EVA (Economic Value Added)
EVA (Economic Value Added) was developed by a New York Consulting firm, Stern Steward & Co in 1982 to promote value-maximizing behaviour in corporate managers (O'Hanlon. J & Peasnell. K, 1998). It is a single, value-based measure that was intended to evaluate business strategies, capital projects and to maximize long-term shareholders wealth. Value that has been created or destroyed by the firm during the period can be measured by comparing profits with the cost of capital used to produce them. Therefore, managers can decide to withdraw value-destructive activities and invest in projects that are critical to shareholder's wealth. This will lead to an increase in the market value of the company. However, activities that do not increase shareholders value might be critical to customer's satisfaction or social responsibility. For example, acquiring expensive technology to ensure that the environment is not polluted might not be of high value from a shareholder's perspective. Focusing solely on shareholder's wealth might jeopardize a firm reputation and profitability in the long run.
EVA sets managerial performance target and links it to reward systems. The single goal of maximizing shareholder value helps to overcome the traditional measure problem, where different measures are used for different purposes with inconsistent standards and goal. Rewards will be given to managers who are able to turn investor's money and capital into profits efficiently. Researches have found that managers are more likely to respond to EVA incentives when making financial, operational and investing decision (Biddle, Gary, Managerial finance 1998), allowing them to be motivated to behave like owners. However this behaviour might lead to some managers pursuing their own goal and shareholder value at the expense of customer satisfaction.
Unlike simple traditional budgeting, EVA focuses on ends and not means as it does not state how manager can increase company's value as long as the shareholders wealth are maximised. This allowed managers to have discretion and free range creativity, avoiding any potential dysfunctional short-term behaviour. Rewards such as bonuses from the attainment of EVA target level are usually paid fully at the end of 3 years. This is because workers' performance is monitored and will only be rewarded when this target is maintained consistently. Hence, leading to long-term shareholders' wealth.
Cola-Cola is one of the many companies that adopted EVA for measuring its performance. Its aim, which was to create shareholders wealth, was announced in its annual report. Coca-Cola CEO Roberto Goizueta accredited EVA for turning Coca-Cola into the number one Market Value Added Company. Coca-Cola's stock price increased from $3 to over $60 when it first adopted EVA in the early 1980s. In 1995, Coca-Cola's investor received $8.63 wealth for every dollar they invested.
Most companies refer to stock price increase as an outcome of implementing EVA. However, empirical studies have found that traditional accounting measure have provided a similar, or even better result in increasing stock performance (Dodd J and Johns J 'EVA reconsidered').
EVA is a financial measure based on accounting data and is therefore historical in nature. It has the same limitations as other traditional accounting measures and cannot adequately replace all measures within the company especially the non-financial ones. Due to the historical nature of EVA, manager can benefit in terms of rewards or be punished by the past history of the organisation (Otley, David Performance management 1999). Dodd J and Johns J see the balanced scorecard as one approach to overcome the potential problem of using a single financial measures such as EVA.
How Companies Have Used EVA
Use of EVA
The Coca-Cola Co.
Focused business managers on increasing shareholder value
Used EVA as the lead indicator of a performance measurement system that included "people value added" and "customer value added"
Conducted a study with Stern Stewart that indicated that outsourcing IT often led to short-term increases in EVA
Herman Miller Inc.
Tied EVA measure to senior managers' bonus and compensation system
4 Ms of EVA
As a mnemonic device, Stern Stewart describes four main applications of EVA with four words beginning with the letter M.
EVA is the most accurate measure of corporate performance over any given period. Fortune magazine has called it "today's hottest financial idea," and Peter Drucker rightly observed in the Harvard Business Review that EVA is a measure of "total factor productivity" whose growing popularity reflects the new demands of the information age.
While simply measuring EVA can give companies a better focus on how they are performing, its true value comes in using it as the foundation for a comprehensive financial management system that encompasses all the policies, procedures, methods and measures that guide operations and strategy. The EVA system covers the full range of managerial decisions, including strategic planning, allocating capital, pricing acquisitions or divestitures, setting annual goals-even day-to-day operating decisions. In all cases, the goal of increasing EVA is paramount.
To instill both the sense of urgency and the long-term perspective of an owner, Stern Stewart designs cash bonus plans that cause managers to think like and act like owners because they are paid like owners. Indeed, basing incentive compensation on improvements in EVA is the source of the greatest power in the EVA system. Under an EVA bonus plan, the only way managers can make more money for themselves is by creating even greater value for shareholders. This makes it possible to have bonus plans with no upside limits. In fact, under EVA the greater the bonus for managers, the happier shareholders will be.
When implemented in its totality, the EVA financial management and incentive compensation system transforms a corporate culture. By putting all financial and operating functions on the same basis, the EVA system effectively provides a common language for employees across all corporate functions. EVA facilitates communication and cooperation among divisions and departments, it links strategic planning with the operating divisions, and it eliminates much of the mistrust that typically exists between operations and finance. The EVA framework is, in effect, a system of internal corporate governance that automatically guides all managers and employees and propels them to work for the best interests of the owners. The EVA system also facilitates decentralized decision making because it holds managers responsible for-and rewards them for-delivering value.
The EVA Concept of Profitability
EVA is based on the concept that a successful firm should earn at least its cost of capital. Firms that earn higher returns than financing costs benefit shareholders and account for increased shareholder value. In its simplest form, EVA can be expressed as the following equation:
EVA = Net Operating Profit After Tax (NOPAT) - Cost of Capital
NOPAT is calculated as net operating income after depreciation, adjusted for items that move the profit measure closer to an economic measure of profitability. Adjustments include such items as: additions for interest expense after-taxes (including any implied interest expense on operating leases); increases in net capitalized R&D expenses; increases in the LIFO reserve; and goodwill amortization. Adjustments made to operating earnings for these items reflect the investments made by the firm or capital employed to achieve those profits. Stern Stewart has identified as many as 164 items for potential adjustment, but often only a few adjustments are necessary to provide a good measure of EVA.
Measurement of EVA
Measurement of EVA can be made using either an operating or financing approach. Under the operating approach, NOPAT is derived by deducting cash operating expenses and depreciation from sales. Interest expense is excluded because it is considered as a financing charge. Adjustments, which are referred to as equity equivalent adjustments, are designed to reflect economic reality and move income and capital to a more economically-based value. These adjustments are considered with cash taxes deducted to arrive at NOPAT. EVA is then measured by deducting the company's cost of capital from the NOPAT value. The amount of capital to be used in the EVA calculations is the same under either the operating or financing approach, but is calculated differently.
The operating approach starts with assets and builds up to invested capital, including adjustments for economically derived equity equivalent values. The financing approach, on the other hand, starts with debt and adds all equity and equity equivalents to arrive at invested capital. Finally, the weighted average cost of capital, based on the relative values of debt and equity and their respective cost rates, is used to arrive at the cost of capital which is multiplied by the capital employed and deducted from the NOPAT value. The resulting amount is the current period's EVA.
EVA Calculation and Adjustments
As stated above, EVA is measured as NOPAT less a firm's cost of capital. NOPAT is obtained by adding interest expense after tax back to net income after-taxes, because interest is considered a capital charge for EVA. Interest expense will be included as part of capital charges in the after-tax cost of debt calculation.
Other items that may require adjustment depend on company-specific activities. For example, when operating leases rather than financing leases are employed, interest expense is not recorded on the income statement, nor is a liability for future lease payments recognized on the balance sheet. Thus, while interest is implicit in the yearly lease payments, an attempt is not made to distinguish it as a financing activity under GAAP.
Under EVA, however, the interest portion of the payment is estimated and the after-tax amount from it is added back into NOPAT because the interest amount is considered a capital charge rather than an operating expense. The corresponding present value of future lease payments represents equity equivalents for purposes of capital employed by the firm, and an adjustment for capital is also required.
R&D expense items call for careful evaluation and adjustment. While GAAP generally requires most R&D expenditures to be expensed immediately, EVA capitalizes successful R&D efforts and amortizes the amount over the period benefiting the successful R&D effort.
Other adjustments recommended by Stern Stewart include the amortization of goodwill. The annual amortization is added back for earnings measurement, while the accumulated amount of amortization is added back to equity equivalents. Goodwill amortization is handled in this manner because by "unamortizing" goodwill, the rate of return reflects the true cash-on-yield. In addition, the decision to include the accumulated goodwill in capital improves the real cost of acquiring another firm's assets regardless of the manner in which the acquisition is accounted.
While the above adjustments are common in EVA calculations, according to Stern Stewart, those items to be considered for adjustment should be based on the following criteria:
- Materiality: Adjustments should make a material difference in EVA.
- Manageability: Adjustments should impact future decisions.
- Definitiveness: Adjustments should be definitive and objectively determined.
- Simplicity: Adjustments should not be too complex.
If an item meets all four of the criteria, it should be considered for adjustment. For example, the impact on EVA is usually minimal for firms having small amounts of operating leases. Under these conditions, it would be reasonable to ignore this item in the calculation of EVA. Furthermore, adjustments for items such as deferred taxes and various types of reserves (i.e. warranty expense, etc.) would be typical in the calculation of EVA, although the materiality for these items should be considered. Unusual gains or losses should also be examined and eliminated if appropriate. This last item is particularly important as it relates to EVA-based compensation plans.
Strategies for increasing EVA
- Increase the return on existing projects (improve operating performance)
- Invest in new projects that have a return greater than the cost of capital
- Use less capital to achieve the same return
- Reduce the cost of capital
- Liquidate capital or curtail further investment in sub-standard operations where inadequate returns are being earned
Advantages of EVA
EVA is more than just performance measurement system and it is also marketed as a motivational, compensation-based management system that facilitates economic activity and accountability at all levels in the firm.
Stern Stewart reports that companies that have adopted EVA have outperformed their competitors when compared on the basis of comparable market capitalization.
Several advantages claimed for EVA are:
- EVA eliminates economic distortions of GAAP to focus decisions on real economic results
- EVA provides for better assessment of decisions that affect balance sheet and income statement or tradeoffs between each through the use of the capital charge against NOPAT
- EVA decouples bonus plans from budgetary targets
- EVA covers all aspects of the business cycle
- EVA aligns and speeds decision making, and enhances communication and teamwork
Academic researchers have argued for the following additional benefits:
- Goal congruence of managerial and shareholder goals achieved by tying compensation of managers and other employees to EVA measures (Dierks & Patel, 1997)
- Better goal congruence than ROI (Brewer, Chandra, & Hock, 1999)
- Annual performance measured tied to executive compensation
- Provision of correct incentives for capital allocations (Booth, 1997)
- Long-term performance that is not compromised in favor of short-term results (Booth, 1997)
- Provision of significant information value beyond traditional accounting measures of EPS, ROA and ROE (Chen & Dodd, 1997)
Limitations of EVA
EVA also has its critics. The biggest limitation is that the only major publicly-available sample evidence on the evidence of EVA adoption on firm performance is an in-house study conducted by Stern Stewart and except that there are only a number of single-firm or industry field studies.
Brewer, Chandra & Hock (1999) cite the following limitations to EVA:
- EVA does not control for size differences across plants or divisions
- EVA is based on financial accounting methods that can be manipulated by managers
- EVA may focus on immediate results which diminishes innovation
- EVA provides information that is obvious but offers no solutions in much the same way as historical financial statement do
Also, Chandra (2001) identifies the following two limitations of EVA:
- Given the emphasis of EVA on improving business-unit performance, it does not encourage collaborative relationship between business unit managers
- EVA although a better measure than EPS, PAT and RONW is still not a perfect measure
Brewer et al (1999) recommend using other performance measures along with EVA and suggest the balanced scorecard system. Other researchers have noted that EVA does not correlate as strongly with stock returns as its proponents claim. Chen & Dodd (1997) found that, while EVA provides significant information value, other accounting profit measures also provide significant information and should not be discarded in favor of EVA alone. Biddle, Brown & Wallace (1997) found only marginal information content beyond earnings and suggest a greater association of earnings with returns and firm values than EVA, residual income, or cash flow from operations.
Finally, a key criticism of EVA is that it is simply a retreaded model of residual income and that the large number of "equity adjustments" incorporated in the Stern Stewart system may not be necessary (Barfield, 1998; Chen & Dodd, 1997; O'Hanlon & Peasnell, 1998; Young, 1997). The similarity between EVA and residual income is supported by Chen and Dodd (1997) who note that most of the EVA and residual income variables are highly correlated and are almost identical in terms of association to stock return.