Economic Value Added Makes a Come Back
Posted by Seymour Burchman, Semler Brossy
Consulting Group, LLC, on Wednesday, August 28, 2019
Seymour Burchman is managing director at Semler Brossy
Consulting Group, LLC. This post is based on his Semler Brossy
It’s like déjà vu all over again. That’s
what many directors might have thought after Institutional Shareholder
Services (ISS) recently announced its new embrace of economic value
added (EVA). Several decades ago, this measure of financial
performance—akin to economic profit—climaxed in popularity, championed
by Stern Stewart & Co. It then swooned for various reasons, even as
many financial analysts lauded its advantages.
But now EVA is back.
Last year, ISS acquired EVA Dimensions, a business intelligence firm that
specialized in measuring economic value run by Stern Stewart cofounder Bennett
Stewart. This spring, ISS began to report the EVA scores for each company in its
voting recommendation reports. With ISS as the new EVA champion, directors may
want to take a fresh look at the measure’s virtues and shortcomings, and prepare
to respond to investors who will be comparing one company’s EVA to another’s.
Introduced in 1982,
EVA’s core benefit has always been that it combines three crucial
metrics—earnings, invested capital, and capital costs—under one umbrella.
Executives don’t need to reconcile the conflicting signals from three measures
to decide if the company is creating value, eliminating the game of see-saw in
trading off earnings and returns. It also gives companies a handy metric for
value creation, which can be an effective supplement to relative total
shareholder return (TSR) as a prime performance measure.
EVA swooned in part
because, as a new measure, it had trouble storming the gates of tradition and
elbowing its way onto the list of well-established metrics for financial
reporting. Still, EVA aids capital efficiency by providing a guide for people at
all levels on when to avoid bad investments. For starters, it indicates how to
make good investments as productive as possible. It also shows when and how to
redeploy capital from the bad investments to the good. In such ways, it raises
capital efficiency without sacrificing growth.
A few studies show that
EVA correlates well with TSR, making it appealing to executives and directors
focused on satisfying investors. Although other studies yield mixed results on
that score, advocates suggest that when you maximize EVA, you also maximize TSR.
In its original
iteration, however, EVA was criticized as being a “black box” metric. Financial
professionals found it challenging to calculate and use, and consequently,
employees had difficulty following the numbers to understand what factors were
driving the financial success of the organization. Although the calculations
have since been tweaked to make them somewhat more accessible, using EVA still
requires people to gain a new kind of financial literacy.
That in mind, with
well-thought-out education to advance literacy, people right down to the front
lines can be taught the basics of EVA. In their own lives, individuals don’t
expect to borrow for free to earn a good return on an investment. Nor do they
expect to make money if they don’t get returns that outpace borrowing costs. The
same principles go within their company: The less capital they use to produce
each dollar of earnings, the more EVA they help the company make. Conversely, if
they invest more, so long as their returns exceed the company’s combined debt
and equity capital costs, they also create value.
The trick for making
EVA easier to use across the workforce is for the financial function to break
down top-line EVA measures into a broad menu of performance drivers. In
preparing a list of the subordinate measures that drive EVA, all employees can
then understand the measure. Here are the steps the finance people along with
senior management need to take:
Unbundle EVA into primary, secondary, and tertiary drivers—the key economic,
strategic, and operational items that deliver value.
Isolate the leverage points—the specific measures where changes yield the most
Map these drivers to departments, locations, and individuals who have
accountability for improving performance.
Set improvement targets calibrated to deliver the desired value improvements,
within resource constraints.
Educate people on the basics so the old familiar numbers are seen as sitting
naturally in the calculation of EVA.
One company in the business of renting equipment embraced EVA a
number of years ago. It broke down EVA into the following top-tier drivers:
revenue, operating costs, and capital charges. The company then divided each of
these drivers into subordinate parts, as follows:
Revenue drivers included average rental price per day for each piece of
equipment, average number of days each piece was rented, number of each type
of equipment, and additional servicing Subsidiary factors included the quality
and responsiveness of customer service and the quality and condition of the
equipment. Tertiary factors included innovations to increase the ease of doing
business with the company versus competitors.
Operating cost drivers included customer acquisition, equipment depreciation,
servicing, fuel, and Subsidiary factors included productivity improvements and
negotiating prowess in cutting deals on marketing and fuel costs.
Capital charge drivers included the value of working capital, equipment,
buildings and parts inventories, and the costs of equity and Subsidiary
factors included working capital management, inventory management, and
To calculate its EVA
score, the company subtracted the operating cost and capital charge drivers from
the revenue drivers. The result was a true picture of economic profit—and a good
proxy for creating shareholder value and raising the stock price.
While this basic
breakdown of drivers would have most meaning to manager-level employees within
the organization, the company’s finance people could break these items down
further so that individuals at every level know how they can improve an EVA
driver. Identifying measures in such a granular way provides a clear line of
sight for different functions in the organization to maximize top-line goals by
first maximizing familiar measures of performance.
For the board, EVA
provides an internal, management-controllable measure to complement TSR, which
is external and not directly controllable. That may make EVA a useful measure
for determining executive compensation.
Harvard Law School Forum
on Corporate Governance and Financial Regulation
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