Economic Value Added (EVA)

Economic value added, or EVA, measures whether a business or investment is truly creating value. A company can report a profit and still destroy value if that profit is smaller than the return its investors could have earned elsewhere for the same risk. EVA captures this by deducting a capital charge, the cost of the capital tied up in the business, from its after-tax operating profit. If the result is positive, the business is earning more than its cost of capital.

EVA was popularized in the 1990s by the consulting firm Stern Stewart & Co., which trademarked the term, and it remains a widely used concept in corporate performance management. For technology leaders, EVA is useful because it makes the cost of capital visible. Technology often ties up significant capital in infrastructure, software and projects, and EVA shows whether that capital is earning its keep.

Definition of Economic Value Added (EVA)

Economic value added is calculated as net operating profit after taxes (NOPAT) minus a capital charge. The capital charge equals the capital invested in the business multiplied by the weighted average cost of capital.

Expressed as a formula, EVA equals NOPAT minus capital invested multiplied by WACC. A business with NOPAT of $50 million, capital of $400 million and a cost of capital of 10 percent has EVA of $10 million, meaning it earned $10 million more than its investors required.

The Capital Charge

The capital charge is what makes EVA different from accounting profit. Traditional profit measures deduct interest on debt but not the cost of equity, which can make capital-intensive businesses look more profitable than they are.

By charging for all capital, EVA encourages managers to use capital efficiently, avoid investments that do not earn their cost and release capital that is not being used productively.

In practice, capital includes fixed assets, such as equipment and capitalized software, and working capital, such as inventory and receivables, less non-interest-bearing liabilities.

Adjustments to Accounting Figures

Full EVA calculations often adjust accounting figures to better reflect economic reality. Common adjustments include capitalizing research and development and other long-term investments that accounting rules expense immediately, and adding back certain non-cash charges.

These adjustments can be complex, and many organizations use simplified versions of EVA, sometimes called economic profit, that apply the capital charge without extensive adjustments.

The simplified approach is usually sufficient for internal decisions, such as evaluating a technology investment or a business unit, where consistency matters more than precision.

Importance of EVA in IT Financial Management

Technology investments often tie up significant capital, in data centers, hardware, capitalized software and long-term projects. EVA makes the cost of that capital explicit, which traditional profit measures do not.

It also links technology decisions to the measures that boards and investors care about.

Organizations that use EVA or economic profit as a performance measure for business units will often apply the same thinking to technology investments, so IT leaders benefit from understanding it.

Evaluating Technology Investments and Assets

An investment can increase operating profit and still reduce EVA if the capital it requires costs more than the profit it adds. EVA helps identify such cases, ensuring that technology investments are judged on whether they create value, not just whether they reduce costs.

EVA also highlights the value of releasing capital. Retiring underused infrastructure, consolidating data centers or moving to services that require less upfront capital can increase EVA even if operating costs stay the same, because the capital charge falls.

This perspective complements capital budgeting, which evaluates investments before they are made, by measuring their contribution once they are in use.

Aligning Incentives

Organizations that use EVA to measure business unit performance give managers an incentive to consider the cost of the capital they use. When technology costs and assets are allocated to business units through cost allocation, EVA shows them the full economic cost of the technology they consume.

This can encourage more careful decisions about technology investments, such as whether a business unit really needs dedicated infrastructure or could use shared services that require less capital.

It also helps explain to business leaders why technology investments that seem profitable on an accounting basis may not be approved if they do not clear the cost of capital.