Economic Value Added (EVA) is a variation to profit, and it refers to a measure of a firm’s estimated economic profit. It can be calculated by deducting the capital costs from the operating profit to get the residual wealth. This residual wealth will let the firm know how their capital is performing in the market versus their other potential investments.

This will also help companies decide between investments, to know which one will yield the most profit. The equation of the Economic Value Added is simple.

Economic Value Added = Net Operating Profits after Taxes- (Capital x minimum rate of return)

If we put this equation to test, suppose you own a company, and you want to open another branch elsewhere. You have \$50,000 to invest in your new branch. You do the math and find out that you will make a profit of around \$5,000 per year. You also want at least a 15% return on capital for your contribution. Once you substitute all these numbers into the equation, you will get:

\$5,000 – (\$50,000 x 15%) = -\$2,500

This proves that such an investment would be a loss. The negative answer should let your investment to be a failure, and so, you should invest your \$50,000 on something more profitable. As is obvious, the calculation can be quite complicated, so you need to treat with care. That said, it could also be a great help when investing in capital intensive industries, as it could help you make smarter investments.

However, doing just a simple math to figure out the Economic Value Added is not enough. This equation isn’t perfect, and so, you have to keep in mind that it has both advantages and disadvantages.