Economic Value Added
Economic Value Added is the financial
performance measure that comes closer than any
other to capturing the true economic profit of an
enterprise. EVA® also is the performance measure
most directly linked to the creation of shareholder
wealth over time. Stern Stewart & Co. guides client
companies through the implementation of a
complete EVA-based financial management and
incentive compensation system that gives
managers superior information - and superior
motivation - to make decisions that will create the
greatest shareholder wealth in any publicly owned
or private enterprise.
EVA =NET OPERATING PROFIT AFTER TAXES
(NOPAT) - [CAPITAL X COST OF CAPITAL]
Put most simply, EVA is net operating profit minus an
appropriate charge for the opportunity cost of all capital
invested in an enterprise. As such, EVA is an estimate of
true "economic" profit, or the amount by which earnings
exceed or fall short of the required minimum rate of return
those shareholders and lenders could get by investing in
other securities of comparable risk.
Profits the way shareholders count them
The capital charge is the most distinctive and important
aspect of EVA. Under conventional accounting, most
companies appear profitable but many in fact are not. As
Peter Drucker put the matter in a Harvard Business Review
article, "Until a business returns a profit that is greater than
its cost of capital, it operates at a loss. Never mind that it
pays taxes as if it had a genuine profit. The enterprise still
returns less to the economy than it devours in resources…
Until then it does not create wealth; it destroys it." EVA
corrects this error by explicitly recognizing that when
managers employ capital they must pay for it, just as if it
were a wage.
By taking all capital costs into account, including the cost of
equity, EVA shows the dollar amount of wealth a business
has created or destroyed in each reporting period. In other
words, EVA is profit the way shareholders define it. If the
shareholders expect, say, a 10% return on their investment,
they "make money" only to the extent that their share of
after-tax operating profits exceeds 10% of equity capital.
Everything before that is just building up to the minimum
acceptable compensation for investing in a risky enterprise.
Aligning decisions with shareholder wealth
Stern Stewart developed EVA to help managers
incorporate two basic principles of finance into their
decision making. The first is that the primary financial
objective of any company should be to maximize the
wealth of its shareholders. The second is that the value of
a company depends on the extent to which investors
expect future profits to exceed or fall short of the cost of
capital. By definition, a sustained increase in EVA will bring
an increase in the market value of a company. This
approach has proved effective in virtually all types of
organizations, from emerging growth companies to
turnarounds. This is because the level of EVA isn't what
really matters. Current performance already is reflected in
share prices. It is the continuous improvement in EVA that
brings continuous increases in shareholder wealth.
A financial measure line managers understand
EVA has the advantage of being conceptually simple and
easy to explain to non-financial managers, since it starts with
familiar operating profits and simply deducts a charge for the
capital invested in the company as a whole, in a business unit,
or even in a single plant, office or assembly line. By assessing
a charge for using capital, EVA makes managers care about
managing assets as well as income, and helps them properly
assess the tradeoffs between the two. This broader, more
complete view of the economics of a business can make
dramatic differences.
Ending the confusion of multiple goals
Most companies use a numbing array of measures to express
financial goals and objectives. Strategic plans often are based
on growth in revenues or market share. Companies may
evaluate individual products or lines of business on the basis
of gross margins or cash flow. Business units may be
evaluated in terms of return on assets or against a budgeted
profit level. Finance departments usually analyze capital
investments in terms of net present value, but weigh
prospective acquisitions against the likely contribution to
earnings growth. And bonuses for line managers and
business-unit heads typically are negotiated annually and are
based on a profit plan. The result of the inconsistent standards,
goals, and terminology usually is incohesive planning,
operating strategy, and decision making.
EVA eliminates this confusion by using a single financial measure
that links all decision making with a common focus: How do we
improve EVA? EVA is the only financial management system that
provides a common language for employees across all operating
and staff functions and allows all management decisions to be
modeled, monitored, communicated and compensated in a single
and consistent way - always in terms of the value added to
shareholder investment.
