What is EVA?

Friday 28th April 2000

Simply put, economic value added is the notion that if shareholders are to earn an adequate return on their investment, that return must be big enough to compensate them for the risk they are taking.

As management guru Peter Drucker put it in a 1995 paper: "EVA is based on something we have known for a long time: what we call profits - the money left to service equity - is usually not a profit at all.

"Until a business returns a profit that is greater than its cost of capital it operates at a loss.

"Never mind that it pays taxes as if it had a genuine profit, the enterprise still returns less to the economy than it devours in resources ... Until then it does not create wealth: it destroys it."

EVA is an adjustment to the the "profit" companies report.

From the operating profit after tax it deducts the cost of the capital the company has used to generate that profit - that is, the interest cost of its debt and the cost of its equity.

The cost of equity is an opportunity cost because, in buying shares, shareholders have foregone the returns they could get by investing their money elsewhere.

It is weighted to reflect the "riskiness" of the business - the higher the risk, the higher the return necessary for adequate compensation.

For the technically-minded, EVA is arrived at by charging the net operating profit after tax with the weighted average cost of capital (WACC), which is determined using a capital asset pricing model (CAPM).

Which model should be used, and therefore what cost of capital should be applied to a company's profits, has long been a contentious topic.

In its studies of New Zealand EVA, ANZ notes some will take issue with the pricing model it has used but says to do that is to miss the point.

"What we are saying is that, regardless if the [1998 EVA loss] figure is $5.5 billion or equally $7.5 billion, there is a serious issue."

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