Economic Profit (EVA)
= Net Operating Profit After Taxes (NOPAT) – Capital Charge
= NOPAT – (Cost of Capital * Invested Capital)
= (NOPAT / Invested Capital) * Invested Capital – (Cost of Capital * Invested Capital)
= (Return on Investment – Cost of Capital) * Invested Capital
= Working Capital + Fixed Capital + Other Operating Assets – Non-Interest-Bearing Current Liabilities
= Short-term Debt + Long-term Debt + Shareholder’s Equity
Total Market Value of a Company (i.e. Enterprise Value)
= Invested Capital + Market Value Added
= Invested Capital + PV of Future Economit Profit
To use the formulas above, some adjustments need to be made to the accounting NOPAT value to obtain an appropriate Adjusted NOPAT, and also adjustments to the balance sheet values for use to calculate an appropriate Invested Capital.
Adjustments to NOPAT
- Unusual gain/loss: Add back loss, or subtract gain. This is to reverse a one-time item.
- Goodwill impairment: Add back. Both a non-cash and a non-recurring item.
- Bad debt expense: Add back. Non-cash item.
- Deferred taxes: Add back (i.e. a portion of the tax expense in the income statement is non-cash, hence the increase in deferred taxes, so you would add back the non-cash portion of the interest expense). Non-cash item.
- Depreciation: Subtracted in NOPAT already, no adjustment required. This is a true economic cost.
- R&D: Add back to reverse the expense charge. Capitalizing the R&D as it is a long-term investment.
- Deferred revenue: Add to revenue (previously not included). Cash inflow has already happened so it should be counted.
Adjustments to Invested Capital (original Invested Capital is calculated from the balance sheet figures as per the formula above)
- Cumulative unusual gain/loss: Add back loss, or subtract gain. This is to reverse one-time items.
- Cumulative goodwill impairment: Add back. Both non-recurring and does not change invested capital in any way.
- Change in bad debt reserve: Add back. Non-cash item.
- Deferred tax liability: Add back. When deferred tax liability increases (e.g. debit Income Tax Expense by $25, credit Income Tax Payable by $20, and credit Deferred Tax Liability by $5), retained earnings was overly low due to the higher Income Tax Expense. This Deferred Tax Liability still rests in the company and has not yet been paid out, so it is still part of Invested Capital.
- Accumulated depreciation. No adjustment requirement. True economic cost.
- R&D: Add back. Capitalizing R&D as a long-term investment as part of Invest Capital.
- Deferred revenue: Add back. Invested Capital is increased by this amount because the capital has already been received by the company.
Other Key Points
Looking at Returns on Invested Capital versus the Cost of Capital is important because:
- You can have increasing free cash flows with returns on invested capital lower than cost of capital, leading to value destruction.
- You can have decreasing negative free cash flows with returns on invested capital higher than cost of capital, leading to value creation.
Comparison between Free Cash Flow and Economic Profit
- Free cash flow subtracts investment into the company (e.g. capex, change in net working capital) in the period the investment occurred, hence a full charge of that amount is levied. For Economic Profit, an equal charge based on the cost of capital * investment amount, is levied for every future period onwards. The PV of the future charges is equal to the original investment amount. So it is a matter of whether you take the charge immediately, or you take the charge over future periods.
- Economic profit can help to detect value destruction better than free cash flow, because even though periodic free cash flow can be increasing, the increase may not be enough to offset the cost of capital, so the periodic economic profit will show a decreasing trend, consistent with the value destruction that is happening.