Economic value added as a measure of corporate evaluation was developed to address the shortcomings of traditional evaluation techniques like EPS, ROE. If a company is formed with a capital of Rs.10 Crores and the entire capital is invested in fixed deposits at an interest rate of 10%, the company will have a return on capital employed of 10% and it will have an annual growth rate of 10% on its income. But the question is whether the company is adding any value to the shareholders? This is an important question to be answered by all the companies. But our traditional evaluation techniques would give a better rating for the hypothetical company we discussed above.
To avoid this kind of misinformation, EVA was developed as a measuring tool for company’s performance.
EVA = NOPAT – (WACC x Capital Employed)
EVA does not use net profit as such from profit and loss statement. It makes adjustments for tax, valuation of stock, depreciation of assets etc. The Net profit after all the adjustments is called NOPAT. By making these adjustments, EVA tries to overcome the draw backs of traditional evaluation techniques which are based on Net Profit. EVA is calculated by subtracting the return on capital employed (based on Weighted Average Cost of Capital) from Net Operating Profit After Tax (NOPAT). The residual value is the value added by the company for time period. If the residual value (EVA) is positive, then the company has added value to the share holders and to the economy and if the residue value is negative, the company has destroyed value.
So compared to traditional evaluation techniques, EVA is a better measure of corporate evaluation. But EVA is not free from drawbacks. To calculate the value of NOPAT in its stricter sense, companies have to make more than 100 adjustments to Net profit. Many companies hesitate to compute and disclose EVA because of the complexities involved.