Economic Value Add: The Best Financial Metric to Measure Long-Term Shareholder Value Creation

Economic Value Add (EVA) is a financial metric that is becoming increasingly popular among companies looking to create long-term enterprise value for their owners. It measures the “economic profit or loss” of a company rather than its “monetary profit or loss” and is considered by many to be the best financial metric to focus on because it considers both the costs and benefits of invested capital.

A business that focuses on increasing EVA over the long term, becomes meticulous at managing the capital entrusted to it by its shareholders. Many entrepreneurs instinctively focus on EVA when they have limited access to capital, however, it is easy to lose sight of the importance of the cost of capital as the business grows and gains increased access to capital. In this blog article, we explore the concept of EVA and why it is the best financial metric to focus on to create long-term enterprise value.

Economic Value Add is a calculation that subtracts the cost of capital from the net operating profit after taxes (NOPAT). The cost of capital is the amount of money the company must pay to access the funds it needs to operate and grow, such as interest on loans and the return required by its owners. By subtracting the cost of capital, EVA provides a clear picture of the value a company is creating for its owners.

Sometimes a business can increase its earnings while not necessarily increasing its enterprise value; which on the surface seems counterintuitive.  If increasing the value of the business for shareholders is the goal, then all earnings growth is not good growth.

So how can business enterprise value stall despite demonstrated earnings growth?  The simple answer is that the incremental earnings were not enough to cover all the operating costs plus the cost of capital (including the opportunity cost of the equity in the business).
 
EVA provides a clear picture of the return on investment for a company’s shareholders and allows companies to make informed decisions about investment opportunities and prioritize initiatives that will maximize long-term value for shareholders.  It also reflects the time value of money.
Unlike other financial metrics, such as revenue or profit margins, EVA is not influenced by accounting practices or one-time events. It can be used to guide spending/investments in R&D, advertising, new hires, incentive programs, M&A, etc. It encourages judicious investment in long-term value-creation strategies and measures progress on initiatives that most accounting metrics miss.

It also provides discipline on capital expenditures as the cost of capital changes over time. It is a reliable and consistent measure of a company’s performance over time, which is essential for creating long-term value.

Here are some practical ways to improve your company’s EVA.
1) Increase profits without tying up any more capital.  This can be in the form of improving margins and/or lowering operating costs or both if the total capital does not increase.  It encourages streamlining operations and investing in growth initiatives whenever the benefits exceed the cost of capital
2) Decrease capital without losing earnings.  Some possible options include:
            - Lowering inventory levels or increasing inventory turns
            - Shortening selling terms or improving collection practices
            - Negotiating better supplier terms or taking advantage of supplier incentives
            - Divesting redundant assets
3) Divest, liquidate or discontinue parts of the business, where the lost earnings are more than offset by the savings in the cost of capital.
4) Only invest (increase capital – capital expenditures PLUS working capital) in projects that provide a return that exceeds the cost of capital.
5) Reorganize the capital structure of the business to lower the overall cost of capital.
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In conclusion, Economic Value Add is the best financial metric to focus on to create long-term value. By focusing on EVA, companies can make informed decisions about investment opportunities, prioritize initiatives that will maximize long-term value, and create sustainable and profitable growth for their shareholders.

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