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.
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