Due Diligence

Economic value added (EVA) is a measure of a company’s financial performance that captures the surplus generated over and above the required return on the capital invested in the business. It is an implementation of the residual income concept: the profit left after charging the business for the full economic cost of the capital employed.

• Formula (standard form): EVA = NOPAT – (WACC × Capital Employed)
  • NOPAT = Net operating profit after tax (operating profit adjusted for tax, before financing effects)
  • WACC = Weighted average cost of capital (the blended cost of equity and debt)
  • Capital Employed = The invested capital that supports the operating profit (often measured as total assets less current liabilities, or equity plus interest-bearing debt)

Interpretation: A positive EVA indicates the business is generating returns in excess of its cost of capital and therefore creating shareholder value. A negative EVA indicates the opposite — the firm’s operations are not earning the return investors require.

Why EVA matters for strategy and performance management

• Aligns incentives: EVA links operating performance to the cost of capital, helping to align managers’ decisions with shareholder value creation.
• Focuses on capital efficiency: By charging a cost for capital, EVA emphasises efficient use of assets and discourages investment projects that do not earn the required return.
• Supports value-based management: EVA is used as a performance metric for investment appraisal, budgeting, incentive compensation and capital allocation to ensure decisions increase long-term value rather than short-term accounting profit.
• Communicates economic profit: Unlike raw accounting profit, EVA attempts to reflect the economic reality of financing costs and the opportunity cost of capital.

Key components and typical Stern Stewart adjustments

• NOPAT adjustments: Remove non-operating items, one-off gains/losses, and align tax treatments. Capitalise certain operating expenses (for example, R&D or advertising) that generate future economic benefits.
• Capital base adjustments: Capitalise operating leases, adjust for goodwill amortisation, add back certain provisions that represent invested capital, and remove non-operating assets.
• WACC estimation: Use market values where practical, ensure consistent treatment of tax shields and risk premia, and use a long-term horizon for cost of capital assumptions.
• Stern Stewart recommended a number of standardised adjustments (often many dozens) to convert accounting statements into an economic-profit framework; these are intended to make EVA comparable across businesses and periods.

Simple numeric example

• Suppose a business reports operating profit (EBIT) of £120m – tax (rate 25%) = NOPAT = £90m.
• Capital employed = £900m. WACC = 10% x capital charge = £900m × 10% = £90m.
• EVA = £90m – £90m = £0 – the firm is earning exactly its cost of capital; no economic profit has been created.

Practical strengths

• Intuitive: Direct connection between profit and capital cost makes the measure persuasive to senior management and investors.
• Actionable: Encourages managers to consider both returns and capital use when evaluating projects and performance.
• Versatile: Can be applied at business unit, divisional or project levels and used to design incentive schemes.

Limitations and risks

• Sensitivity to assumptions: WACC and capital base choices materially affect EVA; inconsistent or optimistic assumptions can mislead.
• Complexity and manipulation risk: The many possible adjustments, while intended to improve economic accuracy, can be used selectively to shape results.
• Short term vs long term: Over-emphasis on current EVA can discourage longer-term investments (e.g. R&D) unless these are capitalised or explicitly adjusted.
• Not the only metric: EVA should complement, not replace, other strategic measures (market position, innovation pipeline, customer metrics).

When to use and implementation considerations

• Use EVA when the objective is to embed value-based management, make capital allocation decisions transparent, and align compensation with economic outcomes.
• Implementation steps:
  1. Define consistent accounting adjustments and governance for their application.
  2. Establish a robust approach to costing capital (market-based where possible).
  3. Train management and non-financial stakeholders in interpretation and trade-offs.
  4. Integrate EVA into planning, investment appraisal and incentive systems, with safeguards for long-term investment.
  5. Monitor and periodically review adjustment policies and WACC assumptions.
• Avoid simplistic application: ensure transparency in the chosen adjustments and present EVA alongside supporting metrics (cash flows, ROIC, strategic KPIs).

Relationship to other concepts

• EVA is a specific operationalisation of the residual income approach and is closely aligned with shareholder value maximisation and agency-theory remedies (better linking of pay to long-term performance).
• Alternatives / complements include cash-flow-based measures (FCF, NPV), return on invested capital (ROIC), and other risk-adjusted profit measures (RAROC).

Relevant strategy theorist: G. Bennett Stewart III

G. Bennett Stewart III (commonly cited as Bennett Stewart) is the central figure in the development and commercialisation of EVA. As co-founder of Stern Stewart & Co., he led the effort to translate residual-income theory into a practical, widely adoptable performance metric and management system that executives and boards could use to manage for shareholder value.

Backstory and relationship to EVA

• In the 1980s and early 1990s, a small team at Stern Stewart & Co. formalised and branded the economic profit approach as “Economic Value Added” (EVA). Stewart played a leading role in refining the calculation, promoting standardised adjustments so that EVA could be consistently used across diverse firms, and building an advisory practice that helped companies embed EVA into planning, capital allocation and executive compensation.
• Stewart’s work focused on making the abstract notion of “value creation” operational. He argued that traditional accounting measures (e.g. reported earnings) often obscure the true economic performance of a business because they fail to account properly for the cost of capital and capitalised investments. EVA was presented as the remedy: a single metric that made the economics of managerial decisions clearer and linked pay to true economic outcomes.
• Through client engagements, publications and speeches, Stewart and Stern Stewart & Co. persuaded a number of large corporations to adopt EVA frameworks in the 1990s. The metric also stimulated a broader management conversation about value-based management, capital efficiency and incentive design.

Biography (career highlights and contributions)

• Profession and role: Bennett Stewart is an American management consultant and thought-leader best known as co-founder and a senior leader of Stern Stewart & Co., the consultancy that developed and popularised EVA.
• Principal contributions:
  • Institutionalised the EVA metric and the operational practices required to apply it in corporate settings.
  • Co-authored and promoted publications on value-based management (notably “The Quest for Value”, a widely cited book on how managers can create shareholder value through disciplined capital allocation and performance measurement).
  • Advised many large, multinational firms on how to redesign planning, performance measurement and incentive systems around economic profit.
• Legacy: Stewart’s work shifted executive attention from accounting profits towards economic profitability and cost of capital. EVA’s influence is clear in the subsequent proliferation of value-based management techniques and in the emphasis on capital efficiency in contemporary strategic practice.

Context and critique in strategy literature

• Stewart’s EVA sits within a longer intellectual lineage that includes economists and strategists who emphasised the primacy of shareholder value (for example Alfred Rappaport’s work on shareholder value creation). EVA’s distinctive contribution was to provide a practical, implementable metric plus diagnostic adjustments that managers could apply in firms with differing accounting practices and capital structures.
• Critics have pointed out that EVA can be overly rigid if used in isolation, that its many adjustments can introduce subjectivity, and that it must be carefully managed to avoid short-termist behaviour. Proponents argue these weaknesses are manageable with disciplined governance and appropriate long-term incentive design.

Concluding note

EVA is a powerful tool when used as part of a broader value-based management system: it converts the abstract idea of “creating shareholder value” into a measurable, actionable figure that ties operational results to the cost of capital. G. Bennett Stewart III’s contribution was to turn that concept into a widely adopted management practice by defining adjustments, demonstrating application across real companies, and promoting EVA as the backbone of incentive and capital-allocation systems. Use it with clear rules, transparent governance and complementary strategic metrics to avoid the common pitfalls.

Economic value added (EVA) is a measure of financial performance that captures the surplus generated above the required return on the capital invested in the business: the profit left after charging the business for the full economic cost of the capital employed.