Economic Value Added - Explained
What is the EVA Method of Business Valuation?
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What is the Economic Value Added?
Economic Value added is method of measuring the return on investment expected from the company above the relative cost of capital.
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How to Calculate the Economic Value Added?
The equations is:
Economic value added = Net operating profit after taxes adjusted − (Percent cost of capital × Average operating assets adjusted)
Economic Value Added is very similar to a calculation of Residual Income. The main differences are:
First, operating profit is calculated net of income taxes. Finding operating income after taxes simply requires deducting income taxes from operating income.
Second, adjustments are made to operating income and average operating assets. Although more than 150 possible adjustments can be made, most firms limit adjustments to 15 or less.
Three examples of adjustments to be considered when using EVA are:
- Research and development (R&D) - U.S. GAAP requires that R&D costs be expensed as incurred. However, R&D work typically benefits the company in future periods. EVA capitalizes R&D costs (that is, records these costs as a long-term asset) and amortizes these costs over the estimated useful life of R&D activities.
- Advertising - U.S. GAAP also requires that advertising costs be expensed as incurred. Since marketing efforts typically benefit the company in future periods, EVA capitalizes these costs and amortizes them over a period of time.
- Non-interest bearing current liabilities - EVA requires deducting non-interest bearing current liabilities from average operating assets. This is because current liabilities that do not require an interest payment are a free source of capital.
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Use Economic Value Added for Business Valuation
Take the amount of requested or required investment. Determine the cost of obtaining that capital. That is, what will investors require as a return (dividend or capital appreciation) for that amount of investment.
Then determine the amount of return that the company will generate in excess of this required cost of capital. The metric will determine if the company will produce returns that exceed the expectation of lenders or investors.
The present value of these expected excess values is then added to the capital invested.
Economic Value Added as Valuation Tool for Startups
The EVA method is sound in nature in that it values the firm based on the value of returns from invested capital above the firms average cost of capital.
The difficulty with this approach is attributable to the early stage of the startup in the business lifecycle and the growth-based nature of the venture.
The early stage of the business makes the estimation of revenue (or profits) difficult to project. Also, the growth-based nature of the venture means that the firm will likely not return any profits to investors until a given date in the future.
As such, the EVA approach is better suited to established firm that makes constant returns (such as dividends) to investors.
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