Economic Value Added (EVA)

[nansverma]

I apologize in advance if this is not the right post. A quick question about EVA (Economic Value Added). Study notes Crouhy, Page 17 - it is defined as :
EVA (economic value added), or NIACC (net income after capital charge), is the after-tax adjusted net income less a capital charge equal to the amount of economic capital attributed to the activity, times the after-tax cost of equity capital.

In Giacomo notes (Credit Risk), it is defined = (RAROC- shareholder's cost of capital )* Economic Capital.

These two definitions seems to be exchanging economic capital and cost of equity capital. Please clarify. Thank you

 

[Nicole Seaman]

I apologize in advance if this is not the right post. A quick question about EVA (Economic Value Added). Study notes Crouhy, Page 17 - it is defined as :
EVA (economic value added), or NIACC (net income after capital charge), is the after-tax adjusted net income less a capital charge equal to the amount of economic capital attributed to the activity, times the after-tax cost of equity capital.

In Giacomo notes (Credit Risk), it is defined = (RAROC- shareholder's cost of capital )* Economic Capital.

These two definitions seems to be exchanging economic capital and cost of equity capital. Please clarify. Thank you

Hello @nansverma

I'm sure David or another member can help to clarify this for you, but I wanted to make sure that you had seen the many threads throughout the forum that discuss EVA (to find, use the search or tag functions to search for economic value added). I also found this article that David mentioned in another post that might be helpful to you: https://www.investopedia.com/university/eva/.

Nicole

 

[David Harper CFA FRM]

Hi @nansverma I consulted EVA for several years as a management consultant (and learned under one of the Stern Stewart thought leaders), including several EVA installations. Neither Giacomo nor Crouhy provide rigorous definitions, and it's no secret that I am highly critical of the Giacomo reading because it is very sloppy with many errors. While the original (Stern Stewart) EVA is NOPAT/Invested_Capital (I am actually the author of this Investopedia tutorial on EVA @ https://www.investopedia.com/university/eva/ ), there are many valid variations of EVA. The criticism against either the Giacomo/Crouhy version above is that they are cash-adjusted variations on ROE by which I mean they exclude debt as a source of invested capital. When I was consulting EVA, you would never do that ... it wouldn't be called EVA. That said, these would be "trying to be" variations on true EVA, I suppose, because they explicitly subtract an equity (capital) charge from a shareholder's earning base (EVA can be summarized as: adjustments from accounting to true economics, and an explicit charge for the use of capital!).

Given they are both employing a variation on: (after-tax earnings base) - (explicit charge for use of risky equity capital) * (capital base), I would say that either is acceptable. The academic requirement would be ratio consistency, and this is interesting and why your point is excellent: they should be switched:

• Giacomo's probably should be: EVA = (RARORAC - Cost of Economic Capital) * Economic Capital.
• Crouhy's probably should be "after-tax adjusted net income less a capital charge equal to (the amount of equity capital attributed to the activity times the after-tax cost of equity capital)" ... please note its written in the source in a way that could be confusing, we are subtracting the capital charge, itself a product of the capital amount and the cost of such capital.

Again, my view is we can't really make sense of what either is saying without specific numerical examples. That's why I suspect they are sloppily incorrect. But neither of mine above is conceptually wrong because you can actually define several different capital bases, including the economic capital is really a measure of risk. So to summarize, I don't think there is any point in getting too caught up in these word definitions unless and until we get comfortable with the basic idea: from an adjusted (from accounting to economics/cash) earnings base, we are subtracting an explicit charge for capital (which can be defined various ways). Thanks,

 

[nansverma]

Hi @nansverma I consulted EVA for several years as a management consultant (and learned under one of the Stern Stewart thought leaders), including several EVA installations. Neither Giacomo nor Crouhy provide rigorous definitions, and it's no secret that I am highly critical of the Giacomo reading because it is very sloppy with many errors. While the original (Stern Stewart) EVA is NOPAT/Invested_Capital (I am actually the author of this Investopedia tutorial on EVA @ https://www.investopedia.com/university/eva/ ), there are many valid variations of EVA. The criticism against either the Giacomo/Crouhy version above is that they are cash-adjusted variations on ROE by which I mean they exclude debt as a source of invested capital. When I was consulting EVA, you would never do that ... it wouldn't be called EVA. That said, these would be "trying to be" variations on true EVA, I suppose, because they explicitly subtract an equity (capital) charge from a shareholder's earning base (EVA can be summarized as: adjustments from accounting to true economics, and an explicit charge for the use of capital!).

Given they are both employing a variation on: (after-tax earnings base) - (explicit charge for use of risky equity capital) * (capital base), I would say that either is acceptable. The academic requirement would be ratio consistency, and this is interesting and why your point is excellent: they should be switched:

• Giacomo's probably should be: EVA = (RARORAC - Cost of Economic Capital) * Economic Capital.
• Crouhy's probably should be "after-tax adjusted net income less a capital charge equal to (the amount of equity capital attributed to the activity times the after-tax cost of equity capital)" ... please note its written in the source in a way that could be confusing, we are subtracting the capital charge, itself a product of the capital amount and the cost of such capital.

Again, my view is we can't really make sense of what either is saying without specific numerical examples. That's why I suspect they are sloppily incorrect. But neither of mine above is conceptually wrong because you can actually define several different capital bases, including the economic capital is really a measure of risk. So to summarize, I don't think there is any point in getting too caught up in these word definitions unless and until we get comfortable with the basic idea: from an adjusted (from accounting to economics/cash) earnings base, we are subtracting an explicit charge for capital (which can be defined various ways). Thanks,

Thanks a lot David. That was very helpful explanation and clarification. Feel comfortable now, knowing what you mentioned about accuracy and sloppiness.