Economic Value Added and Economic Profit

Suppose you borrow $800,000 at 6% and buy a laundromat that throws off $40,000 a year after tax and after the interest bill. Your accountant will tell you that you made $40,000. But you put in $300,000 of your own savings, which was earning something elsewhere, and you took on risk. If your money could have earned 12% in a similar-risk business, that $300,000 was owed $36,000 before you got to call anything profit. You cleared $4,000, not $40,000.

Company income statements have exactly this blind spot. Interest paid to lenders is a line item; the cost of shareholders' money is not. That is why a firm can grow earnings for a decade and still be a worse place to have parked capital than an index fund. Economic value added — EVA, a term trademarked by Stern Stewart in the 1990s, and generically economic profit — puts the missing line back in.

The one line

$$\text{EVA} = \text{NOPAT} - \text{WACC} \times \text{Invested Capital}.$$

NOPAT is net operating profit after tax: operating profit, taxed as though the company had no debt at all. Invested capital is the money tied up in the operations — roughly net working capital plus net fixed assets, or equivalently debt plus equity minus non-operating cash. The second term is the capital charge: rent on that capital at the blended cost of capital. In English: profit after paying everybody, lenders and owners alike.

Divide through by invested capital and the same statement becomes a spread:

$$\text{EVA} = (\text{ROIC} - \text{WACC}) \times \text{Invested Capital}.$$

Value is created only when ROIC beats the cost of capital, and the size of the prize is the spread multiplied by how much capital you can run at that spread.

Worked example: the same year, two verdicts

A speciality chemicals business reports EBIT of $140m on invested capital of $800m, with a marginal tax rate of 25% and a WACC of 9%.

• NOPAT $= 140 \times (1 - 0.25) = 105$.
• Capital charge $= 0.09 \times 800 = 72$.
• EVA $= 105 - 72 = 33$.

Cross-check with the spread form: ROIC $= 105 / 800 = 13.125\%$, so the spread is $13.125\% - 9\% = 4.125\%$, and $0.04125 \times 800 = 33$. The two routes agree, as they must.

Now management invests another $200m in a capacity expansion that adds $14m of NOPAT. Reported profit rises to $119m — a 13% jump, the kind of number that makes a good slide.

The capital charge is now $0.09 \times 1000 = 90$, so EVA falls to $119 - 90 = 29$. The expansion earned an incremental ROIC of $14 / 200 = 7\%$ against a 9% cost of capital, so it burned $4m of value in its first year. Earnings per share went up; the business got worse.

It reconciles with DCF

EVA is not a rival to discounted cash flow — it is the same valuation rearranged:

$$\text{Enterprise Value} = \text{Invested Capital} + \sum_{t=1}^{\infty} \frac{\text{EVA}_t}{(1 + \text{WACC})^t}.$$

The sum on the right is market value added: the premium the market pays over the book cost of the assets. Take the original firm and hold EVA flat at $33m forever. The present value is $33 / 0.09 = 366.7$, so enterprise value is $800 + 366.7 = 1166.7$. Value the same firm as a NOPAT perpetuity and you get $105 / 0.09 = 1166.7$ — identical. The usefulness is not a different answer; it is that EVA tells you which year and which division the value came from, which a single DCF number never does.

Conventions that matter in practice

Invested capital is an accounting number, and accounting was not designed for this. Stern Stewart's original method listed over 160 possible adjustments; in practice desks use a handful:

• Capitalise R&D and brand spend. Expensing them understates capital and flatters ROIC for pharma and software.
• Capitalise leases. Since IFRS 16 and ASC 842 this is largely done for you on-balance-sheet, which changed retailers' reported ROIC materially.
• Add back cumulative goodwill impairments, so managers cannot improve ROIC by writing off a bad acquisition.
• Strip out excess cash and non-operating assets, which belong in the equity bridge, not the capital base.

Where you meet it

EVA and its cousins show up in three places: divisional performance measurement and bonus plans, where it beats a revenue or EBITDA target because it prices the balance sheet a manager is consuming; capital allocation screens, where projects are ranked on spread rather than payback; and in reverse-engineering a share price, where you ask how many years of positive spread the market is currently paying for. That last question — how long can this company keep out-earning its cost of capital? — is the whole of competitive-advantage analysis, written in one number.