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Saturday, June 12, 2010

Economic Value Added - Commonsense Idea of "Profit"

“Checking the results of a decision against its expectations shows executives what their strengths are, where they need to improve, and where they lack knowledge or information.”  - Peter Drucker

To move a business forward, it must be measured.  Economic Value Added (EVA) is a financial performance method to calculate the true economic profit of a corporation.  EVA can be calculated as the following:

EVA = NOPAT - c * K

EVA is Economic Value Added
NOPAT is Net Operating Profit after Tax
c is the Weighted Average Cost of Capital (WACC)
K is capital employed

Shareholder of a company receives a positive value added when the return from the capital employed in the business operations is greater than the cost of that capital.

EVA has a variety of usages:
  • Setting organizational goals
  • Performance measurement
  • Determining bonuses
  • Communication with shareholders and investors
  • Motivation of managers
  • Capital budgeting
  • Analyzing equity securities
EVA is a great performance evaluation over time and is based on the idea that a business must cover both the operating costs and capital costs.  It is effectively used as an incentive to balance the business and move to the next level of profitability.

“Start with good people, lay out the rules, communicate with your employees, motivate them and reward them. If you do all those things effectively, you can't miss.” - Lee Iacocca