Description: Economic value added shows the incremental rate of return in excess of a firm’s total cost of capital. Stated differently, this is the surplus value created on an initial investment. It is not just the difference between a firm’s percentage cost of capital and its actual rate of return percentage, since it is designed to yield a dollar surplus value. If the measurement is negative, then a company is not generating a return in excess of its capital costs. It is extremely important to break down the drivers of the measurement in order to determine what parts of a company are keeping the measure from reaching its maximum potential.
Economic value added has become the most fashionable measurement for determining the ability of a company to generate an appropriate rate of return, thanks in part to the efforts of several consulting firms that specialize in installing the systems that roll up into this measurement. Some studies have shown that a favorable economic value added measurement correlates closely with the market price achieved by a company’s stock, so it can become the cornerstone of a company’s efforts to increase its market value. It can also be linked to a company’s compensation system, so that managers are paid (or not) based on their ability to combine efficient asset utilization with profitable operating results.
Formula: Multiply the net investment by the difference between the actual rate of return on assets and the percentage cost of capital. The three elements of the calculation are as follows:
- Net investment. The net investment figure used in the formula is subject to a great deal of variation. In its most limited form, one can use the net valuation for all fixed assets. However, some assets may be subject to accelerated depreciation calculations, which greatly reduce the amount of investment used in the calculation; a better approach is to use the straight-line depreciation methodology for all assets, with only the depreciation period varying by type of asset. A variation on this approach is to also add research & development, as well as training costs, back into the net investment, on the grounds that these expenditures are made to enhance the company’s value over the long term. Also, if assets are leased rather than owned, they should be itemized as assets at their fair market value and included in the net investment figure, so that managers cannot use financing tricks to enhance their return on investment.
- Actual return on Investment. When calculating the return on investment, research & development, as well as training expenses, should be shifted out of operating expenses and into net investment (as noted in the last point). In addition, any unusual adjustments to net income that do not involve ongoing operations should be eliminated. This results in an income figure that is related to just those costs that can be legitimately expensed within the current period.
- Cost of capital. Please refer to the Cost of Capital web page.
The formula is as follows:
(Net Investment) x (Actual Return on Investment – Percentage Cost of Capital)
Cautions: The focus of this measure is to increase the return on capital employed. However, this may keep managers from investing in assets that have problematic returns, but which may yield excellent returns if the company is willing to wait a few years to see if the market or the product matures. Also, if the calculation is being made for individual divisions of the same company, the person creating the measurement may become entangled in complex expense allocations from the various corporate service centers to the operating divisions, with constant bickering amongst the division managers to reduce their share of these costs.