REV: JULY 11, 2006
MIHIR A. DESAI FABRIZIO FERRI
Understanding Economic Value Added
EVA is based on something we have known for a long time: what we generally call profits, the money left to service equity, is usually not profit at all. Until a business returns a profit that is greater than its cost of capital, it operates at a loss. Never mind that it pays taxes as if it had a genuine profit. The enterprise still returns less to the economy than it devours in resources . . . it does not create wealth; it destroys it.1 — Peter Drucker This note explores the concept of Economic Value Added (EVA)2 and its practical applications as a management control system for performance measurement and incentive compensation.
The Concept of Economic Value Added
EVA is a remarkably simple, yet powerful measure of performance. A firm employs capital in order to generate revenues and profits. Investors who provide that capital—creditors as well as shareholders—expect a fair return on their investments. EVA aims to measure the firm’s ability to generate profits in excess of the cost of the capital employed to generate those profits. In particular, it is calculated as the difference between after-tax operating profits and the cost of capital invested by both debt holders and equity holders: EVA = NOPAT − (Cost of Capital * Capital )
where: NOPAT = Net Operating Profits After Taxes Capital = Capital invested by debt holders and equity holders Cost of Capital = Weighted average of the after-tax cost of debt and cost of equity
1 Peter F. Drucker, “The Information Executives Truly Need,” Harvard Business Review (January/February 1995), p. 59. 2 EVA is a registered trademark of Stern Stewart & Company.
________________________________________________________________________________________________________________ Professors Mihir A. Desai and Fabrizio Ferri prepared this note with the assistance of Steve Treadwell (MBA 2005) as the basis for class discussion. Copyright © 2005 President and Fellows of Harvard College. To order copies or request permission to reproduce materials, call 1-800-545-7685, write Harvard Business School Publishing, Boston, MA 02163, or go to http://www.hbsp.harvard.edu. No part of this publication may be reproduced, stored in a retrieval system, used in a spreadsheet, or transmitted in any form or by any means—electronic, mechanical, photocopying, recording, or otherwise—without the permission of Harvard Business School.
Understanding Economic Value Added
While the term EVA is relatively new, the concept is not. EVA is essentially identical to the notion of residual income (net income minus a charge for the cost of equity capital)3 developed by economists such as Alfred Marshall in the 1890s. General Motors implemented a residual income measure for performance evaluation and compensation in the 1920s.4 Over the last two decades, a number of factors (deregulation and integration of capital markets, more liquid securities markets, expansion of institutional investment, advances in information technology) have significantly increased the mobility of capital, forcing firms to compete not only in product markets but also in capital markets, where returning the cost of capital—the return expected by investors—is a key success factor. At the same time, finance theory has evolved making the estimation of a cost of equity a more accessible task. Taking advantage of these developments and the growing demand for new “value-based” management practices that could better align the interests of managers with those of shareholders, the consulting firm Stern Stewart & Company, in the 1980s and 1990s, revived the notion of residual income. Stern Stewart developed this notion into a broader, EVA-based management control system, implemented at dozens of large, publicly traded companies including AT&T, Coca-Cola, and Quaker Oats.5 The appeal of EVA lies in its intuitive interpretation. A positive...