Corporate Finance

Economic Profit and EVA

Measure what accounting profit hides: whether a company (or a division, or a year) actually beat the cost of the capital it used.

  • Intermediate
  • 6 min total
  • 10 chapters

What decision this helps you make: Whether a "profitable" unit is genuinely creating value, and how to set targets and bonuses that can't be gamed by growing with cheap-looking capital.

What this topic is

Economic profit (popularized as EVA, or Economic Value Added, a trademark of Stern Stewart & Co.) is profit AFTER charging for all the capital used: operating profit after tax minus (capital employed × cost of capital). Positive means the business beat its funding cost; negative means accounting profit masked value destruction.

Why it matters

Net income can grow for years while owners get poorer. All it takes is pouring ever more capital into mediocre returns. Economic profit catches exactly that, which is why it became the backbone of value-based management and capital-charged bonus plans.

Who should learn it

Executives setting targets, managers judged on divisional P&Ls, analysts comparing capital-hungry businesses, and students bridging accounting to finance.

What you will understand

  • Compute economic profit from numbers you already have
  • See why growing net income can still destroy value
  • Use capital charges to make divisions own their balance sheets
  • Know EVA's adjustment burden, and when simpler is better

Prerequisites

Common misconception

"Positive net income means the company created value." Net income charges for debt (interest) but treats equity as FREE. A company earning 4% on shareholders' money reports profit while paying investors less than their capital could earn elsewhere: profitable on paper, value-destroying in fact.