When Profits Are Losses: Analyst's Toolkit

BOSTON (TheStreet) -- Earnings can be misleading.

A company that has ample profits but carries expensive financing may be in worse shape than one with softer earnings and cheaper financing. A metric for performance evaluation developed by Stern Stewart & Co. known as Economic Value Added, or EVA, can help draw a distinction between firms that are flying high and those treading water.

Investment managers such as T. Rowe Price(TROW Quote), Charles Schwab(SCHW Quote), Legg Mason(LM Quote), BlackRock(BLK Quote) and Franklin Resources(BEN Quote) suffered earnings declines as the stock market took a nosedive starting late last year. But they have recently performed beyond expectations as investment gains have stanched net outflows from mutual funds and boosted management fees. Applying EVA to those companies will show which are enriching shareholders beyond the minimum required return.

The theory behind EVA is that investors, whether equity or debt holders, demand a base charge for the use of their money to fund firm activities. The weighted average of those charges is called the weighted average cost of capital, and represents the minimum return that a firm must generate to satisfy the most basic expectations of its investors. Multiplying the weighted average cost of capital by the total invested capital, the sum of the debt, additional paid-in capital, common shares and all other forms of invested capital, results in the amount that it costs the company to maintain its financing structure. Economic Value Added takes that charge and subtracts it from the net operating profit after tax (NOPAT), which results in the profitability of the firm after the effect of its financing choices.