Economic Value Added and Value Drivers

Why Accounting Profits Miss the Point (The EVA Insight)

A company can report $100 million in net income and still destroy shareholder value. How? If that $100 million required $2 billion in capital and the cost of that capital is 10%, the true economic profit is negative $100 million.

The point is: Accounting profit ignores the cost of equity capital. Economic Value Added (EVA) corrects this by charging the business for all capital it uses, not just debt.

EVA was formalized by Stern Value Management in 1983 and has become a standard tool for measuring whether management is creating or destroying value relative to the capital entrusted to them.

The EVA Formula: Two Equivalent Forms

Form 1: Dollar Profit Minus Dollar Charge

EVA = NOPAT - (Invested Capital x WACC)

This says: Take your operating profit after tax, then subtract the dollar cost of all capital employed.

Form 2: Spread Times Capital

EVA = (ROIC - WACC) x Invested Capital

This says: Calculate the spread between your return on invested capital and your cost of capital, then multiply by the capital base.

Both forms produce the same number. The first is more intuitive for dollar-denominated thinking. The second shows the "spread" that determines value creation.

The durable lesson: Positive EVA means the company earns more than its cost of capital. Negative EVA means it would have been better to return the capital to investors.

NOPAT Calculation: What the Business Actually Earns

NOPAT = Operating Income x (1 - Tax Rate)

NOPAT stands for Net Operating Profit After Tax. It represents the cash the business generates from operations, after taxes but before financing costs.

Worked example:

• EBIT (Operating Income): $500,000
• Tax rate: 20%
• NOPAT = $500,000 x (1 - 0.20) = $400,000

Why this matters: NOPAT excludes interest expense because that is a financing decision, not an operating result. By using NOPAT, you can compare companies with different capital structures on equal footing.

Invested Capital: The Denominator That Matters

Invested Capital = Short-Term Debt + Long-Term Debt + Total Equity - Non-Operating Assets

Alternative calculation: Invested Capital = Total Assets - Non-Interest-Bearing Current Liabilities

Non-interest-bearing current liabilities include accounts payable and accrued expenses (things you owe that do not charge explicit interest). These are "free" financing provided by suppliers and employees.

The point is: Invested capital represents what shareholders and lenders have put into the business to fund its operations.

EVA Worked Example: The Full Calculation

Inputs:

• NOPAT: $8 million
• Invested Capital (beginning of period): $50 million
• WACC: 8%

Calculate capital charge: Capital Charge = $50M x 8% = $4M

Calculate EVA: EVA = $8M - $4M = $4 million

Interpretation: The company generated $4 million of economic profit above its cost of capital. Shareholders are better off than if they had invested elsewhere at an 8% return.

Using the spread formula:

• ROIC = NOPAT / Invested Capital = $8M / $50M = 16%
• EVA = (16% - 8%) x $50M = 8% x $50M = $4 million

Same answer. The 8% spread between ROIC and WACC, applied to $50M of capital, produces $4M of value creation.

The Value Driver Tree: Linking Operations to Value

EVA connects directly to operational decisions through a value driver tree. The tree decomposes EVA into its component parts:

EVA = (ROIC - WACC) x Invested Capital

Where ROIC breaks down further:

ROIC = NOPAT Margin x Capital Turnover

• NOPAT Margin = NOPAT / Revenue
• Capital Turnover = Revenue / Invested Capital

So the tree looks like:

EVA
 |
 +-- ROIC
 |    |
 |    +-- NOPAT Margin
 |    |    |
 |    |    +-- Gross Margin
 |    |    +-- Operating Expense Control
 |    |    +-- Tax Efficiency
 |    |
 |    +-- Capital Turnover
 |         |
 |         +-- Working Capital Management
 |         +-- Fixed Asset Utilization
 |
 +-- WACC (determined by capital structure and risk)
 |
 +-- Invested Capital (scale of operations)

The durable lesson: Every operational metric eventually flows through to EVA. Inventory days, pricing power, and capacity utilization all connect to value creation.

Three Value Drivers That Move EVA

Driver 1: Operating Margin Improvement

Higher margins flow directly to NOPAT. A company that improves operating margin from 10% to 12% on $100M revenue adds $2M to NOPAT (after tax adjustment).

Actions that improve margins:

• Reduce operating costs without sacrificing quality
• Improve pricing power through differentiation
• Achieve operating leverage as revenue scales

Driver 2: Asset Management

Faster asset turnover means the same invested capital generates more revenue. This improves ROIC even if margins stay flat.

Actions that improve asset management:

• Turn working capital faster (reduce inventory days, accelerate receivables collection)
• Increase capacity utilization and economies of scale
• Sell or exit underperforming assets earning below cost of capital

The point is: A company with $50M invested capital generating $100M revenue (2x turnover) creates more value than one generating $75M (1.5x turnover), all else equal.

Driver 3: Capital Efficiency

Every dollar of invested capital gets charged WACC. Reducing capital requirements without hurting operations directly increases EVA.

Actions that improve capital efficiency:

• Optimize inventory levels to release trapped cash
• Use operating leases strategically (though accounting now capitalizes most)
• Outsource non-core activities that require heavy capital investment

Key Accounting Adjustments for EVA

GAAP accounting creates distortions that EVA analysis should correct:

Adjustment 1: Capitalize R&D

GAAP expenses R&D immediately, but R&D creates future value. Capitalizing R&D (adding it to invested capital and amortizing it over useful life) produces a more accurate picture.

Adjustment 2: Operating leases

Under current accounting standards, most leases are already capitalized. But if analyzing historical periods, you may need to add operating lease obligations to invested capital.

Adjustment 3: Non-recurring items

Strip out one-time gains and losses to see sustainable operating performance.

Adjustment 4: Provisions and allowances

Add back provisions (like loan loss reserves for banks) to invested capital if they represent capital set aside rather than true losses.

Why this matters: Without adjustments, two companies with identical economics can show different EVAs due to accounting policy choices.

When EVA Works Best (And When It Does Not)

EVA is most useful for:

• Asset-heavy businesses where capital allocation decisions matter (manufacturing, utilities, industrials)
• Performance measurement for divisional managers who control both P&L and invested capital
• Comparing across industries when capital intensity varies widely

EVA is less useful for:

• Technology and service firms with primarily intangible assets (human capital does not appear on balance sheet)
• Early-stage companies that are investing for growth and will show negative EVA by design
• Banks and financial institutions where "invested capital" has a different meaning

The durable lesson: EVA works best when the balance sheet reflects economic reality. Companies with large off-balance-sheet assets (brand value, talent, data) may not be captured well.

EVA vs. ROIC: Which to Use?

Both metrics measure value creation, but they answer different questions:

A small company with 25% ROIC creates less total value than a large company with 15% ROIC (assuming WACC is 10% for both).

Use ROIC when:

• Comparing companies of different sizes
• Assessing business quality independent of scale

Use EVA when:

• Measuring absolute value creation
• Evaluating management performance in dollar terms
• Linking compensation to shareholder value

Connecting EVA to Stock Valuation

EVA is not just a performance metric; it connects to intrinsic value:

Firm Value = Invested Capital + Present Value of Future EVAs

If a company is expected to generate $10M of EVA annually forever, and WACC is 10%:

• PV of future EVAs = $10M / 0.10 = $100M
• If invested capital is $80M
• Firm Value = $80M + $100M = $180M

The point is: Positive EVA companies trade above book value. Negative EVA companies trade below book value. The relationship is mathematical, not coincidental.

Next Steps

1. Pick a company with clear segment reporting and calculate NOPAT from the income statement. Start with operating income and apply the effective tax rate.

2. Calculate invested capital from the balance sheet. Total debt plus equity minus excess cash is a quick approximation.

3. Look up the company's WACC (financial databases provide estimates) or calculate it using CAPM for cost of equity and after-tax cost of debt.

4. Compute EVA and interpret: Is this company creating or destroying value relative to its cost of capital?

5. Build a simple value driver tree showing how ROIC decomposes into margin and turnover. Identify which lever has the most room for improvement.