Economic value added
The periodic addition to shareholder value resulting from the efficient management and allocation of resources.
The important insight from EVA analysis is that a whole firm, a project or a division will be destructive of shareholder value in the following circumstances:
(1) Whenever its returns are inferior to the relevant economic cost of capital.
(2) Even if it appears to be profitable when measured on an accounting basis (for example on an Earnings per share basis).
EVA can be considered at the whole-firm level or in relation to smaller business units or projects.
EVA at the whole-firm level
The periodic addition to total shareholder value from the efficient management and allocation of the whole firm's resources.
EVA can be quantified at a whole-firm level as:
EVA = [Return on book capital LESS Market cost of capital] x Book capital.
Example 1: EVA calculation
Taking a simplified example, take an all-equity financed firm with:
(1) A market capitalisation (P0) of $130m.
(2) Book value of equity $100m.
(3) Annual after tax returns of $13m.
To keep this illustration simple, we will assume no growth.
In other words the whole of the annual after tax returns of $13m are paid out as dividends (D1).
Return on book capital = 13 / 100 = 13%.
Market cost of capital = 13 / 130 = 10%
(Using Ke = D1/P0).
EVA = [13% - 10% = 3%] x $100m
In practice a number of adjustments would be made both to the market values and to the book values used in the calculation of the EVA.
So the application of EVA analysis is both more complicated, and arguably more subjective, than the simple calculation illustrated above.
Example 2: MVA calculation
Turning back for now to our simple example, EVA is also closely related to Market value added (MVA).
MVA is the total present value of the expected EVA in the current and future periods.
For example in this case the EVA is a simple fixed perpetuity of $3m.
The total present value of the fixed perpetuity of $3m is evaluated using:
(1) The simple fixed perpetuity formula 1/r.
(2) The market cost of capital 10%.
MVA = $3m / 0.10
EVA at the individual project level
It is also possible to calculate and analyse EVA at the individual project level.
In simple terms, EVA is positive when the project Internal rate of return exceeds the (appropriately risk-adjusted) Weighted average cost of capital.
A simple decision rule when using EVA at the project level is:
(1) Reject all negative EVA projects.
(2) Positive EVA projects will be considered further.