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The central idea in most organizations is to tie managerial compensation to measures of financial performance that are linked closely to changes in shareholder wealth. In theory, this should motivate managers to maximize shareholder value.

The most direct financial performance measurement is the business's stock price. However, stock prices can be limited in their usefulness. The litmus test for any performance measure is whether it accurately reflects the decisions taken by management.

 

Economic Value Added (EVA), like other performance measures, attempts to resolve the tension between the need for a performance measure that is both highly correlated with shareholder wealth and responsive to the actions of a company's managers.

 

Investment distortions typically arise because a manager is not "charged" for the capital he or she uses or even rewarded for the shareholder value created. This is the fundamental contribution of EVA. It rewards managers for the earnings they generate but is also conditional on the amount of capital employed to reap these earnings. In this vein, EVA is defined as :

                   EVA    =        NOPAT - (K_w x Net Assets)

            Where         NOPAT          =        Net operating profit after-tax,

                    K_w       =        Weighted average cost of capital and

                   Net Assets     =        adjusted book value of net capital

 

If managerial compensation is tied to EVA, then the managers inclination to consume capital is now tempered by the fact that he or she must pay a capital charge evaluated at the weighted average cost of capital on the net capital he or she used.

 

Earnings-based compensation schemes can cause over-investment of capital, whereas return on net assets (RONA-based compensation) can result in under investment of capital. Therefore, EVA has evolved as the focal point in many organizations as a means of marrying their project selection and managerial compensation schemes.

 

Why does EVA offer the correct incentives in the example above? The answer is simply that EVA is fundamentally related to shareholder value. At a company level, the present value of EVA's equals a business "market value added" (MVA), which is defined as the difference between the market value of the organization and the (adjusted) book value of its assets. Moreover, at a project level, the present value of the future EVA's equals the NPV derived from the usual free cash flow forecasts.

 

If EVA and free cash flow analyses give identical NPV estimates, why is it that EVA is useful for compensation and NPV is not? The reason is that one needs flow measures of performance for periodic compensation since compensation is designed to provide a flow of rewards. EVA is a flow measure, whereas NPV is a stock measure.

 

Moreover, of the available flow measures, EVA is the only one that explicitly takes into account the cost of the capital and the amount of capital invested in the company. In this respect, EVA is superior to another flow measure, cash
flow.

 

The goal of a good financial performance measure is to ask how well a company has performed in terms of generating operating profits over a period, given the amount of capital tied up to generate those profits. EVA is novel in that it provides as answer to this question. The idea is that the business financiers could have liquidated their investment in the company and put the liberated capital to some other use. Thus, the financiers could have liquidated their investment in the company and put the liberated capital to some other use. Thus, the financier's opportunity cost of capital must be subtracted from operating profits to gauge the organizations' financial performance. In this spirit, EVA views NOPAT as a representation of operating profit and subtracts a capital charge that views the economic book value of assets in place as a measure of the capital provided to the company by its financiers.

 

Estimating this capital base is the most cumbersome (yet necessary) aspect of the calculating EVA. How do we arrive at this number? A company's balance sheet contains one measure of the value of the organizations' assets in place. Unfortunately, due to a plethora of accounting distortions, the total asset value on this balance sheet is not an accurate representation of either the liquidation value or the replacement-cost value of the business assets. It is, therefore, of limited use for asset valuation and must be adjusted.

 

Stern Stewart is careful to adjust this accounting balance sheet before arriving at an estimate of the value of a company's assets in place. In fact, Stern Stewart considers more than 250 accounting adjustments in moving to EVA.

 

In practice, however, most organizations find that no more than 15 adjustments are truly significant. The adjustments include netting the non-interest bearing current liabilities against the current assets, adding back to equity the gross goodwill, restructuring and other write-offs, capitalized value of R&D (and possibly advertising), LIFO reserve and so on. (These accounting adjustments are referred to as "Equity Equivalents").

 

The debt balance is also increased by the capitalized value of operating lease payments. The goal of these adjustments is to produce a balance sheet that reflects the economic values of the organizations assets more accurately than the accounting balance sheet.

 

Limitations And The Future

 

EVA is, therefore, a powerful concept. However, before all businesses rush to adopt it, they should note that EVA is not the holy grail since it has its limitations. A frequently asked question is: What does EVA add to conventional valuation analysis? The answer is nothing. EVA based financial analysis will not (and should not) change the conclusions reached on the basis of cash flow-base valuation analysis.

 

However, this equivalence is to EVA's credit. In fact, one limitation of EVA is that it is often touted as a new valuation tool, which is simply incorrect. EVA should be viewed primarily as a behavioral tool that alters the distortions prevalent in many companies. The most severe limitation of EVA is what it (as well as most other financial measures) fails to capture on an ex post basis.

 

The most basic component is represented by its physical assets in place. If we assume that this is an economic value, then we can equate this part to EVA's estimated capital component. In addition to this component, however, is the present value of the business growth opportunities. The components value is certainly less tangible and can be large for many businesses. One can view this part of company value as being driven by what the market expects to happen.

 

Unfortunately, EVA is unable to capture changes in this value. In fact, attempts to capture this value bring us back to simply looking at changes in an organizations' stock price. However, the limitations of stock price in judging corporate performance is what motivated our investigation of EVA in the first place.