A rising tide lifts all boats. As aggressive tightening by the Federal Reserve is underway, this tide is bound to recede and that is why it is more important than ever to be able to identify the high quality stocks from the low quality ones. Economic value added is an important metric for self-directed stock investors to understand in order to make more informed investment decisions on current and future stock purchases.
What is Economic Value Added?
Economic value added measures a business’s financial performance based on the residual wealth generated. The cost of obtaining capital is deducted from the operating profit and adjusted for taxes to calculate residual wealth. Economic value added gives insight on the profitability of a company after excluding the costs to fund the business. A positive economic value added number means the company is generating income from the funds invested while a negative number indicates management is not efficiently allocating capital and changes may be needed within the business. Stock investors can benefit from the economic value added calculation to gain financial insight into prospective companies to make more informed decisions when it comes to the stock market.
How Do I Calculate Economic Value Added?
The easiest way to calculate economic value added is through a set of financial statements that include a balance sheet and income statement. The first figure you will need is the net operating profit after taxes, referred to as NOPAT. The next factor is the invested capital, which is the total amount of money raised by a company by issuing securities to equity shareholders and debt to bondholders. The final factor is the weighted average cost of capital, known as WACC. Using the above information, the formula for economic value added is as follows:
EVA = NOPAT – (Invested Capital * WACC)
How Does Economic Value Added Affect Stock Price?
Although economic value added might not directly affect the stock price, there are indirect effects. Investors will often calculate economic value added to determine if the company is effectively using capital. If the resulting value is negative, you might refrain from purchasing shares of stock since the company is not making a profit. However, if the calculation yields a positive number, you might decide to invest money into the company since there is a profit. Just because the economic value calculation is positive doesn’t mean you should invest though. Instead, other factors need to be taken into consideration, such as how consistent they are in achieving positive EVA, whether EVA is increasing over time or not, and whether profits were generated by one-off events.
When a company cannot find a sufficient number of investors because economic value is unfavorable, it can lead to lasting impacts on the company. A lack of funds necessary to continue operations may create business continuity issues and ultimately closure. As a result, management and business owners need to place an emphasis on effectively utilizing invested capital to attract additional shareholders and continue business growth. If the company you are looking to invest in does not prioritize economic value added, it may be time to look elsewhere for your next investment. Moreover, a negative economic value added can indicate unprofitable operations, further decreasing the stock price of a company. Although some investors may purchase shares in the hope that a rebound is near, many will refrain as risk is heightened with consistent losses.
What are the Advantages and Disadvantages of Using EVA?
One of the top advantages of using economic value added is that it provides investors a clear indicator of how effectively a company utilizes its capital. When a negative calculation comes up, investors can use that information to evaluate management’s operations, leading to more informed business decisions. In addition, economic value added can be used as a management incentive to remain profitable and efficient. When management has a simple calculation benchmark, they are more likely to properly track and make necessary changes. Depending on your level of involvement in the company as an investor, you can use the calculation to motivate members to continue to effectively use contributed capital.
As with anything, economic value added does come with disadvantages as well. The first disadvantage is that economic value added typically works best with asset-rich companies that are stable. Companies with intangible assets, such as technology businesses, may not be as good candidates for an EVA evaluation since it does not account for the return on expenses like research and development. This doesn’t necessarily mean EVA isn’t useful for companies with intangible assets; it just means it doesn’t paint a complete picture. Another disadvantage is that calculating economic value can be time-consuming and complicated with the many adjustments needed.
Economic value added can be a great way to track how profitable a company is with managing and allocating capital. Tackling economic value on your own can be a daunting task, which is why JAVLIN Invest is here to help. The innovative app by JAVLIN Invest calculates EVA for you so that you can start making better informed investment decisions. Download the app today to learn more.