What Does Economic Value Added - EVA Mean?

A measure of a company's financial performance based on the residual wealth calculated

by deducting cost of capital from its operating profit (adjusted for taxes on a cash basis).
(Also referred to as "economic profit".)

The formula for calculating EVA is as follows:

= Net Operating Profit After Taxes (NOPAT) - (Capital * Cost of Capital)

Introduction

What is Performance Measurement (PM)?

Historically, PM systems was developed as a means of monitoring and maintaining

organisational control, which is the process of ensuring that an organisation pursues
strategies that lead to the achievement of overall goals and objectives (Nanni, et al
1990). PM plays a vital role in every organisation as it is often viewed as a forward-
looking system of measurements that assist managers to predict the company's
economic performance and spot the need for changes in operations. In addition, PM can
provide managers, supervisors and operators with information required for making daily
judgements and decisions. PM is increasingly used by organisations, as it enables them
to ensure that they are achieving continuous improvements in their operations in order
to sustain a competitive edge, increase market share and increase profits.

Traditional measures

Traditional PM has mainly been financial measuring ratios such as ROI (Return on
Investment), RI (Residual Income), and EPS (Earnings per share). These metrics
accounts for the costs associated with capital and help firms spot areas in which capital
is being invested unprofitably. Although these financial data have the advantage of being
precise and objective, the limitations are far greater, making them less applicable in
today's competitive market. Organisations, that have adopted the traditional PM, have
experienced great difficulty in trying to fit the measures with increasing new business
environment and current competitive realities.

While the traditional financial metrics are value-based, they are nonetheless lagging
indicators. They offer little help for forward-looking investments, where future earnings
and capital requirements are largely unknown investments such as new product
introductions and capital or new market entry. This will lead to narrow short-term
decision-making based on bottom-line financial results.

On the other hand, most of the criticism of traditional PM stems from their failure to
measure and monitor multiple dimensions of performance, by concentrating almost
exclusively on financial measure (Brignall and Ballantine, 1996). They solely concentrate
on minimising costs and increasing labour efficiency while neglecting other operational
performance measures such as quality, responsiveness and flexibility (Skinner, 1974)
Therefore focusing on financials to the exclusion of all other factors can produce
distortions such as low cost and high margin productions unnecessarily.
However, despite the criticisms made on traditional financial measure, many companies
still use them to measure performance. Many organisations, even until the end of 1970s,
operate performance under central control, through large functional department. Thus,
allowing managers to use slow-reacting and tactical management control system such as
'budgets'. These budgeting measures mainly focus on short-term value creation as it
only attempts to control and improve existing operations. However budgeting systems
are inflexible for today's dynamic and rapidly changing environment organisations still
continue to use them. This is because implementing new measures designed to manage
strategy and not control is very difficult.

Moreover, most companies motivate their worker through reward system. Rewards can
be financial such as cash payments, bonuses or share options and non-financial such as
promotion. Traditionally, employees are rewarded with bonuses at the end of the year
once a specific target has been achieved. However, this reward system causes short-
termism as employees are seen to narrow down their focus by just targeting the
'rewarded' goal. They may not take other factors, such as quality and service into
consideration. Hence leading businesses to run without long-term vision.

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 measure such as EVA.

How Companies Have Used EVA

Name Timeframe Use of EVA

The Coca-Cola Co. Early 1980s Focused business managers on increasing shareholder value
AT&T Corp. 1994 Used EVA as the lead indicator of a performance measurement system
that included "people value added" and "customer value added"
IBM 1999 Conducted a study with Stern Stewart that indicated that outsourcing IT
often led to short-term increases in EVA
Herman Miller Inc. Late 1990s 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.

Measurement
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.

Management System

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.

Motivation

To instil 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.
Mindset

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.[1]

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.