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Home > Business Strategy Best Practice > Why EVA Is the Best Measurement Tool for Creating Shareholder Value

Business Strategy Best Practice

Why EVA Is the Best Measurement Tool for Creating Shareholder Value

by Erik Stern

Executive Summary

  • Economic value added (EVA) has transformed the corporate finance scene and business practice by transferring modern business theory from classroom to boardroom.

  • Traditional metrics, with their roots in accounting, distort economic reality. For example, crucial long-term intangible investments often fall foul of traditional metrics.

  • If stockholder value is the goal, then the key to any metric must be the cost of capital, or stockholders’ required return.

  • At its best EVA is not just a financial metric, it is a complete management system focused on value creation.

  • 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.

  • 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.

  • 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).

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Further reading

Books:

  • Bloxham, Eleanor. Economic Value Management: Applications and Techniques. Hoboken, NJ: Wiley, 2003.
  • Stern, Joel M., and John S. Shiely. The EVA Challenge: Implementing Value-Added Change in an Organization. New York: Wiley, 2004.
  • Young, David, and Stephen F. O’Byrne. EVA and Value-Based Management: A Practical Guide To Implementation. New York: McGraw-Hill, 2000.

Website:

  • A site set up by Stern Stewart, the global consulting company which pioneered the development of the EVA framework: www.eva.com

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