Economic Value Added (EVA) – Part 4

In this week’s video I discuss the calculation of EVA… watch it below!

VIDEO SUMMARY:

This video is on EVA or Economic Value Added and today we are going to focus on the calculation. Let’s jump right into it.

The important thing to realize here is there are two equations for EVA. You can calculate it two different ways and you will get the exact same result. Each equation tells you something different.  So here’s what I do, I calculate EVA twice using both methods.

So let’s just look at one of the equations to start with. In this equation you have NOPAT – WACC * K. Now this follows the same format as we’ve been discussing. It is NOPAT – capital charge. We are trying to find out the difference between the profit we earn, and the assets at risk. We find the assets at risk, by taking the total capital times your WACC (weighted average cost of capital). If you remember, your WACC represents the riskiness of your business. So by multiplying your capital times the riskiness of your business, you get the total assets at risk.

So let’s stop and think about what is going on here. Think of investors as a manufacturing plant. This is a little bit of a non-traditional example, but just go with me. A manufacturing plant has inputs, production costs, and outputs. Supplies go in, you incur costs to produce a product, and products go out which you sell for a profit. Investors are doing the same thing, instead of supplies it’s capital, and instead of products, you are producing profit. So as an investor, you bring capital into a business, while it’s sitting there, it incurs a cost, and when you’re done, hopefully you have generated a profit. So what is the cost you incur when it’s sitting there? The cost, is your cost of the risk you are holding. So remember, markets are assessing uncertainty at the beginning of the period. If the investor thinks there is a 15% risk they are not going to get their money, they are going to discount for the cost of holding that risk. So what we are saying here is a certain amount of capital is going to be at risk. This equation specifies how much, and then compares that amount against the profit you expect to earn. So it’s very simple. Profit minus your costs, is the value the investor is going to get.

So here is the main takeaway. We are all investors. I don’t care what it is you do. Whether you are a business owner, a business executive, or an employee in a company. You have resources you are putting to work. Even if the only resource you have is time. You are making decisions on how to put it to work. We are investing those resources. You want to make decisions to invest those resources in the most effective way possible. EVA helps you do that. You look at your capital, you figure out how much is at risk, you compare it against your expected profit, and that tells you how much economic value is added. And if you are looking at multiple opportunities, this equation will provide you guidance on the most effective place to put your capital to work.

Now in the next video we are going to look at the other equation and talk about the concept of “spread.”

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Neither Zach De Gregorio or Wolves and Finance Inc. shall be liable for any damages related to information in this video. It is recommended you contact a CPA in your area for business advice.