Economic Value Added: What Companies
Posted by Jim Kroll, Marc Roloson, and
Jamie Teo, Willis Towers Watson, on Monday, April 29, 2019
Jim Kroll, Marc Roloson, and
Jamie Teo are directors at Willis Towers Watson. This post is
based on their Willis Towers Watson memorandum.
Institutional Shareholder Services (ISS)
is adding Economic Value Added (EVA) metrics in its proxy research
reports this year, which is causing many companies to wonder: What is
EVA? Why is ISS interested in EVA, and how will it be used? And what
should boards and management do about it?
What is EVA?
Simply put, EVA is a
financial measure of a company’s residual profit after accounting for the cost
of capital. If a company’s net operating profit exceeds its cost of capital, it
is creating value. If not, it is destroying value.
EVA = net
operating profit after tax – capital charge
= [operating income X (1 – tax rate)] – (weighted average cost
of capital X capital)
Proponents of EVA often
claim it is highly aligned with shareholder value creation, and it holds
managers accountable for generating healthy returns on an organization’s
capital. It is also considered harder to game since managers cannot take on
additional capital to drive returns because cost of capital is removed from
profit. Despite these benefits, critics are quick to point to the measure’s lack
of clarity and its “black-box” perception as reasons not to adopt the metric.
EVA first gained
popularity in the early 1990s, and a small, but still significant, number of
companies adopted the measure. A relatively small number of companies use EVA,
or some version of EVA, today. It is an excellent and powerful financial
performance measure, but can be challenging to calculate, communicate and
incorporate into incentive plans. Most companies choose instead to employ some
combination of core value drivers like growth, margins and returns in their
incentive plans because they are easier to measure and communicate.
ISS’S interest in EVA
ISS’s focus has
elevated interest in EVA. As part of its 2019 policy updates, ISS announced that
it would begin displaying EVA-related performance metrics in the
pay-for-performance section of its research reports. This interest in EVA-based
assessments to inform investment decisions is reinforced by ISS’s recent
acquisition of EVA Dimensions, a research firm specializing in this analysis.
Since the acquisition, ISS has examined and standardized a series of EVA metrics
that will be shown in its reports as another potential lens for investors to use
when assessing company performance in addition to its current use of total
shareholder return (TSR) and company financials.
How is ISS using EVA?
Now that ISS research
reports have begun to show this information, we expect board members and
management to raise questions. It is important to note that ISS is only
displaying EVA metrics for informational purposes and is not using this
information to determine say-on-pay vote recommendations or in
pay-for-performance assessments. Perhaps anticipating questions in the
marketplace, ISS further notes that its inclusion of EVA metrics is not
meant to suggest that companies should use EVA as a metric in incentive programs.
Both its Compensation
resources on EVA affirm this.
Four metrics that aim
to assess a company’s ability to generate and increase value on a three-year
basis are new to this year’s ISS proxy research reports.
of EVA divided by sales
of EVA divided by capital
Regressed change in
EVA over the past four years, divided by average of sales in the first three
Regressed change in
EVA over the past four years, divided by average of capital in the first
When reviewing EVA
performance, companies should take note of the 15 non-GAAP adjustments
underlying ISS’s EVA calculation, which are explained in detail in “The
EVA Measurement Formula: A Primer on Economic Value Added (EVA)”. Examples
include treating R&D and advertising as investments, not expenses, and
capitalizing restructuring costs.
What companies should do
Based on what we know
today, there is no reason for alarm or to make wholesale changes to incentive
compensation metrics. If EVA is not a current incentive metric, companies are
under no obligation to make it one. Rather, boards and management should
continue to work together to ensure the most relevant and impactful metrics are
incorporated into the company’s incentive compensation programs.
That said, it may be a
good idea for companies to understand how EVA shapes their perceived
performance, including how ISS is calculating it. EVA is a powerful performance
metric, and having a baseline understanding can only serve to make it easier to
better understand and communicate the company’s performance and how it creates
value for shareholders..
Given the potential
renewed interest in EVA, companies and boards may also want to revisit their
philosophy of value creation and make sure they are using the right combination
of value drivers in their incentive plans and performance reporting to the board
Harvard Law School Forum
on Corporate Governance and Financial Regulation
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