Economic value added is a corporate finance calculation that determines the economic profit made by a company. Economic profit is the difference between the cost of economic inputs and the revenues generated from the sales of the inputs or goods produced with the inputs. Economic profit differs from accounting profit because economic profit includes the cost of capital involved to generate the revenues earned from financial transactions. The basic economic value added formula is net operating profit after taxes (NOPAT) minus the cost of capital. If a company has NOPAT of $100,000 and a cost of capital of $40,000, the economic value added is $60,000. This concept and calculation was developed by Stern Stewart and Co.
Stern Stewart and Co. is a consulting firm based in New York since 1982. The company focuses on developing portfolio strategies and valuation methods for equity investments. The company created the economic value added formula as a way to improve the corporate finance techniques used in the financial industry. According to its website, Stern Stewart and Co. has worked with over 400 companies worldwide to develop the formula and improve its application in economic finance. While Stern Stewart and Co. owns a trademark on the economic value added formula, it is very similar to the residual income calculation used in corporate finance.
The residual income formula is a basic calculation of income left over after a business has paid all of its monthly expenses. Banks and lenders often used this formula to determine how much capital a company would have available for making fixed payments on loans or credit lines. The residual income formula also helped companies to determine how much cash flow they could generate on certain levels of sales revenues. The problem with this formula is it does not calculate how much capital a company spends on business investment projects. Hence, the creation of the economic value added formula.
A variation in the traditional economic value added formula involves the use of rate of return and cost of capital percentages. The basic formula for this variation is the return percentage on invested capital minus the cost of capital percentage times the original capital invested. This formula can be used in conjunction with other corporate finance formulas since it involves capital percentage figures. Companies may also use this method to break down possible bank loan opportunities and determine which lender offers the company the highest economic value added on projects.
