Why EVA is essential metric for value investors
As value investors, we’re constantly searching for that edge – the key insight that unlocks hidden potential in undervalued companies.
As I wrote in this article, common valuation metrics— such as EPS, P/E, and P/B— distort the real picture because they are accounting numbers optimized for different purposes (e.g., tax optimization).
Value investors need a metric that shows the true economic performance, cleaned from those distortions.
This is where the EVA (Economic Value Added) metric comes into the picture.
What is EVA?
EVA, at its core, is a measure of a company’s profitability relative to its cost of capital. Unlike accounting profits, EVA considers the opportunity cost of capital employed in the business. Accounting considers equity as “free,” which is obviously not the case, as shareholders expect a return.
EVA is not an accounting term and does not appear on financial statements. It must be calculated by making specific adjustments to reported numbers.
The formula for EVA is:
EVA = Net Operating Profit After Tax (NOPAT) − (Capital Employed × Weighted Average Cost of Capital (WACC))Let’s break down each component:
Net operating profit after tax (NOPAT): this is the profit a company generates from its core operations after accounting for taxes. It excludes the effects of financing and capital structure.
Capital employed: this is the total amount of capital invested in the business, including both debt and equity. It represents the resources used to generate profits.
Weighted Average Cost of Capital (WACC): this is the average rate of return a company is expected to pay to its investors (both debt and equity holders). It reflects the riskiness of the company’s investments.
Why EVA matters to value investors
Let’s take a look at an example:
Source: ISS EVA
On above chart EVA (red dotted line) is moving accurately in synch with MVA (Market Value Added - difference between the actual market value of the company's stock and the initial capital that was invested in the company by both bondholders and stockholders).
Unlike EPS, which was out of synch with MVA:
Source: ISS EVA
For value investors, EVA is an important measure for:
True profitability: EVA provides a more accurate picture of a company’s true profitability than traditional accounting metrics. By considering the cost of capital, it reveals whether a company is truly creating value for its shareholders or simply generating accounting profits that don’t justify the capital employed.
Alignment with shareholder value: EVA is directly linked to shareholder value creation. A positive EVA indicates that a company is generating returns above its cost of capital, which should translate into increased shareholder wealth. Only about half of public companies actually achieve this. Conversely, a negative EVA suggests that the company is destroying value.
Identifying undervalued companies: companies with high and improving EVA are often undervalued by the market. This is because the market may not fully appreciate the company’s ability to generate economic profits. By focusing on EVA, value investors can identify these hidden gems and capitalize on the market’s mispricing.
Management accountability: EVA holds management accountable for their capital allocation decisions. It forces them to focus on projects and investments that generate returns above the cost of capital. This can lead to more disciplined capital allocation and improved long-term performance.
Competitive advantage: a consistently high EVA suggests that a company has a sustainable competitive advantage. This could be e.g. due to a strong brand, proprietary technology or a cost advantage. These competitive advantages allow the company to generate superior returns on its capital.
How to use EVA in your investment process
Screening: use EVA margin as a screening tool to identify companies with high and improving economic profitability. Look for companies with EVA margins above their industry average.
Trend analysis: analyze the trend in EVA margin over time. A consistently increasing EVA margin is a positive sign, indicating that the company is becoming more efficient and profitable.
Comparison with peers: compare a company's EVA margin with its peers. This will help you identify companies that are outperforming their competitors.
Valuation: incorporate EVA margin into your valuation models. You can use it to estimate future cash flows and determine the intrinsic value of a company.
Management assessment: evaluate management's ability to generate economic profits. Look for companies with management teams that are focused on capital allocation and shareholder value creation.
EVA for different investor types
EVA fits the different investor types.
Dividend investors: EVA growth is linked to both share price and dividend growth. Companies with strong EVA growth deliver better total returns and dividend increases.
Value investors: EVA helps avoid value traps — companies that look cheap on traditional metrics but are actually destroying value.
Growth investors: EVA distinguishes between value-creating and value-destroying growth, helping investors focus on quality growth stocks.
Potential pitfalls
While EVA margin is a powerful tool, it's not without its limitations:
Data availability: calculating EVA margin requires detailed financial data, which may not be readily available for all companies.
Accounting adjustments: calculating NOPAT and capital employed requires making accounting adjustments, which can be subjective and time-consuming.
Industry differences: EVA margins can vary significantly across industries. It's important to compare companies within the same industry.
Short-term focus: EVA margin is a backward-looking metric. It doesn't necessarily predict future performance.
Conclusion
EVA margin is a valuable tool for value investors seeking to identify undervalued companies with outsized return potential. By focusing on economic profitability and capital allocation, it provides a more complete picture of a company's true value. While it's not a silver bullet, incorporating EVA margin into your investment process can help you unlock hidden value and achieve superior investment results. The next time you're digging through financial statements, consider the EVA of the company – it could be the key to your next big win.