Economic Value Added
A metric that helps measure a company’s true economic profit. As a result, it helps investors determine whether the company is creating value for its shareholders.
Developed by consulting firm Stern Stewart & Co., the idea behind EVA is that if a company’s operating income is larger than its cost of capital, that business is creating value for shareholders. Stern Stewart originally created EVA to help managers gauge the performance of their own businesses, but investors have since adopted it as a useful metric for sizing up a company.
To get an idea of how EVA works and why it’s so important, consider this example: Suppose you go into business selling David Gardner jester caps. Your company has $100,000 in capital to work with, and in one year, you rake in $11,000 -- an 11% return on the capital you started with. Nice going, Fool!
But there’s a hitch. Suppose a big chunk of that $100,000 you started with was a loan you took out to get the business off the ground. Did you include the interest payments on the loan in this equation? Sure doesn’t look like it. How about other costs?
EVA helps you tack together all of the tinier pieces of the puzzle so that you have a more accurate picture of the profit a company is actually churning out -- and it’s this economic profit that translates into shareholder value. The equation is:
Much like when you’re making dinner, quite a bit of chopping, dicing, and measuring goes into calculating the different parts of this equation, and only after making these preparations can you go ahead and pull the whole thing together. For this reason, read the definitions of each of these parts carefully to make sure you don’t miss anything.
If, once you’ve run the numbers, your EVA equation pops out a negative result, that means that the company has destroyed value and that your money would be best invested somewhere else.
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