be less useful.
My recommendation is to give EVA serious consideration due to the major distortions within traditional accounting. However, since cash flows are the real source of value-creation, you need to take EVA with a grain of salt. And don't forget that value-creation comes from lots of things that have little to do with financial measurement.