Executive Summary
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Economic value added (EVA) has transformed the corporate finance scene and business practice by transferring modern business theory from classroom to boardroom.
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Traditional metrics, with their roots in accounting, distort economic reality. For example, crucial long-term intangible investments often fall foul of traditional metrics.
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If stockholder value is the goal, then the key to any metric must be the cost of capital, or stockholders’ required return.
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At its best EVA is not just a financial metric, it is a complete management system focused on value creation.
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Incentive-based EVA uniquely aligns the interests of managers, employees, and stockholders. Studies show that EVA companies, after implementation, have increased their market value over peer by some 50% over five years.
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Bold implementation of EVA signals the beginnings of transparency and accountability, though it is too often the subject of lip service. Implementing EVA half-heartedly or without incentives spells disappointment.
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A balanced scorecard demands EVA as the balancing mechanism. EVA covers everything managers can influence, and therefore all drivers of value.
Introduction
Financial measuring tools are many and varied. The media and equity analysts focus on financial accounting metrics such as sales and sales growth, margin, operating profit and operating profit growth, bottom-line earnings and its partner earnings per share (EPS), market value, return on equity, and return on assets or cash flow.
Each of these metrics is flawed. Neither sales nor operating profit accounts for the financial requirements necessary to achieve them, in terms of either annual expenses or capital invested. Bottom-line profits and EPS take no account of the fact that equity has a cost. Market value ignores the capital employed to create it—invest more, and of course market value rises, without necessarily creating value. And yet each is popular.
Why is so fundamental a series of misapprehensions so widespread? The answer lies in the past. Accounting operating profit is conservative—literally. It focuses on collateral, or at least what would be left of a company after bankruptcy. This is a more than adequate measure for a bank, but it is misleading for an investor. The theory of modern business is founded on the blindingly simple insight that business is primarily about economics, not accounting.
The Problems with Existing Corporate Finance Measures
Debt-inspired measures are misleading because they expense—write off as expenses—aspects of business that are becoming increasingly important. Long-term intangible investments (training, brand building, and so on), in particular, create much of the value of companies today. Yet traditional accounting procedures expense these rather than treating them as investments. Additionally, investments in acquisitions (goodwill) and in restructuring (extraordinary items) are expensed. This is a mistake. A focus on value demands that long-term investments should appear on the balance sheet for the current year, taking the cost of capital into account.
Unless they take into account the cost of capital, return measures can become inflated. Furthermore, concentrating on percentages can lead to a misguided focus—for example, reducing capital investments (especially intangibles) calculated to create profits in the future.
If the hurdle rate for returns is very high, increases may discourage optimal creation of value. If the hurdle for returns is very low, increases may destroy value. If return objectives are above the required returns of investors—the right benchmark—then managers may forgo investments that create value. If returns are the objective and an increase fails to meet this required return, value destruction results.
Of other measures, cash flow will not provide the right answers in growing businesses. When Wal-Mart was growing rapidly, new stores cost more than the existing cash flow, yet no one demanded that the company stop investing and growing. Furthermore, the net present value of free cash flow emphasizes success in the terminal value of the equation rather than the horizon that managers can visualize and experience. Free cash flow, in other words, is not a flow measure.
MVA
The best measure of corporate performance is market value added (MVA), because this measure differentiates between the total market value, including debt and equity, and the total capital invested: MVA is the difference. (MVA may also be viewed as management value added—the value managers have added to a company.)
The problem is that MVA is strongly affected by stock price, which is notoriously independent of senior executives. This makes MVA less useful for encouraging the creation of value, since it has limited operational use.
The Need for a Meaningful Financial Measure
An alternative is necessary, one that focuses on what managers can influence rather than what they cannot. The measure should differentiate between financial inputs—what enters a company over time—and outputs—the value created. Clearly our choice should not be a driver of value such as the financial accounting metrics that managers can influence. Consider instead output, on an annual basis, as operating profit after tax, with certain adjustments for intangible and other long-term investments and other accounting anomalies, and input as the annual rental charge on the total capital employed, both debt and equity. The rental charge or required return, known alternatively as the hurdle rate for investments or the weighted average cost of capital, is the true benchmark against which all investments and management should be measured. This is economic value added (EVA).
Understanding EVA
EVA covers all that managers can influence, all drivers of value. This is seen more easily if we view EVA as the capital investment multiplied by the difference between the actual return and the required return. If we think in addition about the required return as a mix of business risk and financial risk (where financial risk, or debt level, has a potential benefit also), then we have four of the major components of market value as defined by Merton Miller and Franco Modigliani. These are:
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the cost of capital for business risk
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the amount of debt
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the current level of operating profit
The other components look at future EVA (investor expectations for future growth) in the current level of EVA—what we call FGV, or future growth value. They are the expected return on new investment, and the time horizon for excess growth in profitability or EVA. Managers can influence more or less imperfectly the debt, operating profit, capital expenditure, and future returns. They influence the horizon and business risk little, if at all.
The Value and Scope of EVA
EVA covers profit and loss and the balance sheet, differentiating intangibles and growth, and thus all factors of production. Growing or improving EVA is the goal, with historic investments viewed as sunk. Hence, managers should focus on growing when the returns are greater than the cost of capital, redeploying capital when the returns are less than the cost, and improving returns on existing capital, as well as having an optimal capital structure (debt versus equity).
If value creation is key, then EVA is the answer, and improvement of EVA is the goal. How managers achieve this or choose to accomplish this depends on what they think is success for their business. Of course the answer may depend on the state of the economy. In reality, investing and containing costs are crucial everywhere in the economic cycle. However, criticism thrives in a falling market and falters in a rising one. A falling market puts failing companies under the microscope, and a rising market forgives all but the worst performers.
In other words, containing costs increases current and near-term EVA, and is always crucial. But investing determines near-term and future EVA and is also always crucial, if the cash is available.
Performance measurement is the bedrock of business. Since people manage what they measure, EVA can form the foundation for a more transparent and accountable management system, especially when combined with powerful incentives to improve EVA at every level, in every activity, across all functions, and independent of geography. With rights to make decisions accurately allocated, a fair system of transfer pricing in place, information flowing freely, and the appropriate tools and training offered, responsibility joins transparency and accountability through robust control and performance evaluation. Pay for the right performance, and value-based management results.
Under EVA, budgeting gives way to long-term planning. Control of the ends and the means is relinquished respectively to externally and objectively determined investor expectations, and to management choice and opportunity that allow managers to bet their own success on their meeting or beating stockholder requirements.
Conclusion
EVA is, in short, the best measurement tool for creating stockholder value. A balanced scorecard of metrics allows for a big-picture view, but what is the balancing mechanism? If value creation over the long term is the goal (and if it isn’t, stockholders should run), then EVA must be the balancing mechanism. Sales, margin, operating profit, and bottom-line profit simply fall short. Market value lacks levers. Return measures give the wrong answers. Only EVA can change companies.
Indeed, EVA correlates better with stock price than any other measure: by 50%, compared with up to 30% for other metrics. Since EVA charges for all the factors of production, continuous improvement in EVA always furnishes investors with an increase in value.
Clearly, if an organization pays lip service to EVA and blindly measures it without thinking about the behavioral consequences and the need to balance simplicity and accuracy, or else provides poorly considered or misguided incentives to create EVA, the outcome will disappoint. However, a robust system that’s adhered to in times of boom and bust will provide the foundation of sound decision-making and business practices.
Making It Happen
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Start using EVA as the key financial measure: subtract input (annual rental charge on the total capital employed) from output (adjusted operating profit after tax).
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Employ EVA as the foundation of a more transparent, responsible, and accountable management system, with robust control and performance evaluation.
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With the right to make decisions accurately allocated, put a fair EVA-based system of transfer pricing in place.
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Couple continuous restructuring of existing businesses to milk value with cautious investment in future businesses.
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Focus managers on growing where returns exceed cost of capital, and on redeploying capital where returns are less than its cost.
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Insist on improving returns on existing capital as well as on having an optimal capital structure (debt versus equity).
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