Introducing Best Practice EVA
|By Bennett Stewart, CEO, EVA Dimensions LLC, Author of Best-Practice EVA||Printer-Friendly Version|
Genuine innovations in corporate financial management are rare. Nevertheless, a revolution is now underway that demands the attention of every serious finance professional. A new and significantly better way to measure performance, allocate capital, set goals, price acquisitions, meter bonus pay and maximize shareholder value is about to take root. It involves replacing traditional financial metrics and valuation tools with new ones. Accept my premise, and old standbys, like cash flow and discounted cash flow, IRR, ROI, and the DuPont ROI formula, even profit margins, earnings-per-share growth and P/E multiple, can be retired from service, and for good and valid reasons.
The framework I will describe can be used profitably by finance leaders, business operators, board members and institutional investors alike. In fact, one of my prime objectives is to forge a common ground—a new standard and shared vocabulary that will bridge value-based corporate management and stock market equity research and give all stakeholders in the corporate governance debate a better way to carry on the conversation. Right now, finance is a mish-mash of measures that tell half the truth or hide the truth, with no agreement on any one of them. The market and management talk past each other, and directors and the media are caught in the cross fire. What is desperately needed is one measure and one framework that can accurately weigh all businesses and business decisions on a single scale, and gain common currency. That scale is EVA – actually, a new and greatly improved version of it.
For the reader who may be unfamiliar with it, EVA (standing for economic value added) is a way to measure corporate profit that is better than all others. It measures profit according to economic principles and for the purpose of managing a business and maximizing value, and not by following accounting conventions. It first broke onto the scene with publication of my book, The Quest for Value, in 1991, and then went on to gain wide adoption in management and academic circles after a September, 1993 appearance on the front cover of in Fortune magazine, which declared EVA was “the real key to creating wealth” and later, “today’s hottest financial idea and getting hotter.”
Still, for all its successes in the 1990s, the EVA revolution stalled a little over a decade ago. One reason was the Sarbanes-Oxley legislation that put finance staffs back on their heels and made them risk averse and accounting prone. But I also began to see that there were legitimate reasons why EVA was harder to adopt and use than it should have been. I made a list and we tackled them one by one.
What you will find today is that a set of major advances have made EVA considerably easier to understand and way more effective as a corporate management tool. At the same time, EVA has also become much more wide ranging in its applications. As one example, EVA is now the foundation of a global equity research service that is gaining considerable attention with influential fund managers and major investment houses. I call this flourishing new version Best-Practice EVA, and it represents such a quantum leap that I have written a new book by that title to explain it in full (John Wiley & Sons, March, 2013). The purpose of this article is to summarize the path breaking innovations and make the case that EVA deserves a fresh look.
Let’s roll back the clock and start with a brief primer on EVA before discussing the recent innovations. The main difference between EVA and accounting profit is that it deducts a full weighted-average cost-of-capital charge for the money tied up in the firm’s business assets, which includes setting aside a minimum competitive return for the shareowners. It measures the profit the firm earned net of a priority return for that owners, a profit that is above—or below—the profit that could have been earned had the firm’s debt and equity capital been passively invested in diversified bond and stock funds of the same risk class. EVA consolidates income efficiency and asset management into one net profit score. It makes the balance sheet into an understandable charge to profit and a charge to be managed like any other operating cost. It separates companies and divisions that are truly prospering and growing with returns over their cost of capital from those that are inflating sales and earnings growth with investments at or even below their full cost of capital. It systematically harvests quality earnings from reported earnings figures.
EVA’s most important property, though, is that it always discounts to the exact same net present value as discounted cash flow. With the capital charge, EVA automatically sets aside the profit that must be earned to recover the value of the capital that has been or will be invested, and so it always discounts to the net present value of the cash flows. Intuitively, it makes sense that, if EVA is zero, then NPV is zero, and if EVA is positive and increasing then a firm is developing a positive franchise value and will trade for a market value premium over its invested capital. As a result of this predictable, actually mathematical, link between EVA and NPV, managers can use EVA not only to measure performance period to period. They can project, analyze and discount EVA to measure the NPV of plans, projects, acquisitions and decisions, and use it to help them to improve the NPV, and they can do that instead of discounting cash flow. That way, there is an easy consistency between how plans and decisions are evaluated looking forward and how performance is reviewed after the fact. It’s all EVA-based. That makes the entire management process far simpler, more cohesive and accountable, and inherently more value-based.
The mission of an EVA firm is not EVA per se, but to increase EVA. The level of EVA reflects a by now irrelevant accumulation of past sins and wins. Increasing EVA is a purely forward looking endeavor and is what it takes to increase NPV and drive share value and TSR higher. If EVA is negative, the objective is to make it less so, and if it is positive, to make it more so. This goal produces all the right incentives in any business. It tells managers to intelligently cut costs, to allocate and invest capital wisely, to fund all profitable growth over the cost of capital, and to turn assets faster and release capital from non-productive assets and activities. All the right incentives are contained in a mission to increase EVA. It gives laggards every chance to shine and compete for resources, if they can reverse or even begin to reverse the negative EVA. And, it puts a Bunsen burner under the behinds of the best businesses to keep scaling and growing and innovating in order to increase their EVA. They cannot just rest on their laurels and coast as they are encouraged to do with profit margin or ROI type measures.
EVA is unique in this. Indeed, it is the only performance measure where bigger is always better, where more is always better than less, because more EVA is more NPV – by definition. And just as NPV adds up, EVA is also uniquely the only additive performance measure. If the EVA of a decision—a plant expansion or product extension, for example—is positive, then that decision will add to the EVA of the sponsoring division and to the corporate consolidated results in like amount. As a money measure of value-added profit, EVA adds from the bottom to the top and harmonizes decision making. A division president and headquarters CFO will reach the same conclusion about the merits of a decision, given the same assumptions, if they are looking at EVA.
That is not true of any of the conventional financial indicators. A division already earning a very high ROI, for instance, might turn up its nose at an EVA-positive project that produces a return that is lower than the one it already has, if its management is concerned with maintaining or expanding ROI. That would be a mistake, of course. Management should take on all positive NPV projects, regardless of the impact on conventional ratio metrics, like margins, returns, or sales growth rates. Those are situational metrics. They depend on how the new decision overlays on the existing ratios, which is a totally irrelevant consideration.
Hundreds of companies adopted EVA in the 1990s and tied incentive pay to increasing it, and the results were usually quite stunning. After all, what gets measured gets managed, and you do tend to get what you pay for. Confronted with the balance sheet charge that EVA imposes, managers devoted tremendous energy to animating the value of their assets. They also started to generate more growth in profitable business lines that had been treading water just to maintain high margins or returns. Managing for EVA was, and remains, a proven and universally applicable formula for running a business for greater value. But again, good as it was, and is, there were chinks in the armor that needed to be repaired before EVA could legitimately become the gold standard in corporate financial management.
The first and most glaring problem was that EVA was just a money measure. It lacked a companion ratio indicator or, better, an entire ratio framework, to bring it to life. Let’s face it: Ratios rule the business world, and the absence of EVA in a ratio format was a severe handicap. CFOs were frustrated that they could not use EVA to rank and compare their lines of business against each other or against public peers. Directors, too, were frustrated by EVA because it was not in the form of a statistic that they could use to rate management’s performance or to set appropriately challenging compensation performance targets or to judge the adequacy of the business plans that management had submitted. And although the notion of EVA as a profit performance measure was intuitively appealing to them, many line teams were stymied by an inability to trace EVA to familiar performance drivers like sales growth, gross margin, working capital days, plant turns and the like. As a money measure, EVA was opaque when transparency was really needed.
To an even greater degree than corporate teams, investors require ratio indicators to compare, rank, sort, screen, and discern which stocks to buy or sell across a universe of ever shifting opportunities. But since the ratios did not exist, investors eventually lost interest in EVA. Their unfamiliarity with it discouraged a healthy dialogue with EVA-inclined companies. Even EVA-committed CEOs and CFOs grew reluctant to speak to investors in an EVA language for fear they would not be understood.
EVA was also set back by a number of practical hurdles. Every company had to create its own software plumbing to calculate, track, analyze and value EVA, which was time consuming, expensive to maintain and error prone. An authoritative data file of EVA metrics covering public companies did not exist. EVA was a data point particular to each company. It was not a statistic computed according to a standard set of rules that boards, managers, investors and consultants could trust and use with confidence.
My goal when I formed EVA Dimensions in 2006 was to overcome all these drawbacks and produce a new and superior version of EVA. I believe we have succeeded in every respect. The biggest advance is a set of three headline EVA ratio statistics and a way to take them apart and trace them in steps to all the business performance factors that are moving the EVA needle. Together, the EVA ratios replace and subsume traditional ratio metrics with a superior and simpler framework. Let’s be clear. The innovation is not making EVA more sophisticated or academically appealing. The value is purely practical. It lies in making EVA fundamentally easier to understand and way more effective as a diagnostic framework and decision support tool. EVA is now an open book brimming with managerial and valuation insights. The new ratio-empowered EVA model is fully transparent and connected to business drivers in ways that are gaining a lot of converts where before there was resistance.
The most important of the three new ratio metrics is EVA Momentum, which I define as the change in EVA over a period divided by sales in the prior period. It measures the growth rate in EVA scaled to the sales size of the business. For example, say that a company had $1 billion in sales in 2010, and that its EVA increased by $20 million in 2011 (from $30 to $50 or from –$50 to –$30; it wouldn’t matter because the change is what counts). Then its EVA Momentum for the 2011 year would be 2 percent. That’s the $20 million increase in EVA over the $1 billion in prior-period sales. EVA Momentum can be measured quarter to quarter, year over year, over the past three to five years as a trend and, importantly, over the forecast life of a business plan. However measured, it is a simply magical metric in many ways.
First of all, and this is a real big deal, it is the only ratio indicator where bigger is always better, because it gets bigger when EVA gets bigger, which means that a firm’s NPV and shareholder return are getting bigger, too. It is the one ratio measure that is totally consistent with increasing EVA, which all along was the right goal. And just as is true of the change in EVA, EVA Momentum completely and correctly summarizes the total performance of a business in all ways that it can add value or subtract from it. Managers in all lines of business can aim to maximize EVA Momentum without fear of being misled into making dumb decisions. It can serve as every company’s most important financial goal and the overarching measure that matters.
To be specific, EVA Momentum should be used instead of ROI, operating margin, or EPS growth as the key measure of corporate performance and the decisive score of business plan quality. Put simply, a business plan is better and more valuable if it can credibly generate a greater EVA Momentum growth rate over the plan horizon. The greater the planned EVA Momentum, the greater is the projected growth in EVA, and the greater is the NPV of the plan and the contribution it will make to the firm’s share price.
A second key attribute is that EVA Momentum focuses on change, on turning points, on the news in the data, on performance at the margin. By highlighting change, EVA Momentum helps management to zero in on and magnify worrisome trends and be more alert to emerging risks. Sales, net income, EPS, and certainly EBITDA can all continue to expand long after a business has really started to lose its economic vitality, but EVA Momentum slows down or goes into the red at the earliest stages when a business is maturing or facing competitive pressures, or when its managers are overinvesting in incrementally undesirable growth opportunities. EVA Momentum brings all the pressure points to bear in one net score of performance progress. It is like the proverbial canary in the coal mine, sniffing out trouble and raising a red flag before other measures get in the game. It belongs on every company’s risk management scorecard, if nothing else.
For all these reasons, EVA Momentum is the ideal spanning measure, the one and only metric that CFOs and directors can apply right across even a diverse set of individual business units to fairly compare their performances and appropriately challenge them, regardless of the current state of their profitability or inherited assets or liabilities, which become irrelevant on the EVA Momentum scoreboard. On the one side, it motivates managers in profit-challenged lines of business to turn them around, to increase EVA by making it less negative. On the other side, it tells the managers in the best businesses that if they simply maintain existing high returns and margins and replicate the prior year, their EVA Momentum score is zero. EVA Momentum puts a Bunsen burner under the behinds of the managers in the best business lines to keep scaling, growing and innovating, possibly even to forfeit some of the existing margin and rate of return that they currently enjoy, if that is what it takes to keep EVA marching ever higher.
Let’s state the obvious. Unlike EVA, EVA Momentum is a ratio statistic. Norms and trends can be established. Data from many companies can be pooled and studied. Questions like what constitutes good EVA Momentum performance can be answered. For example, the EVA Momentum for the median Russell 3000 firm—the company swimming in the middle of the EVA performance pack—has been just 0.2% per year on average over the past 20 years. The typical firm just ekes out a slight rise in its EVA profit over time, once the full cost of capital is considered and accounting distortions are eradicated. As economic theory predicts, competitive forces tend to drive returns to the cost of capital over time and at the margin.
Another expected tendency, call it convergence, is also borne out by the data. Firms that generate above or below normal EVA Momentum growth over one period tend to generate EVA Momentum closer to the median rate over the next period of time. Competition, saturation, substitution, fading fads, overpriced acquisitions, management blunders, and bureaucratic creep tend to seep air out of the EVA tire of the best businesses over time and slow it down, and EVA deficient firms are galvanized to restructure and improve and revert to norm. Simply knowing this can temper and shape the expectations of top management and a board of directors when they set Momentum targets as performance or compensation bogeys.
Not all firms are just treading EVA water, of course. Over almost any five-year interval about 40 percent of all firms increase EVA at a meaningful pace, and the better-managed or more fortunate firms increase it by quite a lot (again, though, subject to convergence over the next round). The 75th percentile performer tends to run with an EVA Momentum growth pace of around 1.2% per annum on average over moving five-year windows. That would be equivalent to generating cumulative EVA Momentum of 6 percent over a five-year stretch, meaning that a 75th percentile quality forward plan would have to produce a $60 million increase in EVA for every $1 billion in sales. (One attraction of EVA Momentum statistics is that they can always be converted to a money target or benchmark for any one company or business division.) The 90th percentile EVA Momentum performance has been quite impressive, running at a 3 percent to 3.5 percent per year average rate over the course of rolling five-year spans.
The second EVA ratio is called EVA Margin. It is a headline statistic in its own right, but it is also a cog in the EVA Momentum wheel. It the ratio of EVA to sales—the percentage of sales that falls to the EVA bottom line after deducting all operating costs and capital costs. Put simply, it is a firm’s true economic profit margin. It is a key summary measure of profitability and productivity, consolidating operating efficiency and asset management into a reliable and comparable net margin score. Unlike operating margins, it neutralizes the capital differences across business models or product lines, and produces an inherently fairer, purer and more comparable measure of performance.