Economic Value Added (EVA) – Part 2

In this week’s video, I discuss how to determine the theoretical value of a business… and you can check out my new haircut!

VIDEO SUMMARY

EVA translates financial statements to reflect the true economic value added.

Financial statements can be misleading in this respect. I’m not saying the financial statements are wrong. Accountants do an amazing job at putting them together. They are trying to best represent all economic transactions that occurred. But we are asking something very specific. The goal is to identify the core business, then tear apart the balance sheet and the income statement, and then smoosh them together to get a metric that shows an accurate representation of value created.

Here are some adjustments that are made when calculating EVA:

• Company land sale. Let’s say a manufacturing company has a bad year. They also have a spare parcel of land they never developed, and so they sell it off. That profit from the land sale is included on the income statement as it should. But if you are asking whether or not the core operations of the company generated economic value, you would want to pull out of the financial statements the profit from the land sale.
• Company debt. Let’s say this same company has a capital structure with a lot of debt. This would greatly impact the income statement, because of the debt payments every year. So if you are trying to understand the true economic value of the core business, you would want to pull out the impact from capital structure, and recalculate the taxes.
• Leases. Let’s say this same company has a lot of operating leases. This would be buildings they pay monthly payments for, but the buildings don’t appear on the balance sheet. We need to add them back to the balance sheet

There is a whole list of adjustments you make to get to EVA. The goal is to understand productivity. So we are trying to get an understanding of the profit generated from the core business activity, and the assets it took to generate that profit.

I’m going to put up the equation for EVA

EVA = (ROIC-WACC)*K=NOPAT-WACC*K

This can be simplified to:

EVA = NOPAT – capital charge

So this is saying the Economic Value you created in a period is the profit you generated less the capital someone gave you to generate that profit. This is very fundamental for how to think about business.

Your business is essentially a network of relationships, a set of processes, and unique knowledge of how to do something. Imagine for a moment your business has zero assets. None. You don’t have buildings, equipment, supplies, money to pay salaries. You have nothing. On a theoretical level, if someone were to give you capital for a period, how much profit would that translate into? Someone gives you the building, supplies, salaries, and your business does it’s thing and generates profit.

So this equation is saying, look at your profit. Then compare it against the assets you had that period, and this will show you how much economic value you created. So it’s like someone gives your business all the assets for one period, you perform, and then they take the assets away again, only to give them back the next period. So you are generating profit, and paying this massive capital charge. It’s like you are renting all your assets each period, and subtracting that from your profit.

Now a word of warning, sometimes you have longer term projects, that you want to be able look deeper to ensure you are understanding the long term story. Just because there is a loss one year does not mean that value will consistently destroy value. We need to look deeper than that.

Why this metric is really powerful to understand is it enables you to look at your company in terms of productivity. Now EVA is not a productivity metric per se, because it’s not a ratio. However, it is directly related to productivity, because it uses both profit and assets. So the higher the productivity the greater economic value created. To generate greater economic value added, an organization should strive to increase profits while decreasing assets. You want to create more from less.

To increase EVA, organizations should strive to increase profits while decreasing assets.

We are getting at how effectively business uses capital.  Because the way economics works, is there is so much capital out there, and it should flow towards the areas of highest productivity. If your business is not generating value, you are destroying the underlying capital.

In the next video, dive deeper into the equation and talk about how risk is factored in.

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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.