Economic Value Added: Explained | TIOmarkets
BY TIO Staff
|July 5, 2024Economic Value Added (EVA) is a critical measure used by traders and investors alike to evaluate the economic performance of a company. It is a measure of a company's financial performance based on the residual wealth calculated by deducting its cost of capital from its operating profit, adjusted for taxes on a cash basis. This article will provide a comprehensive glossary on the concept of Economic Value Added, its calculation, significance, and its application in trading.
Understanding EVA is crucial for any trader or investor as it provides a clear picture of a company's true profitability. It is a more comprehensive profitability metric than traditional measures like net income or operating profit. By taking into account the cost of capital, EVA gives a more accurate picture of a company's economic profit – the amount by which earnings exceed or fall short of the required minimum return for shareholders or lenders.
Concept of Economic Value Added
The concept of Economic Value Added is based on the principle that businesses are only truly profitable when they create wealth for their shareholders, and this wealth is above the cost of capital. The idea is that value is created when the return on the company's economic capital employed is greater than the cost of that capital. This is the excess return or the Economic Value Added.
EVA is a refinement of the concept of residual income. While residual income is a measure of absolute profitability, EVA is a profitability indicator that specifically measures the quality of earnings by factoring in the cost of capital. It is based on something we know as the Economic Profit concept. The idea is that businesses should create returns at least as great as their cost of capital. The return above the cost of capital is the EVA.
Components of EVA
EVA is calculated by taking the net operating profit after taxes (NOPAT) and subtracting the capital charge. The capital charge is the amount of capital multiplied by the cost of capital. The formula for calculating EVA is: EVA = NOPAT - (Invested Capital * Cost of Capital).
The NOPAT is the profit a company would generate if it had no debt and held only equity. It is calculated by taking the company's operating profit and subtracting taxes. The invested capital is the total amount of money that has been invested into a company by its owners or shareholders, including both equity and debt. The cost of capital is the minimum rate of return that a business must earn before generating value.
Importance of EVA
EVA is an important measure of a company's profitability because it is based on the concept of economic profit. By taking into account the cost of capital, it provides a more accurate picture of a company's true profitability. It helps investors understand whether the company is truly creating value for its shareholders or just generating profits that are not sufficient to cover the cost of capital.
Moreover, EVA is a more comprehensive measure of profitability than traditional measures like net income or operating profit. It takes into account not just the operational efficiency of the company but also how well it is using its capital. Therefore, a company with a high EVA is considered to be more financially sound and a better investment than a company with a low EVA.
Application of EVA in Trading
In the world of trading, EVA is a powerful tool used to assess the intrinsic value of a company. Traders use it to determine whether a company is undervalued or overvalued. If a company's EVA is positive, it means the company is generating value for its shareholders and it may be a good investment. On the other hand, if a company's EVA is negative, it means the company is not generating enough profit to cover its cost of capital and it may not be a good investment.
Traders also use EVA to compare the performance of different companies. By comparing the EVA of different companies, traders can determine which companies are more efficient at using their capital and generating value for their shareholders. This can help them make more informed investment decisions.
Calculating EVA for Trading
To calculate EVA for trading, traders first need to calculate the NOPAT, the invested capital, and the cost of capital for the company they are interested in. Once they have these values, they can use the EVA formula to calculate the EVA. If the EVA is positive, it means the company is generating value for its shareholders. If the EVA is negative, it means the company is not generating enough profit to cover its cost of capital.
Traders can also use EVA to compare the performance of different companies. By comparing the EVA of different companies, they can determine which companies are more efficient at using their capital and generating value for their shareholders. This can help them make more informed investment decisions.
Interpreting EVA for Trading
Interpreting EVA for trading can be complex as it involves understanding the underlying factors that contribute to a company's EVA. A positive EVA indicates that a company is generating more profit than the cost of its capital, which is a good sign for investors. However, a negative EVA does not necessarily mean a company is a bad investment. It could be that the company is investing heavily for future growth, which could pay off in the long run.
Moreover, it's important to compare a company's EVA with its competitors. If a company has a lower EVA than its competitors, it could indicate that the company is less efficient at using its capital. However, if a company has a higher EVA than its competitors, it could indicate that the company is more efficient at using its capital and is a better investment.
Limitations of EVA
While EVA is a powerful tool for assessing a company's profitability and value, it is not without its limitations. One of the main limitations of EVA is that it is based on the assumption that all profits are reinvested back into the business. This is not always the case, especially for companies that pay out dividends to their shareholders.
Another limitation of EVA is that it can be influenced by accounting practices. Different companies may use different accounting methods, which can affect the calculation of NOPAT and invested capital. This can make it difficult to compare the EVA of different companies.
Accounting Practices and EVA
As mentioned earlier, EVA can be influenced by accounting practices. Different companies may use different accounting methods, which can affect the calculation of NOPAT and invested capital. For example, companies that use aggressive depreciation methods will have a lower NOPAT and a higher invested capital, which will result in a lower EVA.
Moreover, companies that use different methods for calculating their cost of capital may also have different EVA. For example, a company that uses a higher discount rate for calculating its cost of capital will have a higher capital charge and a lower EVA. Therefore, when comparing the EVA of different companies, it's important to take into account the accounting practices used by the companies.
Dividends and EVA
Another limitation of EVA is that it assumes all profits are reinvested back into the business. This is not always the case, especially for companies that pay out dividends to their shareholders. When a company pays out dividends, it reduces its retained earnings and its invested capital, which can result in a higher EVA.
However, this does not necessarily mean that the company is more profitable or a better investment. It could be that the company is not able to find profitable investment opportunities and is returning the excess cash to its shareholders. Therefore, when interpreting EVA, it's important to take into account the company's dividend policy.
Conclusion
Economic Value Added is a powerful tool for assessing a company's profitability and value. It provides a more accurate picture of a company's economic profit by taking into account the cost of capital. Traders and investors can use EVA to make more informed investment decisions and to compare the performance of different companies.
However, EVA is not without its limitations. It can be influenced by accounting practices and it assumes all profits are reinvested back into the business. Therefore, when using EVA, it's important to take into account these factors and to interpret the results with caution.
Start Applying EVA with TIOmarkets
Now that you understand the significance of Economic Value Added in evaluating a company's profitability, it's time to put this knowledge into practice. At TIOmarkets, a top rated forex broker, you can trade over 300 instruments across 5 markets, including Forex, indices, stocks, commodities, and futures, all with low fees. Join a growing community of 170,000+ traders in over 170 countries who are benefiting from our comprehensive educational resources and step-by-step guides. Ready to elevate your trading strategy? Create a Trading Account today and start trading effectively with TIOmarkets.
Risk disclaimer: CFDs are complex instruments and come with a high risk of losing money rapidly due to leverage. You should consider whether you understand how CFDs work and whether you can afford to take the high risk of losing your money. Never deposit more than you are prepared to lose. Professional client’s losses can exceed their deposit. Please see our risk warning policy and seek independent professional advice if you do not fully understand. This information is not directed or intended for distribution to or use by residents of certain countries/jurisdictions including, but not limited to, USA & OFAC. The Company holds the right to alter the aforementioned list of countries at its own discretion.
Join us on social media
Behind every blog post lies the combined experience of the people working at TIOmarkets. We are a team of dedicated industry professionals and financial markets enthusiasts committed to providing you with trading education and financial markets commentary. Our goal is to help empower you with the knowledge you need to trade in the markets effectively.
Trade responsibly: CFDs are complex instruments and come with a high risk of losing all your invested capital due to leverage.
These products are not suitable for all investors and you should ensure that you understand the risks involved.