Economic Value Added (EVA) – Part 5
Watch the exciting conclusion of my video series on EVA!…
VIDEO SUMMARY:
In this video we are going to look at the second EVA equation. So in the last video we talked about the first equation. If you remember, there are two equations that give you the same result, but tell you different things. The first equation calculates out the actual value of the assets at risk. What is different about the second equation is that it performs the calculation using percentages. This can be extremely useful.
The equation is this.
EVA = (ROIC – WACC) * K
ROIC stands for Return on invested capital. ROIC = NOPAT / K
The ROI calculation is the productivity ratio! (Productivity was explained in Part 1 of this video series)
So WACC and ROIC are both percentages. This gives us something called “spread.” Now this is valuable. We are looking at the % going to profit minus the % going to costs. So the difference, “the spread” is the percentage of Economic Value Added.
So if you had a ROIC of 25% and a WACC of 15%, the spread would be 10%. Again, it’s the difference between your profit and your costs. This tells you the percentage of value you create for every dollar you invest.
So here’s the really cool part, now we add in the rest of the equation * K. We are specifying how many dollars will be invested. So if we know, for every dollar I’m getting 10% value. If I invest 1M, I will make 100k in economic value added. So this tells you however much capital I want to flow through my business, this is the value I will create at whatever scale I am at. Based on the percentage of spread.
So here is the takeaway: To increase EVA, a business should strive to increase spread (increase ROI and decrease WACC).
This is a significant concept. A lot of business people understand the concept of increasing ROI, but not many people recognize the impact of decreasing your WACC. How do you decrease your WACC? Through accounting. Accounting is the greatest driver of WACC. Your WACC is based on what the financial markets think about the reliability of your financial statements. So you companies who are skimping on funding your accounting department, you are shooting yourself in the foot. Because the lower you can make your WACC, the greater the spread and the more economic value your business creates.
Now I’m biased, of course, because I’m an accountant. But I see this formula play out every day. This equation is how financial markets work. Imagine for a moment there were no accountants. Every business’ financial statements would be a mess. Investors wouldn’t be able to trust the financial statements, they would assess businesses as too risky, and no one would invest. By using good accounting, people can rely on your statements, and it reduces the WACC to a risk level that is acceptable for investment, and unlocks the capital markets. This equation is describing how money flows through the economy. That’s how important this stuff is.
Leave a comment down below letting me know what you think! If you find these videos helpful, please subscribe to my YouTube channel.
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.