Might EVA be making a comeback?
February 25, 2019
Economic Value Added (EVA) was a popular financial measure in the 1990s, used by many major companies as well as investment analysts. Interest in EVA has recently re-emerged as a result of the acquisition of EVA Dimensions by Institutional Shareholder Services (ISS) last year.
EVA is defined as:
EVA = Net Operating Profit after Tax (NOPAT) – 〈Total Capital (TC) x Weighted Average Cost of Capital (WACC)〉.
So for example, if NOPAT in one year was £2m and the Total Capital figure was £15m and the WACC was 8%, EVA that year would be £800,000. If the following year NOPAT was £2.6m, Total Capital was £22.5m with the WACC still at 8%, the EVA figure would still be £800,000. So NOPAT would have increased by 30% while EVA would not have increased at all.
The EVA measure is supposed to overcome one of the perceived problems with accounting profit, the fact that it does not account for the cost of equity, and therefore the full cost of capital. Whether or not NOPAT growth is truly value-creating depends on how quickly capital is growing and the cost of that capital.
A key benefit of EVA is how it tracks changes in value over time. To create real value, earnings must grow by more than the return required by investors on any new capital invested. In other words, a 20 percent growth in earnings will drive up value much more if it is achieved with minimal capital expenditure than if it is the result of a major acquisition.
Like accounting profit, a company’s EVA can be divided into business unit EVA (or EVA contribution) to provide a common measure across an organisation. EVA enables comparisons to be made between divisions with very different business models; a manufacturing division can be compared to a service or finance division in terms of their relative contribution to overall corporate value.
In the 1990s EVA also was used by a number of companies in their incentive plans. In some notable cases this was done by awarding management a defined share of EVA growth over time. This EVA plan worked particularly well for large, multi-divisional, capital-intensive firms, promising an enduring, definitive linkage between management rewards and (EVA) value creation. Once calibrated, this mechanism could operate without budget-based goal setting or any significant plan changes over many years. This longevity is itself a benefit, with EVA companies knowing that they will reap the rewards of a growth in profits exceeding the growth in capital used to generate them, even if it takes years for their projects to mature. This extends management’s time horizon beyond the end of the fiscal year, enabling them effectively to balance short-term and long-term imperatives.
By the late 1990s the limits of EVA began to become apparent. Unlike the well-understood standard of accounting profit, EVA is very much a non-standard measure, subject to numerous adjustments. These adjustments enable EVA to be tailored for each firm, but also make the measure more complicated for management to understand, and more suspicious to outside investors, especially as the basis for management incentive pay.
EVA’s ability to track value creation is severely degraded when returns lag investments by a year or more, for example in technology firms or any sector undergoing disruption. The dot-com boom in the late 1990s, characterised by companies using a lot of investment without generating any NOPAT, made EVA look irrelevant.
Finally, any incentive plan is only popular as long as it is paying out. In the wake of the bursting of the dot-com bubble in 2001, many bonus plans, including EVA plans, were dropped.
Although EVA lost much of its popularity as a corporate measure, a sizeable corner of the investment community continues to see it as the best proxy for value creation, at least for capital intensive firms that don’t suffer from a significant investment lag. Other analysts continue to see EVA as a fundamentally useful analytical tool. After all, a return above the cost of capital is the literal, textbook definition of value creation.
The governance community has kept its own little corner of sustained interest in EVA. They regard it as an economically sound measure, which is attractive to fund managers focused on value creation. Bonuses which are driven by EVA performance require management to overcome a capital hurdle before getting paid, which is attractive to fund managers looking to hold management to a higher standard. ISS is in the business of creating governance standards, including for compensation governance, in order to advise their investor clients how to vote their proxies. Until now, ISS has taken the path of least resistance by assuming that what investors care about most is total shareholder return (TSR). Although this may be true, the focus on incentive pay versus TSR has had the unintended consequence of significantly increasing the use of TSR as a performance measure, particularly in long-term plans.
This use of TSR has created problems. For one, TSR is not something that management can directly “manage” quarter-to-quarter, or even year-to-year, at least not in a way that is good for shareholders. Strong TSR is the expected result of running one’s business well over a business cycle. Using TSR over three years—the typical duration of a “long-term incentive” plan—sounds better, but near the end of the performance period, management is still left with trying to “manage” TSR.
So focusing on another measure of value creation based on operating results, like EVA, makes sense to some governance experts. But if ISS decides to push EVA as an alternative basis for assessing all the companies it covers, it will need to consider the evidence that it is not a good standard for all, or even most companies, and be flexible in how it is applied. It will also have to recognise that the definition of EVA will need to differ across industries, undermining it as a “standard.”
With ISS paying attention to EVA, companies can prepare for potential renewed interest in it by investors, by taking the following steps:
1. Calculate both a “basic EVA” (as ISS is likely to calculate it across all companies) as well as an “adjusted EVA” (based on NOPAT, Capital, and Cost of Capital suitable to your sector) for your company and its peers to see where your company would stack up.
2. Determine the degree to which your EVA level or growth trend provides an accurate reflection of your company’s value creation over the last three-to-five years.
3. Prepare to explain your company’s position on the applicability of EVA as a measure in your shareholder engagement activities, including in disclosures and other communications, as appropriate.
Some companies with the right set of characteristics noted earlier may even find that EVA is a better measure than the one(s) they are currently using. These companies will have an easier time justifying tracking and reporting it, and even building it into their reward system.
This is an edited summary of an article prepared by Marc Hodak of Farient Advisors, MM&K’s US partner in the Global Governance and Executive Compensation Group (GECN).
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