EVA (Economic Valued Added) is a modern financial measurement tool that determines if a business is earning more than its true cost of capital. Including a cost for the use of equity capital sets EVA apart from more popular measures of bank performance, such as return on assets (ROA), return on equity (ROE), net banking income and the efficiency ratio, which do not consider the cost of equity capital employed. As a result, these measures may suggest a bank is performing well, when in fact it may be diminishing its value to its shareholders. EVA is a tool that focuses on maximizing shareholder wealth. EVA is an appropriate tool for motivation system and in this way it motivates managers to think like owners; and provides a common language within the corporate culture. The EVA application in banks is relatively new (it started to be implemented in U.S. in 1994) and is not as well known as other measures of bank performance. As in the Romanian Banking system this measurement method is not familiar or used, the purpose of this study is to introduce EVA and its advantages compared to other performance indicators and based on this study to try to implement it in one of the Romanian banks.performance measures, EVA, shareholder value, banks, motivation system

CARAGEA Codin

MIHAILESCU Laurentiu

POPA Gabriela

English

Research Papers in Economics

  The Ninth International Conference 
“Investments and Economic Recovery”, May 22 – 23, 2009 
 
 
Vol.12, Nr. 1 special/2009        Economia seria Management 
 
168 
 
EVA – Advanced method for performance 
evaluation in banks 
 
VEA - Metoda avansată de evaluare 
a performantei în bănci 
 
 
Gabriela POPA, Ph.D. Student 
The Bucharest Academy of Economic Studies, Romania 
e-mail: gabriela.popa@otpbank.ro 
Laurenţiu MIHĂILESCU, Ph.D. Student 
The Bucharest Academy of Economic Studies, Romania 
e-mail: laurentiu.mihailescu@ingromania.ro 
Codin CARAGEA 
OTP Bank, Bucharest, Romania 
e-mail: codin.caragea@otpbank.ro 
 
 
Abstract 
EVA  (Economic  Valued  Added)  is  a  modern  financial  measurement  tool  that 
determines if a business is earning more than its true cost of capital. Including a cost for 
the use of equity capital sets EVA apart from more popular measures of bank performance, 
such  as  return  on  assets  (ROA),  return  on  equity  (ROE),  net  banking  income  and  the 
efficiency ratio, which do not consider the cost of equity capital employed. As a result, 
these measures may suggest a bank is performing well, when in fact it may be diminishing 
its value to its shareholders. EVA is a tool that focuses on maximizing shareholder wealth. 
EVA is an appropriate tool for motivation system and in this way it motivates managers to 
think like owners; and provides a common language within the corporate culture. The EVA 
application in banks is relatively new (it started to be implemented in U.S. in 1994) and is 
not as well known as other measures of bank performance. As in the Romanian Banking 
system this measurement method is not familiar or used, the purpose of this study is to 
introduce EVA and its advantages compared to other performance indicators and based on 
this study to try to implement it in one of the Romanian banks. 
 
Keywords:  performance  measures,  EVA,  shareholder  value,  banks,  motivation 
system 
 
    Rezumat 
VEA (Valoarea Economica Adaugata) este un instrument modern de masurare a 
rentabilitatii care arata daca o afacere genereaza castiguri mai mari decat costul real al 
capitalului investit. Incluzand in calculul sau costul pentru utilizarea capitalului, VEA se 
departajeaja de masurile populare de masurare a performantei in banci, ca de exemplu 
rentabilitatea  activelor  (ROA),  rentabilitatea  economica  (ROA),  venitul  net  bancar  si 
indicatorii de eficienta, care nu iau in calcul costul capitalului utilizat. In consecinta, acesti The Ninth International Conference  
“Investments and Economic Recovery”, May 22 – 23, 2009 
 
 
 
 
Economia seria Management    Vol.12, Nr. 1 special/2009 
 
169 
indicatori  clasici  pot  sugera  ca  banca  performeaza  bine  in  timp  ce  de  fapt  ea  isi 
diminueaza valoarea pentru  investitorii  sai. VEA este un instrument care se  axeaza  pe 
maximizarea  valorii  actionarilor.  VEA  este  un  instrument  adecvat  pentru  sistemul  de 
motivare  in  companie,  astfel  ea  motiveaza  managerii  sa  gandeasca  ca  si  actionarii; 
genereaza un limbaj comun in cultura organizationala. Aplicarea VEA in banci este relativ 
noua (a inceput sa fie implementata in U.S. in 1994) si nu este la fel de cunoscuta precum 
celelalte metode de masurare a performantei.  Cum in sistemul bancar romanesc acest 
instrument de masura  nu este familiar sau  folosit, scopul acestui studiu este  prentarea 
conceptului de VEA si a avantajelor sale comparativ cu alti indicatori de performanta, iar 
in baza acestui studiu sa se incerce implementarea sa in una din bancile romanesti. 
 
Cuvinte-cheie:  masurarea  performantei,  VEA,  valoarea  actionarilor,  banci, 
sistem de motivare 
JEL Classification: : G21, G31, G32, M21, M41, O31 
 
Introduction 
 
conomic  Value  Added,  or  EVA,  is  a  financial  measurement  tool  that 
bankers can use to measure the financial performance of their bank. EVA 
determines if a business is earning more than its true cost of capital. It is 
mainly used in the U.S. banking industry since 1994 and is not as well known as other 
measures  of  bank  performance.  EVA  is  an  estimate  of  the  true  economic  profit  (not 
accounting profit), EVA is highly accurate because it includes the cost of debt financing 
and equity financing. 
As in the Romanian Banking system this measurement method is not familiar or 
used, the purpose of this study is to introduce EVA and its advantages compared to other 
performance indicators and latter on to try to implement it in one of the banks. 
 
Economic Value Added - definition 
 
EVA was invented by Stern Stewart & Co. which launched EVA in 1989. EVA 
measures  residual  income:  that  is,  it  measures  the  difference  between  a  firm’s  cost  of 
capital and return on capital. EVA is a tool that focuses on maximizing shareholder wealth. 
As developed by Stern Stewart & Co., EVA is calculated as a company’s “net 
operating profit after taxes” (NOPAT) minus a dollar cost for the equity capital employed 
by the company. The dollar cost of equity capital employed by a company is equal to the 
company’s equity capital (reported on its balance sheet) multiplied by a percentage return 
that the company’s shareholders require on their investment.  
EVA can be estimated focusing both on Management of Capital as well as the 
Management of Profits (as summarized by Verma). 
 
EVA as a measure of value creation through Management of Profits 
 
  EVA = [Return on invested Capital (ROIC) - Cost of Capital (WACC)] x Total Capital 
                                                                                                                          invested 
 
               NOPAT/Invested Capital                  Opportunity Cost of financing  
 
E   The Ninth International Conference 
“Investments and Economic Recovery”, May 22 – 23, 2009 
 
 
Vol.12, Nr. 1 special/2009        Economia seria Management 
 
170 
EVA as a measure of value creation through Management of Capital 
EVA = NOPAT - (WACC x Total Capital Invested) 
The use of this formula will produce either a positive or negative EVA number. A 
positive EVA reflects that the company is increasing its value to its shareholders, whereas a 
negative EVA reflects that it is diminishing its value to its shareholders. EVA is based on 
the principle that since a company’s management employs equity capital to earn a profit; it 
must pay for the use of this equity capital. As management consultant Peter Drucker said, 
“Until a business returns a profit that is greater than its cost of capital, it operates at a loss... 
The enterprise still returns less to the economy than it devours in resources…Until then it 
does not create wealth; it destroys it”. 
In order to create values, ROIC for a bank must be greater than weighted average 
cost of capital (WACC). Therefore, the EVA may be increased in several ways, including:  
1)  increasing NOPAT; 
2)  lowering the WACC and 
3)  reducing invested capital  
 
EVA Calculation 
 
Step 1: Calculating NOPAT (Net Operating Profit After Taxes) 
The  first  step  in  calculating  EVA  is  to  make  adjustments  to  a  company’s  net 
income in order to produce its NOPAT. These adjustments are necessary as the company’s 
net income is calculated under generally accepted accounting principles (GAAP), which 
often distort the current economic realities of the company.  
Stern Stewart & Co. has identified more than 120 potential adjustments that a 
company can make to its net income, but most companies apply about ten adjustments to 
produce a sufficiently accurate EVA figure. The decision on which adjustments to be made 
relay on: 1) the materiality of the adjustments, 2) the effect they will have on management’s 
behavior, 3) how easily they are understood and 4) the degree to which they will impact the 
company’s market value. 
The most common adjustments for a bank refer to its provision for loan losses and 
its provision for taxes. It may make other adjustments, especially if it has nonrecurring 
items and unrealized gains and losses on trading securities during a given period.  
As  noted  in  Velez-Pareja  (2000),  when  EVA  is  used  to  assess  company 
performance in a given period, capital invested and NOPAT should not be calculated in the 
same period. As investors expect to receive returns on the investment made at the beginning 
(and not on the cumulative amount at the end of the period), shareholders compare returns 
(i.e. NOPAT) earned over the period with the capital invested at the beginning (and not at 
the end) of the period. For this reason, capital invested is measured with a lag of one year 
and EVA is calculated as follows: 
EVAt = NOPATt – (Capital Investedt-1 * Cost of Capital) 
With regard to the estimation of EVA for banks, one important difference between 
financial institution and other firms is the role of debt. For non banking firms debt forms an 
integral part of financing operations and therefore interest expense/income is excluded from The Ninth International Conference  
“Investments and Economic Recovery”, May 22 – 23, 2009 
 
 
 
 
Economia seria Management    Vol.12, Nr. 1 special/2009 
 
171 
NOPAT calculations so that returns are unlevered. A bank’s debt funding is effectively the 
raw material which is intermediated (“manufactured”) into high yielding assets. Interest 
expense, on this view is the equivalent of the cost of goods sold. 
The above has two consequences 
￿  Interest expense is included in NOPAT and, because of this, 
￿  When calculating the cost of capital we define capital as equity and equity 
equivalents. (the cost of other funding – eg., debt and deposits – having been 
expensed  in the income statement, thus allowing for the  value creation of 
below market cost). 
 
Step 2: Calculating Cost of Equity Capital 
The cost of equity capital employed by a company is equal to its equity capital 
multiplied  by  a  percentage  return  that  the  company’s  shareholders  require  on  their 
investment.  
Cost of Equity Capital = Equity capital * Percentage Return Required 
In calculating a bank’s EVA, the equity capital figure used is often based on its 
“total capital”, which is the sum of its Tier 1 and Tier 2 capital. 
The percentage return that a bank’s shareholders require on their investment is 
based on the fact that they require both a return for just investing their money and a return 
that reflects the risk inherent in investing specifically into that specific bank.  
Percentage Return Required = Risk-Free Rate + (Beta Coefficient x Market Risk 
Premium) 
The  risk-free  rate  is  the  interest  rate  that  can  be  obtained  by  investing  in  an 
investment with no risk (in practice there are usually used the short term government bonds 
(in Romania the market for these instruments is not matured, but starting with 2009 the 
National Bank intends to encourage the development of these products and their trading). 
The beta coefficient is the level of risk inherent in investing in a specific company relative 
to investing in the overall stock market. The market risk premium is the risk associated with 
investing in the stock market as a whole. 
 
EVA vs. other traditional performance measures 
 
Including a cost for the use of equity capital sets EVA apart from more popular 
measures of bank performance, such as return on assets (ROA), return on equity (ROE) and 
the efficiency ratio, which do not consider the cost of equity capital employed. As a result, 
these measures may suggest a bank is performing well, when in fact it may be diminishing 
its value to its shareholders. 
Every  useful  performance  metric  attempts  to  measure  changes  in  shareholder 
value. Economic value added (EVA) is the best metric available. The others each have 
significant drawbacks: 
￿  Traditional  income  measures,  including  operating  profit,  earnings  before 
taxes,  net  income  and  earnings  per  share,  can  be  easily  manipulated,  and  they  do  not 
account for the cost of equity. Financial markets are interested in knowing how the reported 
profits weigh against the of cost financial resources employed. Reported profits without 
consideration for cost of capital are irrelevant.    The Ninth International Conference 
“Investments and Economic Recovery”, May 22 – 23, 2009 
 
 
Vol.12, Nr. 1 special/2009        Economia seria Management 
 
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￿  Market-based measures, including market value added (MVA), excess return 
and future growth value (FGV), can only be calculated for publicly-traded entities. 
￿  Cash flow measures, including cash flow from operations (CFO) and cash 
flow return on investment (CFROI), include neither the cost of equity nor the cost of debt. 
Other EVA strong points vs. other traditional performance measures. 
￿  EVA is an easier concept of profitability than ROI and furthermore, it can be 
translated into day-to-day operations. Theoretically EVA is much better than conventional 
measures in explaining the market value of a company. Financial theory suggests that the 
market value of a company directly depends on the future EVA-values. The market value of 
a company = Book value of equity + present value of future EVA. A bank’s present value 
should equal its invested capital plus the present value of future EVA and if the bank’s 
present value is lower, the stock is undervalued and vice versa. Value of a bank’s share is 
equal the market value of assets and the sum of EVAs of all future periods discounted back 
to the present. When a bank no longer earns a return on its incremental investments greater 
than its cost of capital, no EVA is added from new investments. 
￿  When the costs of employed capital are shown in the income statement the 
importance  of  capital  from  the  viewpoint  of  profitability  could  easily  be  seen.  After 
realizing the true costs of capital managers are often able to decrease excess employed 
capital considerably. 
￿  Since  EVA  may  be  calculated  for  private  entities  or  for  divisions  within 
companies, it can be used as a motivational tool deep within the organization. Traditional 
managers understand that their companies need to control operating costs and succeed in 
the commercial markets. Today, companies also must compete in the capital markets by 
keeping their cost of capital low, especially in the banking industry.  
 
EVA implementation 
 
The main benefits of the EVA’s implementation may be summarized in “The Four 
M’s”: Management System, Motivation, Mindset, Measurement (Marusak 2007). 
Management System 
￿  Simply measuring EVA can give managers a better focus on performance. 
￿  Provides a foundation for a comprehensive financial management system.  
Motivation 
￿  Incentive plans to make managers think like owners because they are paid like 
owners.  
￿  EVA Bonus Plan. 
Mindset 
￿  Changes corporate culture. 
￿  EVA system provides a common language for employees across all corporate 
functions.  
￿  Facilitates decentralized decision making.  
Measurement 
￿  Most accurate measure of corporate performance over any given period. 
￿  Translates accounting profits into economic reality.  
In order to implement EVA, the management should support this development and 
the following steps are compulsory  for a successful implementation: especially  the key 
persons (top and middle managers) have to understand and commit to EVA thoroughly; 
without  the  full  support  of  managers  there  will  not  be  substantial  results;  good 
understanding helps to tailor EVA to the specific need of a company; EVA will be most The Ninth International Conference  
“Investments and Economic Recovery”, May 22 – 23, 2009 
 
 
 
 
Economia seria Management    Vol.12, Nr. 1 special/2009 
 
173 
beneficial if broken down into small parts; integration of EVA to incentive systems for all 
the employees is a good way to make all the employees work hard for common goals; 
EVA, usually, improves profitability through the improved capital turnover ; companies 
have usually done a lot in cutting costs but there is still much to do in improving the use of 
capital.  
 
Conclusion 
 
As it has illustrated in this paper, EVA can be an important tool that bankers can 
use to measure and improve the financial performance of their bank. Since EVA takes the 
interest of the bank’s shareholders into consideration, the use of EVA by bank management 
may lead to different decisions than if management relied solely on other measures. 
 
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Does EVA Beat Earnings? Evidence on Association with Stock Returns and Firm Values,

Economic value added: the real key to creating shareholder wealth,

Performance evaluation methods in commercial banks and associated risks for managing assets and liabilities,

Shareholder value and the clash in performance measurment.Are banks special?,

EVA – Advanced method for performance evaluation in banks

http://www.management.ase.ro/reveconomia/2009-1s/27.pdf

EVA – Advanced method for performance evaluation in banks

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