Before we even talk about if there is any pitfalls of EVA, we should really note that EVA has many distinctive advantages:

• In my earlier article, we have compared EVA with earnings per share and return on investment/assets and found that both the traditional ratios do not reflect the true cost of capital- there is no hinge whether shareholders value have been created or destroyed,

• EVA is extremely easy to compute- just extract the data from both the income statement and the balance sheet and put in some adjustments to derive the EVA,

• EVA is easy to understand like the net present value (NPV) concept wherein EVA( particularly future EVA) if positive, increases shareholders’ wealth and a negative EVA is vice versa,

• EVA is easy for layman besides accountants to understand its concept as it is logical and comply with the economic terms of “economic profit” ,

• EVA is part of Return on Investment re deploys assets turnovers and utilization which ordinary managers can easily relate to,

• EVA is also really the discounted free cash flows of a business,

• EVA is an all round performance metric which measures the operating profit, business investment and the cost of capital as a financing cost .

• As EVA is a performance metric principally for gauging the creation or not of the shareholder value, it therefore should complements very greatly the Value-based management (VBM) methodology.

Well, after understanding so much of the advantages of EVA, what then might be the pitfall(s) or cons of EVA?

As EVA is still based on an accounting based concept, it therefore suffers:

• like other accounting rate of returns for example like the ROI. Using the normal accounting convention of the historical costs concept, asset values are quoted on historical costs unaffected by inflation, the true rate of return is not able to be properly ascertained,

• EVA is distorted by the fact of the upfront normal depreciation being small at the beginning of a project and big at the end of the project. Therefore companies with a lot of new investments have lower EVA than their true profitability would imply and companies with a lot of old investments have bigger EVA than their true profitability would imply. The extent of this challenge depends on the asset structure (the relative proportions of current assets, depreciable assets, un-depreciable assets) and on the length of the investment period. This pattern is similar to the ROI where when we examine a single project the ROI is a poor estimator or the true rate of return, since at the beginning of the project when the capital base is big, the ROI is small and then at the end when the capital base is small then the ROI is big.

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