- Measures a company’s value based on excess earnings above its cost of capital.
Procedures to Conduct Economic Value Added (EVA) / Residual Income Method
Economic Value Added (EVA) and the Residual Income Method are frameworks used to assess the value created by a company beyond its cost of capital. Here’s a step-by-step guide to implementing these measures:
Step 1: Calculate Net Operating Profit After Taxes (NOPAT)
- Start with the operating income of the company.
- Subtract taxes applicable on the operating income to derive NOPAT.
- Formula: NOPAT = Operating Income × (1 - Tax Rate)
Step 2: Determine the Total Capital Employed
- Identify the total assets of the business.
- Subtract current liabilities to compute capital employed.
- Formula: Total Capital Employed = Total Assets - Current Liabilities
Step 3: Calculate the Cost of Capital
- Obtain a weighted average cost of capital (WACC), which reflects the average rate of return required by all of the company’s investors.
- This rate is essential to determine the threshold for value creation.
Step 4: Compute EVA
- EVA is calculated by subtracting the cost of capital from NOPAT.
- Formula: EVA = NOPAT - (Total Capital Employed × Cost of Capital)
Step 5: Analyze and Interpret the Results
- A positive EVA indicates that the company is generating value above its cost of capital.
- A negative EVA suggests that the company is not covering its cost of capital and is therefore destroying value.
- Use these insights for decision-making and performance evaluation.
Step 6: Regular Monitoring and Reporting
- Implement a system for regular calculation of EVA to track performance over time.
- Share results with stakeholders to highlight financial performance and strategic direction.