Origin of EVA

Definition

The origin of Economic Value Added (EVA) can be traced back to the work of Joel Stern and G. Bennett Stewart III in the late 1980s, where it was designed as a performance metric to assess a company's financial health by measuring its true economic profit. EVA is built on the idea that a company's profitability should exceed its cost of capital to create value for shareholders, offering a clearer picture than traditional metrics like net income. This concept was developed in response to the growing need for businesses to focus on long-term value creation rather than short-term earnings.

5 Must Know Facts For Your Next Test

1. EVA emphasizes the importance of deducting the cost of capital from net operating profit, providing a more comprehensive view of economic performance.
2. Companies that consistently generate positive EVA are considered to create shareholder wealth, while those with negative EVA are viewed as destroying value.
3. EVA is increasingly used by corporations as a management tool and performance incentive, aligning management decisions with shareholder interests.
4. The formula for calculating EVA is: EVA = NOPAT - (Capital x Cost of Capital), where NOPAT is Net Operating Profit After Tax.
5. Since its inception, EVA has been adopted by numerous firms worldwide as a central metric for evaluating financial performance and strategic decision-making.

Review Questions

• How does the concept of EVA differ from traditional profitability measures?
  • EVA differs from traditional profitability measures like net income because it accounts for the cost of capital. While net income only reflects revenue minus expenses, EVA provides insight into whether a company is truly generating value over its cost of capital. This focus on economic profit helps organizations prioritize long-term financial health instead of just short-term earnings, making it a more effective measure of real performance.
• In what ways can understanding the origin of EVA influence corporate financial strategies?
  • Understanding the origin of EVA can shape corporate financial strategies by highlighting the importance of focusing on long-term value creation. Since EVA was developed in response to shortcomings in traditional metrics, companies can use it to ensure they make investment decisions that exceed their cost of capital. This can lead to better resource allocation, improved management incentives, and ultimately an enhanced approach towards creating shareholder value.
• Evaluate how the introduction of EVA has transformed corporate performance measurement and its implications for shareholder value creation.
  • The introduction of EVA has transformed corporate performance measurement by providing a clearer focus on economic profit instead of mere accounting profits. This shift encourages companies to prioritize investments that exceed their cost of capital, leading to more sustainable business practices. As organizations adopt EVA as a core performance metric, they align their operations with shareholder value creation, potentially improving investor relations and market perception, ultimately impacting stock prices positively.

Related terms

Net Present Value (NPV): A financial metric that calculates the difference between the present value of cash inflows and outflows over a period of time, helping assess investment profitability.

Cost of Capital: The required return necessary to make a capital budgeting project worthwhile, serving as a benchmark for evaluating investment opportunities.

Shareholder Value: The value delivered to shareholders as a result of the company’s ability to generate earnings and create profits, often assessed through metrics like stock price appreciation and dividends.