Monday, November 20, 2006

EVA - Economic Value Added

If you invest in a business and if the net income (bottom line) is positive, do you think your investment in this business is a good idea?

It depends. What would the same investment have earned elsewhere? If you earned 100,000 on 1,000,000 in this business then you earned 10% profit. If investing elsewhere would have gotten you 130,000 that is 13% interest then this business did not really earn you any profit, instead you lost money due to missed opportunity cost.

So, a new measure was required to determine if the business is doing justice to the capital invested. What makes up capital? 1) Paid in capital when shares were issued 2) Retained earnings  3) Debt. 1 and 2 can be combined treated as capital invested by owners and capital invested by debtors.

Debtors always have a rate of return regardless of how business does. The interest rate they charge is what is their rate of return. But what about the owners or investors. What rate they should  expect? One way to come up with appropriate rate of return is to match it up with the risk of the investment. We can use beta of a stock and use CAPM to come up with a appropriate rate of return. Expected return = risk free rate + beta (market return - risk free rate).

Then, the capital structure of any company  consists of debt and equity in different portions. So, we can take the weighted average of debt capital and equity capital and determine WACC (Weighted average cost of capital). We use this to find out new measure economic value added.

We start with NOPAT (net operating profit after taxes). This is done to unmask the tax impact of interest you are paying on the debt. We want to remove the tax benefits first. NOPAT = Operating income * (1- tax rate).

Now calculate EVA  as EVA - NOPAT - (Capital * cost of capital).

EVA helps you compare any investment with respect to other investment opportunities. Many companies such as Coca Cola, TCS adopted EVA with zeal to make it a point to show to their shareholders that investing in their companies is the best or one of the best investing opportunities they can find amongst many such opportunities. Way to go.

Check out for nice articles, tutorials on EVA. But, it is not very easy to calculate EVA for every company that interests you unless you can come up with a pluggable spreadsheet or find ready-made calculator. But, you can develop a rule of thumb. That is to subtract a percentage of market value from the net income an see how it fairs. Market value is the worth of your investment. You can dump it at this time, collect that much money and move one. So, market value is the theoretical money you have. On that you want to earn say 13%. So, if the market value of your company is 1 million dollars then you have to earn at least 100,000 per year. Is your company earning that much?


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