Fundamentals of Financial Analysis , Economic Value Added (EVA®)

Fundamentals of Financial Analysis

Chapter: 9 Fundamentals of Financial Analysis

Section: 6 Economic Value Added (EVA®)

The accounting principles that are applied to compute profit or loss does not take into account cost of common equity financing employed in the business. Therefore, net income shown in the income statement overstates profit from a strict point of view. This problem is addressed by EVA^® concept and the true profit is computed by subtracting the cost of common equity from the after tax profit figure derived from the income statement. This is a new thinking in the business world. EVA^® can help investors to identify the companies that are truly maximizing the shareholder wealth. Many world renowned companies such as Coca Cola, AT&T, etc. are successfully adopting EVA^® to evaluate performance.

EVA^® = Return on Invested Capital (ROIC) – Weighted Av. Cost of Capital (WACC)

In order to adopt EVA^® as a measure for corporate performance, companies need to know their cost of equity component in the capital structure. There are different approaches to compute cost of equity. For listed shares Capital Asset Pricing Model (CAPM) could be used. Alternatively, opportunity of equity can be considered to calculate EVA^®.

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