Innate Measurement Bias in EVA and How to Fix it: The Total EVA and Operating EVA

Abstract

Economic value added (EVA) is the performance metric bound to be biased by design. The measurement bias comes from contrasting NOPAT, which is a purely operating profit, with the capital charge on the money investors have put into the firm, which is calculated by applying the after tax WACC made-up to incorporate the financing side effects. Such a synthetic construct can be uninformative or even misleading, and therefore is doubtfully eligible to be the period measure of either operating or total performance.To eliminate distortions in measuring performance we have to (A) recognize the two sources of income attributable to the providers of funds, primary is the NOPAT generated by the firm’s core assets, and another is the financial side effects, generally the interest tax shield subsidy from the government; and (B) use the cost of unlevered equity (i.e. the risk of assets) as a hurdle rate to calculate the charge on the book invested capital. Splitting the aggregate financial result into the operating and side effect financing components enables an undistorted concurrent assessment of the operating and the overall performance by means of the Operating EVA (OEVA) and the Total EVA (TEVA) metrics respectively. TEVA is a better choice than the EVA for the purpose of measuring corporate performance, and OEVA is the index giving an informative snapshot of the ongoing operations. The TEVA and OEVA analysis is consistent with the free cash flow valuation and provides additional managerially relevant information for the performance evaluation.