economic value added


Economic value added (EVA)

A method of performance evaluation that adjusts accounting performance for investors' required return on investment. Suppose a division produces a 12% return on capital invested. Given the risk of the division's business line, if investors would usually require 14% on capital invested for this level of risk, the division destroyed shareholder value by the EVA metric. This Stern-Stewart has a trade mark on this term.

Economic Value Added

A company's after-tax earnings less its opportunity cost. The economic value-added measure is a metric of how well it has performed over a given period of time compared to how it could have performed.

economic value added (EVA)

a measure of a firm's overall profit (loss) position when allowance is made for the OPPORTUNITY/ECONOMIC COSTS of the firm's capital (that is, the revenues the firm's assets could have earned in some alternative use). Whereas accounting PROFIT = SALES REVENUE less accounting COSTS (see PROFIT AND LOSS ACCOUNT), EVA = sales revenue less accounting cost less opportunity economic costs.

To illustrate: assume sales revenue is £1,000,000 and accounting cost is £900,000; on conventional criteria the firm thus makes an accounting profit of £100,000. However, when allowance is made for the opportunity cost of the firm's assets if liquidated and redeployed in an alternative use the picture changes. If the firm's assets could have earned, say, £200,000 in some alternative activity (e.g. even putting the money on interest-bearing deposit with a bank) then the positive accounting profit is turned into an economic loss of £100,000. Thus, shareholders' wealth has been ‘destroyed’ rather than ‘created’.

However, whilst producing accurate accounting cost and profit data can be difficult, obtaining reliable economic cost and profit data can be even more problematic. For example, a high proportion of the investment in the firm's current activity may represent a ‘sunk’ cost with little prospect of recovery if liquidated, while there is a difficulty in identifying which are likely to be viable alternative activities where the firm's new investment might yield higher profit returns than currently being achieved.