The term economic value added refers to a calculation that allows the investor-analyst to understand the surplus value created by an investment. Economic value added is oftentimes used to determine if a company is able to generate appropriate returns for shareholders.
Economic Value Added = Incremental Investment x (Return on Investment - Cost of Capital)
Return on investment measures allow the investor-analyst to understand the company's ability to provide shareholders with an acceptable return on their investment. This is usually assessed by examining metrics such as net worth, returns on equity or assets, earnings, economic value added, and dividends. Return on investment metrics provide analysts with a way to determine a fair price to pay for a share of common stock. One of the ways to understand if a company's incremental investments are increasing the worth of the business is by calculating the company's economic value added (EVA).
Businesses are constantly investing in new equipment, funding research and development efforts and investing in their employees. One of the ways to assess these incremental investments is by calculating the company's economic value added. This metric compares the incremental investment between two accounting periods and compares it to the net income generated in the latest accounting period to develop a return on investment. This value is then subtracted from the company's cost of capital and multiplied times the incremental investment. The result is a dollar value that represents the economic value added for the incremental investment.
In addition to assessing the performance of an entire company, EVA can also be used to determine the performance of an individual investment. However, the analyst must ensure the investment has stabilized with respect its earnings impact.
A mutual fund manager would like to understand the contribution of Company ABC's recent investments. The fund manager suspects the company's growth rate is slowing and new investments are not additive to earnings. He asked his analytical team to calculate the company's economic value added over the last year. The team examined both the company's income statement and balance sheet for insights. The team treated Company ABC's R&D expense as an investment, removing it from the calculation of net income (net of taxes) and adding R&D costs to the company's increase in fixed assets. After making these adjustments, the team found the change in net income to be $398,000, an incremental investment (increase to fixed assets) of $1,912,000. Finally, the company's weighted average cost of capital was found to be 12.2%. Return on investment was found to be:
= $398,000 / $1,912,000, or 20.8%
Company ABC's economic value added was then calculated as:
= $1,912,000 x (20.8% - 12.2%)
= $1,912,000 x 8.6%, or $165,000