Difference Between EVA and ROI

Key Difference – EVA vs ROI
 

There are a number of factors that should be considered when making investments where returns play an essential role. It is important to compare the investments in the company as a whole as well as among various business divisions. EVA (Economic Value Added) and ROI (Return on Investment) are two widely used measures for this purpose. The key difference between EVA and ROI is that while EVA is a measure to assess how effectively company assets are utilized to generate income, ROI calculates the return from an investment as a percentage of the original amount invested.     

CONTENTS
1. Overview and Key Difference
2. What is EVA
3. What is ROI
4. Side by Side Comparison – EVA vs ROI
5. Summary

What is EVA?

EVA (Economic Value Added) is a performance measure normally used to assess the performance of business divisions, in which a finance charge is deducted from the profits to indicate the usage of assets. This finance charge represents the cost of capital in monetary terms (derived by multiplying the operating assets by the cost of capital). EVA is calculated as below.

 EVA = Net Operating Profit After Tax – (Operating Assets* Cost of Capital)

Net Operating Profit After Tax (NOPAT)

A profit from business operations (gross profit less operating expenses) after deduction of interest and taxes.

Operating Assets

Assets utilized to generate revenue

Cost of Capital

The opportunity cost of making an investment. Companies can acquire capital in the form of equity or debt; many companies are keen on a combination of both. If the business is fully funded by equity, the cost of capital is the rate of return that should be provided for the investment of shareholders. This is known as ‘cost of equity’. Since there is usually a portion of capital funded by debt as well, ‘cost of debt’ should be provided for debt holders.

Weighted Average Cost of Capital (WACC)

WACC calculates an average cost of capital considering the weightages of both equity and debt components. This is the minimum rate that should be achieved in order to create shareholder value.

E.g. Division A made a profit of $15,000 for the financial year of 2016. Company’s asset base was $80,000, comprising of both debt and equity. The weighted average cost of capital of the company is 11%, and this is used when calculating the finance charge.

EVA = 15,000 – (80,000*11%) = $6,200

The finance charge of $8,800 represents the minimum return required by the providers of finance on the $90,000 capital they provided. Since the actual profit of the division exceeds this, the division has recorded residual income of $6,200.

One of the main drawbacks of EVA is that this is an absolute amount and cannot be compared with similar company EVAs. Even when comparing EVA with the ones in previous years, the company should be careful to assess the relativity in the comparison. For instance, EVA would have increased compared to the prior year; however, if the company had to significantly invest in new capital during the year this increase may not be as favorable as it seems.

What is ROI?

ROI is another vital investment evaluation technique that can be made by companies to measure performance. This helps to calculate how much returns are made compared to the amount of capital invested. ROI can be calculated as a whole for the company as well as for each division in case of a large-scale company. ROI is calculated using the following formula.

ROI = Earnings Before Interest and Tax (EBIT) / Capital Employed

EBIT – Net operating profit before deducting interest and tax

Capital Employed – Addition of debt and equity

This is a measure that indicates the level of efficiency of a company and is expressed as a percentage. Higher the ROI, more the value generation for investors. When ROI is calculated for each division, they can be compared to identify how much value they contribute to company’s overall ROI.

ROI is one of the principal ratios that can be calculated by investors as well to measure the gain or loss arrived from an investment relative to the funds invested. This measure is a frequently utilized one in evaluating by individual investors in assessing the profitability in various investment decisions.

This is the return from an investment and can be simply calculated as a percentage,

ROI = (Gain from Investment – Cost of Investment) / Cost of Investment

ROI assists in comparing returns from different investments; thus, an investor can select which one to invest in between two or more options.

E.g. An investor has the following options to invest in stocks of two companies

Company A’s stock – cost = $ 900, value at the end of one year = $ 1,130

Company B’s stock – cost = $ 746, value at the end of one year=$ 843

The ROI of the two investments are 25% ((1,130 – 900) /900) for Company A’s stock and 13% ((843 – 746) /746) for Company B’s stock.

The above investments can be easily compared since both are for a period of one year. Even if the time periods are different ROI can be calculated; however, it does not provide an accurate measure. For instance, if Company B’s stock takes five years to pay off as opposed to one year then its higher returns may not be attractive for an investor who prefers to make a quick return.

What is the difference between EVA and ROI?

 Summary – EVA vs ROI

Regardless of the difference between EVA and ROI, both have their own advantages and disadvantages and are preferred by various managers in different ways. Managers who prefer to use a straightforward method which allow easy comparisons may use ROI. Furthermore, tax is an uncontrollable expense which is not directly related to the use of assets reduce the effectiveness of EVA as an investment decision tool. However, ROI does not clearly indicate the minimum rate of return that should be generated since the cost of capital is not considered in its calculation.

Reference:
1.”What Is the Difference Between Economic Value Added & Residual Income?” What Is the Difference Between Economic Value Added & Residual Income? | Chron.com. N.p., n.d. Web. 14 Feb. 2017.
2.”Cost Of Capital.” Investopedia. N.p., 25 Mar. 2016. Web. 14 Feb. 2017.
3.”Return on Investment (ROI): Advantages and Disadvantages.” YourArticleLibrary.com: The Next Generation Library. N.p., 13 May 2015. Web. 14 Feb. 2017.
4.”Return on Investment (ROI).” Return on Investment (ROI) Definition & Example | Investing Answers. N.p., n.d. Web. 13 Feb. 2017.

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1.”Return on Investment Analysis Graph”By SK – FED Architected Agile Template (CC BY-SA 3.0) via Commons Wikimedia