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Economic Value Adding (EVA) ... a proprietary methodology promoted by Stern Stewart & Co.
Economic Value Added is a measure of economic profit. It is calculated as the difference between the Net Operating Profit After Tax and the opportunity cost of invested Capital. This opportunity cost is determined by the Weighted Average Cost of Debt and Equity Capital ('WACC') and the amount of Capital employed.
An equivalent way to calculate EVA® is to multiply Capital by the difference between the Return on Capital and the WACC. If one of the firm's goals is to increase EVA® on a sustainable basis, notice from this formula that it can be accomplished in four different ways. First, the firm can grow the business by investing where the returns exceed the WACC. Second, the firm can improve the operating efficiencies on its existing Capital, thereby increasing the return on Capital. Third, a firm can harvest Capital from its losing investments, where the return is less than the WACC and has almost no hope for improving. The funds thus generated by harvesting is disgorged to the shareholders or it is used to make worthwhile investments elsewhere. Fourth, the firm can increase its ratio of debt-to-equity when doing so lowers the WACC and doesn't threaten flexibility or survival.
What separates EVA® from other performance metrics such as EPS, EBITDA, and ROIC is that it measures all of the costs of running a business-operating and financing. This makes EVA® the soundest performance metric, and the one most closely aligned with the creation of shareholder value. In fact, EVA® and Net Present Value arithmetically tie, so companies can be assured that increasing EVA® is always a good thing for its investors - certainly not the case with EPS (see Enron) or Free Cash Flow. Many even argue that EVA® is a better decision tool than NPV because it captures the period-by-period value creation or destruction of a given firm or investment, and makes it easy to audit performance against management projections.
Given the usefulness of the measure, many companies have adopted it as part of a comprehensive management and incentive system that drives their decision processes. Such focus on value creation has served the shareholders of these companies well. Between 1997 and 2007, Stern Stewart & Co.'s EVA® adopters have beat broader market indices by a significant margin:
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