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Economic Value Added (EVA) is the most powerful concept in finance and investing, but most people are unfamiliar with it.

Problem

As every investor knows, it is easy to tell if a company has done well in the past – all that information is available in financial statements and reports. The real challenge is to gauge if a company can do well in the future. And investing is all about the future.

Solution

In this regard, EVA is very instructive. EVA is a measure of economic profit. Economic profit is different to normal profit and shows us whether a company is able to generate sufficient return to reward all the business’ financiers, including the often-neglected shareholders. Since EVA levels tend to persist, it can be a good forward-looking indicator for a business.

EVA = NOPAT – (WACC x Invested Capital)

NOPAT is the profit generated from the operations of the business. WACC is the cost of capital in the business and invested capital is the amount of capital that is being used in the business. The main advantage that EVA has over other metrics, is that it is a monetary value output. This is easy to understand and can be used by management to keep track of whether they are engaging in value creating projects or not.

Summary

EVA is a powerful financial metric that can be used by both management and investors to gauge the performance of a business. Since EVA trends can remain intact for long periods, it is a useful forward-looking indicator when investing.

 

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