| Maximising shareholder value by using EVA/Economic Profit metrics in conjunction with the balanced scorecard |
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Economic value added (EVA®) provides a basis for four important financial management functions:
· Measuring corporate performance; · Ranking capital expenditure decisions; · Providing incentives that align employee and shareholder interests; and · Communicating vital information to the market about the firm's prospects.
At its most basic, EVA is a measure of corporate performance that differs from others by charging profit for the cost of all the capital a company employs. But EVA is much more than just a measure of performance. It is the framework for a complete financial management and incentive compensation system that can guide every decision a company makes, transform a corporate culture and improve the working lives of everyone in an organisation.
EVA has gained broad acceptance in the academic community and the business press and is changing the way investor’s picks stocks. Some of the world's leading investment banks, including Goldman Sachs and CS First Boston, have formally adopted EVA as a principal tool for valuing companies, and many others in the world are following their lead.
EVA's principal advantage over conventional accounting measures of performance is its direct relationship with company valuation and the stock market.
How does EVA link to the stock market?
Along with EVA a company should consider MVA (Market Value Added) as the ultimate concern for shareholders. It is the difference between a firm's market value (MV) and its economic book value (EBV). Market value represents the amount of cash that investors can withdraw from the firm. EBV is the resources investors (both debt and equity providers) have committed to the firm.
MVA is MV minus EBV. It represents the wealth a company creates or destroys for its shareholders. It is the value added by management to the resources invested in the firm.
Although MVA is what shareholders care most about, it is of limited use for internal management purposes. Because changes in a company's MVA are driven largely by changes in its share price, MVA can be measured only at the consolidated level of the firm at which the share price is quoted. Thus, MVA does not provide a measure of internal corporate performance that can be taken to the level of individual business units.
EVA can be used to serve that purpose as a second best alternative. It is not MVA, but since MVA is equal to the present value of future EVA's, measuring performance and linking incentives to changes in EVA will likely provide strong incentives for managers to maximise improvements in MVA. What is EVA
EVA is a measure of internal operating performance. It begins by determining the amount of total investor capital supporting a business unit or activity. Then it multiplies that capital by the difference between the unit's after-tax return on total capital (ROTC) and a required or minimum rate of return, a so-called cut-off rate (C).
The required rate of return, also known as the "cost of capital", reflects the rate of return investors would expect to earn on an investment of comparable risk. EVA = TC [ROTC - C]Managers can increase EVA by taking one or more of the following actions:
1. Build the business by increasing total capital through new investment, but only as long as ROTC exceeds C. 2. Manage the business more efficiently so as to increase ROTC, even without growth in the firm. 3. Harvest the business by discarding capital when ROTC is less than C with little improvement potential.
By rearranging this equation – you get:
EVA = NOPAT – Capital Charge (the required return on capital).
Where NOPAT is net operating profit before interest, but after tax (excluding the tax shield of interest), less a charge for capital employed (being net operating assets employed times the required return on funds employed i.e. the cost of capital). Measuring EVA
The EVA calculation begins with a firm's audited financial statements, but economic reality requires that both capital and income be adjusted for anomalies introduced by the accounting system.
Although there many anomalies that require attention, the most important fall into a few major categories. Some of the most important include:
1. Capital expenditures that are expensed on the profit-and-loss statement. Examples include research and development (R&D) and advertising and promotion. EVA requires that significant capital investments be capitalised as assets on the balance sheet, with an annual write-down over the expected economic life of the asset. Of course the life expectancy of R&D is significantly longer than for advertising and promotion.
2. Taxes in an EVA context are recorded only when paid. This is the cash focus of EVA.
3. Goodwill arising from acquisitions is retained on the balance sheet as an asset. The rule here is that if investors have paid for it, managers must earn at least the required rate of return on the investment. By contrast, accounting conventions usually require that goodwill be written off in some arbitrary fashion either all at once in the year of acquisition as under British practice, or gradually over 40 years as in the US, and 20 years in Australia.
4. Depreciation presents a special problem. Generally accepted accounting principles allow for accelerated write-down of depreciable assets. This conserves cash by minimising taxable income. The problem is that economic assets and economic trading income both are understated. Accounting for depreciation means plant follows a "concave" path when its economic path is actually "convex" that is, gradual erosion in value in the early years followed by an increasingly rapid write-off in later years. EVA follows convexity. Of course this is a more complex adjustment and is only used where warranted.
5. Reserve accounting for extractive industries, including mining, forest products and oil and gas, presents a special situation. Whereas industrial firms experience a decline in the value of the plant, the reserves of extractive industries fluctuate in value with the price of the commodity. EVA recognises holding period gains and losses annually, not in profits, but in the plant account. Gains and losses are capitalised in plant - the former as a reduction in plant, the latter as an increase in plant. This treatment spreads the fluctuations out over time. Accounting practice, in contrast, assumes no change in the value of reserves until they are sold, an unrealistic treatment at the very least.
6. Other adjustments that may be considered include extraordinary items, restructuring gains and losses, the treatment of operating leases, to mention just a few. These and other adjustments follow the intuitive economic model in contrast to the accountants' focus on comparability and conservatism. EVA and Capital Expenditure
The practical utility of EVA is based on the powerful causal relationship between MVA and expected future EVA.
The most important application of EVA is the evaluation of capital expenditures, including the pricing of acquisitions. The critical observation is that EVA and Net Present Value (NPV) are mathematically identical.
If NPV and EVA are the same, why should you use EVA?
The answer is that, as a performance measure, EVA has a memory. Investments made years ago are included in current EVA calculation. In contrast, prior years' decisions often are conveniently forgotten in the NPV calculation when viewed on an annual basis by operating managers eager to forget past mistakes. Incentive Compensation
The key to creating enhanced shareholder wealth with EVA decision-making tools is to make the interests of managers and shareholders congruent. Rather than measuring performance one way and providing rewards on some other basis, EVA is at once a performance measure and a reward system.
The real magic in EVA comes from changing behaviour, and that depends crucially on using it as the basis for incentive compensation. If you pay people for generating more EVA, you will get more EVA and, with it, greater shareholder wealth. You will also get a more successful organisation and greater non-monetary satisfaction.
However, plugging EVA into a conventional incentive scheme won't get you anywhere. In fact, the typical incentive system in use today actually is a disincentive system. It places far too much emphasis on the short term, provides little or no motivation for superior performance, causes managers to be excessively conservative and encourages them to sit on their hands in boom times and bad times; in short, it drives companies to under perform. It also tends to pay too much for mediocrity and way, way too little for outstanding performance.
By contrast, EVA bonus plans make managers think and act like owners by paying them like owners. We do that by calculating bonuses as a fixed percentage of EVA increases, giving managers a piece of the EVA action. These bonuses don't have any caps. The more EVA increases, the bigger the bonus - without limits. We are able to do away with upper limits because we pay only for sustainable increases in EVA.
A portion of any exceptional bonus award goes into a "bonus bank" for payment in subsequent years, and is forfeited if EVA subsequently falls.
Doing away with the conventional bonus cap gives a manager a pecuniary reason to continue striving for better performance even in boom years. Under conventional incentive plans, in contrast, managers have every reason to go into leisure mode once their bonuses have "capped out", and to engage in wealth destroying behaviour such as pushing additional sales into the next bonus year. The bonus bank, meanwhile, lengthens managers' horizons and gives managers a reason to work long hours to minimise the carnage in a downturn. Having money at risk in the bonus bank is what turns managers into genuine owners.
EVA isn't about finance, it's about motivating people. EVA is a means to unlock the potential for achievement that exists throughout every organisation. No magic formula handed down by management can accomplish that. But a management system that provides employees with better information and insights, that makes them accountable for performance and that properly rewards them for success can produce remarkable results.
The general framework has characteristics designed to make managers behave like shareholders even if the managers own no shares at all. The principal characteristics are:
It is this Bonus Bank that provides a downside risk for the manager, very much like the risk borne by shareholders. Thus, the "bank" ensures that declarations are paid in full, including the holdback, as long as improved performance is sustained. The effect of the bank also lengthens the decision-making horizon of the individual, because the half-life of the bank is slightly longer than three years.
The desirable distribution between fixed and variable pay optimally is about 50-50. In today's business climate 80-20 or 75-25 is not unusual for senior managers; and for middle managers, 90-10 or even higher is not uncommon. Larger variable pay tied to sustained performance is essential to maximise shareholder value.
Managers' decision-making horizons can be lengthened even more by requiring that a fraction of each year's incentive payment be used to purchase share options. The options should contain a rising exercise price that is equal to the required return C, minus the dividend yield on ordinary shares.
Incentives should be employed as a critical component of culture change toward a share-holder value framework. EVA incentives work best when almost all employees, even those on the shop floor, are sensitive to EVA in their day-to-day decisions. EVA and the Balanced Scorecard
The Balanced Scorecard has been a common topic of conversation with respect to establishing financial measures that enable a company to monitor performance. Bob Kaplan’s analogy is to the airplane pilot who must be attentive to a variety of gauges – speed, altitude, course, etc. – to accomplish his goals. Similarly, management must monitor various factors that will determine its success. In addition to financial measures these include quality, customer satisfaction, innovation, people development, and so forth.
EVA and the Balanced Scorecard are more complementary than they are conflicting. Management should be able to integrate these two approaches, but must be careful as to the order of priority.
Balanced Scorecard metrics are not ends in themselves; the goal is to increase shareholder wealth. Balanced Scorecard metrics are critical drivers of success, but success is measured in the financial markets by financial measures. The best such measure is Market Value Added (MVA), which measures the difference between a company’s total market value and the resources (debt and equity) provided by investors. The objective of all companies should be to increase this spread; that is, grow MVA.
Operationally, the financial measure that best corresponds with MVA growth is EVA. Just as MVA measures the difference between value and capital, EVA isolates the difference between earnings and the cost of capital. Increasing premium earnings (EVA) will lead to growth in premium value (MVA).
The Balanced Scorecard identifies the actions that must be taken to increase EVA and MVA. But there are tradeoffs among the individual balanced scorecard measures. Quality improvement is important but at what point do diminishing returns set in? How much should a company invest in customer satisfaction? Financial measures must be the guide to managing these tradeoffs. This means that the financial measure can not be just another factor of equal importance to other metrics. It must drive the decisions, provide the basis for goal setting, and be the determining factor for incentive compensation measures.
Managers are reluctant to grant such importance to financial measures, because the measures are so often incomplete. They measure the income statement results, but ignore the balance sheet. Or they gauge current performance but fail to measure how the company is preparing to meet the challenges of the future. EVA does not suffer these limitations. Because it considers the impact on both earnings and capital, EVA internalizes the tradeoffs and reflects the net benefits of initiatives aimed at the Balanced Scorecard metrics. And EVA can be modified to avoid penalizing current year’s results because of development expenditures necessary for the company’s long-term success. Without the guidance of EVA executives may over-invest in one particular area of the Scorecard, especially if it is tied to incentive compensation.
In summary, we recommend a hierarchical approach to corporate governance. This begins with a mission to increase shareholder wealth, measured by MVA. To focus managers on this goal, we recommend adoption of EVA growth as the internal performance goal, the criterion for decision-making, and the focus of planning, capital budgeting and incentive compensation. The Balanced Scorecard then enables the company to plan, communicate, and act on strategies to increase EVA and MVA.
The EVA financial management system
EVA resonates with so many constituencies because it is a return to basics, a rediscovery of the most fundamental elements of business management that brings a lasting change in a company's priorities, systems and culture. EVA applies both modern financial theory and classical economics to the problems of running a business. It tells managers to do those things that they intuitively know are the right things to do, but that so often are obscured by conventional accounting-based measures of performance.
When companies employ EVA to the fullest, EVA becomes far more than just another way of adding up costs and computing profits. It is:
____________________________________________________________________ Economic book value (EBV) is the resources committed by lenders and shareholders. To calculate EBV, we begin with the accounting book value (ABV) provided by generally accepted accounting principles - the firm's audited financial statements. ABV hardly measures economic reality. Numerous adjustments must be made to ABV in arriving at EBV, several of which are described later.
Net Present Value, of course, is the generally accepted procedure that is employed in finance courses at graduate schools of business. It discounts expected future free cash flows to their present value and subtracts from the results the present value of cash outlays made to generate positive cash flows. |