What Is Economic Value-Added (EVA) And The Comparision To Earnings Per Share Or Return On Assets

As part of the role to assist senior management,the financial executive needs to find the best metric to measure the financial performance of his organization.

Normally,many companies are still using Earnings per share,Returns on Assets as the key performance metric.

Introduction:

Economic value-added (EVA) has increasingly gain acceptance amongst many top-notched organization. Those who used EVA feel that using it as a performance metric will enable them to know whether shareholders value has been increased or decreased. After all,with the increase in shareholders value,only then wealth has been created for the shareholders/investors.
Also,EVA as a performance metric for creating shareholders wealth is closely tied in with the Value-based management (VBM) as they share the same principle of realigning business practices towards increasing shareholders wealth.

WHAT IS ECONOMIC VALUE ADDED (EVA) OR EVA DEFINITION: 

In simple term,EVA is:

after-tax operating profit remaining after deducting a charge for the capital employed in the business:

EVA=Net operating profit after tax(NOPAT)-(Capital employed x Cost of capital) 

[ NOPAT is a measure of the operating profit of an organization whilst capital employed is a measure of its business investment and cost of capital is the financing cost similar but not identical to borrowing costs.]
As this represents real profit,positive EVA enhances shareholder value whilst negative EVA reduces shareholder value.
So what can make this metric so important compared to other performance metrics? By reviewing the following limitation of the earnings per share and return on assets we might be able to answer the above-said question:

• Earnings per share tell us nothing about the cost of generating those profits. If the cost of capital (loans,bonds,equity) is,say,17 percent,then a 16 percent earning is actually a reduction,not a gain,in economic value. These profits also increase taxes,thereby reducing cash flow,which drain economic value of the company.

• Return on assets is a more realistic measure of economic performance as it attempts to relate how much profit a business generates relative to its asset leves, but again this metric ignores the cost of capital. A company might have a high profitable year with high return on assets but it might not be a surprise if its cost of capital can be higher than its ROA %.

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