Economic Value Added (EVA) and the closely related Residual Income Method measure the profit a business earns above the cost of all the capital it uses. As a valuation method, the value of a company equals its invested capital (or the book value of its equity) plus the present value of the residual income it is expected to generate in future.
When to Use EVA and Residual Income
- Banks, insurers and financial institutions, where book equity and return on equity drive value and free cash flow is hard to define
- Performance measurement and incentive design, linking management rewards to value creation
- Companies with negative or lumpy free cash flows but meaningful book value
- As a cross-check to a DCF, since both give the same value when assumptions are consistent
How the Method Works
- Calculate NOPAT: operating profit × (1 – tax rate), adjusted for accounting distortions.
- Measure invested capital: the operating assets financed by debt and equity.
- Determine the WACC, or the cost of equity for the residual income version applied to equity.
- Compute EVA: EVA = NOPAT – (invested capital × WACC). For the equity version, residual income = net income – (book equity × cost of equity).
- Value the business: value = invested capital + the present value of future EVA, including a terminal value that reflects fading excess returns.
Strengths and Limitations
Strengths: the method anchors value to the balance sheet, shows whether growth actually creates value, and suits financial firms. Limitations: it depends on the quality of accounting data, and accounting adjustments need judgement.
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