Economic Value Added EVA
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- čas přidán 7. 08. 2024
- Economic Value Added explained! What does Economic Value Added mean? How to calculate Economic Value Added? Let’s introduce Economic Value Added step-by-step. Start with understanding the context first, and then get into the details of the calculation, including an example.
⏱️TIMESTAMPS⏱️
0:00 Introduction to Economic Value Added EVA
1:06 Accounting profit versus economic profit
1:49 ROIC vs WACC
2:26 Economic Value Added formula
3:24 Economic Value Added example
4:58 How to improve Economic Value Added EVA
To understand the need for a concept like Economic Value Added, let’s look at some profitability numbers. Which of these companies has the best profitability performance for the year? Exxon Mobil with a net income of $14B? Facebook with a net income of $18B? Johnson & Johnson with a net income of $15B? Or Walmart with a net income of $15B? Which one would you vote for?
I would imagine that most of you voted for the company with the highest net income number. The higher the net income, the better the financial performance, right? Not necessarily, it depends on how you look at it.
You can either look at a company from the perspective of accounting profit, or from the perspective of economic profit, and there are ways to convert numbers from one perspective to the other. With accounting profit, you look at metrics like GAAP-based net income. With economic profit, you look at the returns generated above the required rate of return. Economic profit is the “tougher” way to measure, it sets the bar higher. Economic Value Added is one of the ways to measure economic profit, and was developed and copyrighted by Stern Stewart and Company.
If you analyze the performance of a company from the economic profit perspective, you can choose between two approaches. The first one is comparing ratios. For example, ROIC (Return On Invested Capital) versus WACC (Weighted Average Cost of Capital). ROIC represents the returns generated, WACC represents the required rate of return. If ROIC is 12%, and WACC is 8%, then a company creates value. Only returns that exceed the required rate of return are good enough! The second approach is to adjust absolute amounts, this is where Economic Value Added comes in.
Here’s the Economic Value Added formula. This might look a bit cryptic at first. Fear not, we will go through each of the elements of the EVA formula, as well as illustrate Economic Value Added with a numerical example.
EVA equals NOPAT minus WACC times the invested capital. NOPAT is Net Operating Profit After Tax. WACC is the Weighted Average Cost of Capital. Invested Capital is interest-bearing debt + equity, or if you want to start off from the other side of the balance sheet net assets less non-interest-bearing current liabilities. Both of these definitions of invested capital should get you to the same number.
The second part of the formula is often summarized as the “capital charge”, the amount you deduct from NOPAT to get to the Economic Value Added, a variation on the idea of residual income.
Let’s fill in the #EVA formula with some more detail. To calculate NOPAT, we need to start from accounting profit in the income statement. This is the number we are looking for as a starting point: Operating Income, sometimes called EBIT (Earnings Before Interest and Tax). NOPAT equals Operating Income times 1 minus the effective tax rate. NOPAT measures the after-tax return generated for debt and equity holders combined, so it’s broader than net income which just measures the returns for the shareholders. If a company has an Operating Income of $20B, and an effective tax rate of only 10% (low, but certainly possible), then NOPAT is .9 times $20B equals $18B. If the company’s WACC is 8%, and its invested capital $150B, then we can start to fill in the Economic Value Added formula and see the result! $18 billion minus 8% times $150 billion, is $18 billion minus $12 billion, so $6 billion. Due to the “capital charge” of $12B (the dollar number representing the required rate of return on the invested capital), NOPAT of $18B shrinks to an EVA of $6B! This is the economic profit that is left over when adjusting for the cost of capital.
How can companies improve EVA? Increasing NOPAT, decreasing WACC, decreasing the invested capital.
Here’s a bonus tip to put EVA into perspective. If EVA is NOPAT minus WACC times invested capital, and ROIC is NOPAT divided by invested capital, then you can also write the EVA formula as (between brackets) ROIC minus WACC, times invested capital. With the same numbers we used before, 12% minus 8%, times $150B, equals 4% times $150B, is $6B of EVA.
Economic Value Added: a way to measure economic profit in absolute amounts, closely related to ROIC and WACC.
Enjoyed this video? Then subscribe to the channel right now, and let's dive into the related topics of ROIC czcams.com/video/wLvCmFDEBXc/video.html and WACC czcams.com/video/1O-DbtVueMw/video.html
Brilliantly simple 6 minutes explanation. Best I have found yet.
Thank you very much, Radu! Please spread the word about the video and the channel.
The only regret i have after watching this video is why didn't I found this channel earlier.
Hello Suraj! Welcome to the channel. More than 160 videos for you to catch up on. ;-)
Really well explained, the main idea, but also the details - in a very crisp video. Thank you.
Glad you liked it, Dusica! And thank you for taking the time to comment. :-) Have a great weekend!
Thank you, your 6min explanation is clearer than a 1h course
Wow, happy to hear that. Glad I could help you.
omg thank you so much kind sir. you just helped me understand eva and wacc in 6 minutes. something my uni professors were not able to do in 3 months.
Fantastic! Happy to help! Please share the videos with your fellow students, and ace that exam!!!!
I found this helpful, thank you.
I'm so glad! Thank you for watching and commenting. Please subscribe, and spread the word!
Cool video lecture! :)
Glad you liked it!
Very well explained!!!
Thank you very much, Danilo!!!
great stuff, thanks a lot
Glad you liked it!
Thank you! Very helpful
You're welcome!
Perfect explanation, thank you very much!!!!
Glad it was helpful, Kenny! Have you applied the EVA formula yet to any companies?
I watched your video precisely because the EVA formula was implemented in the Brazilian company that I currently work, your video helped a lot in understanding the formula. Thanks!
@@kennypcm Nice to hear that! Happy to help!
very well explained
Thank you! :-)
Nice
Great video! Only the nose of the boy at the beginning was a bit disturbing hahaah
Thanks, Mike!
Could you also explain SVA, please?
Hi Filippo! I had never heard of SVA before you asked the question, but apparently Shareholder value added (SVA) represents a company's worth to shareholders in the absence of liabilities and capital costs.
Can I ask, if the company experiences a loss, can EVA calculations be done?
Yes. The calculation can be done, but the outcome will surely be a negative number.
Is invested capital (as referred here) and capital employed the same thing?
That is a good question, Bilal! Sadly, the answer is "it depends". Terms like "invested capital" and "capital employed" are non-GAAP terms, in other words in the real world there is no standardized definition that all companies apply. See the examples in my video on ROIC czcams.com/video/wLvCmFDEBXc/video.html So whenever you see terms like these being used in presentations, always check the appendix for the definition and calculation!!!
@@TheFinanceStoryteller Perfect, thank you so much!
can you discuss about cash value added?
Nope, don't know what it is, so not planning to make a video on it.
thanks. add MVA please.
Thanks for the suggestion! I will look into the topic, and see if there's a "story" there.
were did you get the 12 billion dollars?
It's all an example with numbers I simply picked for illustration purposes. 8% WACC times $150 billion of invested capital is $12B, as 0.08 * $150B = $12B.
Hello,
Can you help me in mentioned below question?
Apple Ltd has deployed a capital of 400 million in Orange Ltd a 100 per cent owned subsidiary company and it incurs a cost of 10 per cent. The after-tax profit generated by the subsidiary company is INR 45 million. Compute the EVA generated by the company?
That sounds like you are asking me to do your homework for you. By doing it yourself, you will learn a lot more!
@@TheFinanceStoryteller Not like that I am stuck in this question I need some clarity that's why I am asking you.
The wording in the question is a bit odd. In order to get to EVA, I think you need to deduct the "capital charge" from the after-tax profit. With the numbers given, capital charge should be 10% of 400 million. Have another look around 3 minutes into the video, the wording there is slightly different but the idea the same. Hope this helps!
How to calculate WACC?
That is explained in this related video: czcams.com/video/1O-DbtVueMw/video.html
You didn't tell us the answer to the first question though :(
Good catch, Jason! You would have to apply the EVA formula to each of those 4 companies in order to come up with a comparison (which I didn't do yet).
@@TheFinanceStoryteller I'll have to do that then. I guess it would be good practice, anyway. :)
Yes...yes...this is good... but what exactly is "economic value"?
Is it a value for the shareholders?
Or is it just a value for the overall economy?
Maybe it sounds a little mean, but as an investor, I'm more concerned with value being created for the shareholders - regardless of any value created for the overall economy.
Yes, EVA is trying to measure value created for shareholders. The idea is that accounting profit can be "distorted", while economic value tries to compare returns generated versus the cost of capital.
@@TheFinanceStoryteller Well...alrighty then. Thanks again!
Hey Richard, here's a suggestion for you... Read up or watch the documentaries on Enron ("smartest guys in the room"), Theranos ("out for blood"), Worldcom, Parmalat, Olympus (Michael Woodford - "Exposure"), Bausch and Lomb. Once you understand how these accounting frauds worked, you have a good understanding of how to look for red flags. I once took a short forensic accounting class where the professor showed what happens when companies record fake revenue (the offset entry is fake receivables, which obviously never get collected, and there is no COGS for fake revenue as nothing gets shipped). An interesting one is to review Enron's annual report of the year before they "blew up", and see if you can find the disconnects.
@@TheFinanceStoryteller Okay, good suggestions. Thanks again!
too many abbreviations (wacc,nopat,ebit,eva,roic) .... you didn't clearly define what EVA is without arithmetic... no one cares about the arithmetic, just tell me what the "bottom line" means
EVA is indeed a concept that supposes you already studied and understand WACC, NOPAT, EBIT and ROIC, as it builds on them / combines them. You will find videos for three out of those four topics on my channel, I suggest you watch these first. The core idea of Economic Value Added (EVA) is for a company to generate returns above the required rate of return. Only then do you create value.
Nice
Thanks, Ronnie!