What sets EVA, or economic value added, apart from more common measures of financial performance is that it shows profit after the cost of all a company’s capital, both equity and debt. In contrast, measures like net income and earnings show only how much money goes toward paying for debt. In the second part of TSC’s three-part Getting Down to Fundamentals series, we’ll take a look at EVA and how it can enhance investors’ stock-picking savvy.

The ideas behind EVA were being developed by management consulting firm Stern Stewart in the 1980s, though the idea didn’t really catch on until the ’90s. EVA shows whether a company’s really making a profit after paying the going rate for capital. (Here’s the hitch: It’s virtually impossible for retail investors to determine EVA for a particular company because companies don’t make public some of the information that goes into the formula. But you can check out Stern Stewart’s Web site for the lowdown on the 200 biggest U.S. companies by market cap .)

Though you may show profitability in a GAAP

Generally Accepted Accounting Principles

sense, if you’re not recovering the cost of equity capital, you’re destroying shareholder value, not building it, says Joseph Carcello, a professor at the University of Tennessee’s business school. You can’t assume equity capital is free, just because it’s not explicit. There’s an opportunity cost of no longer having that cash to use for other purposes.

To think of EVA another way, says Carcello, imagine two companies that each generated $1 million in annual net income. In the first case, the assets used to crank out that profit were financed by selling shareholders one share of stock for $1. In the second case, assets were financed by selling stock worth $1 million. Though equally profitable, one company devours shareholder capital, while the other scarcely uses any. From a shareholder point of view, there’s no question that the first company is the better investment.

What EVA Can Tell Investors

EVA is a dollar figure that tells how much wealth a company has created above and beyond its cost of capital. But the actual number matters less than the trend in EVA, says Dennis Soter, a partner at Stern Stewart. If EVA is positive, but is expected to become less positive, that’s not a very good situation. Conversely, if a company has negative EVA but it’s expected to improve, that can be a tremendous investment opportunity.

Even in healthy companies, trends in EVA may foreshadow stock performance better than trends in the bottom line. Wal-Mart (WMT — Get Report ) offers a case in point: From 1991 to 1994, net income rose steadily while EVA slowly dropped, though it remained positive. Though Wal-Mart generated profits of $8.6 billion for the period, it added economic value — money over and above the cost of equity and debt capital — of only $1.3 billion. Its stock price, up 38.6% for the period, bested the S&P 500 by a mere 1.9%.

But then business took off. Wal-Mart created $5.4 billion in value from 1995 to 1999 — and its stock price soared 379%, outpacing the S&P by 182%.

Wal-Mart’s Good Face of EVA

Wal-Mart’s stock price soared in the late ’90s as EVA surged. The chart shows EVA performance