Best-Practice EVA E-Book

Bennett Stewart

• Herausgeber: John Wiley & Sons
• Kategorie: Fachliteratur
• Serie: Wiley Finance Editions
• Sprache: Englisch

Seitenzahl: 644

Veröffentlichungsjahr: 2013

Beschreibung

Best-Practice EVA tells the new EVA story from the ground up. Stewart covers EVA essentials--the classic economic profit version of EVA--in the first three chapters of the book. He shows readers how simple and intuitive EVA really is, how it is defined, and why it is better than all other measures of corporate profit. You discover how it naturally guides managers into making all the right decisions--the ones that will truly maximize value. You see how to use it in profit-sharing bonus plans that create the powerful incentives of an owner. Later, Stewart introduces new ratios that make EVA much more powerful and much easier to use than ever before. The pinnacle of the new ratio framework is EVA Momentum, calculated by taking the change in EVA versus the prior period, and dividing by the revenues in the prior period. It measures the growth rate in EVA, scaled to the sales size of the business. It is the only corporate performance ratio where bigger always is better, because it gets bigger when EVA does, which means it should be every company's most important financial goal, the one ratio metric that everyone aims to maximize as the key measure of corporate success. Stewart then walks through the nuts and bolts of Best-Practice EVA, kicking off with an in-depth look at EVA Margin, or EVA as a percent of sales. It's a key productivity metric, and Stewart's candidate to replace ROI. The last link in the Best-Practice program is PRVit--the EVA market score report. Stewart shows how to read and interpret the report, how the score is determined, and why investors are turning to it to screen and rate stocks. He also shows why it is finding a home with CFOs and IR directors who want insights into how the market is pricing their stock. The book concludes with battle-tested tips from the firing line, practical suggestions for how you can test drive and adopt Best-Practice EVA at your company.

Leseprobe

Contents

Cover

Praise

Series

Title Page

Copyright

Dedication

Preface

SHORTCOMINGS WITH FIRST-GENERATION EVA

INTRODUCING THE NEW BEST-PRACTICE EVA MODEL

OUTLINE OF THE BOOK

THE BEST-PRACTICE EVA AGENDA

Chapter 1: EVA 101

Chapter 2: EVA and Value

VALUATION DETAILS

GETTING FROM EVA TO THE SHARE PRICE

THE TIE BETWEEN EVA AND SHAREHOLDER RETURNS

Chapter 3: Accounting for Value

MIXING OPERATING AND FINANCING DECISIONS

DISCHARGE SURPLUS CASH

TREAT LEASED ASSETS AS OWNED

REVERSE IMPAIRMENT CHARGES

CAPITAL GAINS AND LOSSES GO TO THE CAPITAL ACCOUNT

RESTRUCTURING COSTS ARE INVESTMENTS, TOO

R&D AND BRAND SPEND ARE INVESTMENTS

BAD DEBT RESERVES

DEFERRING TAXES ADDS VALUE

SMOOTH TAXES

FIX RETIREMENT COST DISTORTIONS

STRATEGIC INVESTMENTS

SIMPLE MEASURES MAKE FOR COMPLEX CONVERSATIONS

SUMMING UP

Chapter 4: What’s Wrong with RONA?

Chapter 5: The New EVA Ratio Metrics

EVA MOMENTUM

MARKET-IMPLIED EVA MOMENTUM

EVA MARGIN

A FIRST LOOK AT EVA MOMENTUM

MARKET METRICS

LET’S GET REAL—A FIRST LOOK AT AMAZON

Chapter 6: EVA Margin

EBITDAR—CASH OPERATING PROFIT

PRODUCTIVE CAPITAL

WORKING CAPITAL

PROPERTY, PLANT, AND EQUIPMENT (PPE)

INTANGIBLE CAPITAL

AMAZON UNDER THE EVA MARGIN MICROSCOPE

A TALE OF TWO COMPANIES

PRODUCTIVE CAPITAL

INTANGIBLES

CORPORATE CHARGES

PERCENTILE RATINGS

EVA AND MVA AT TIFFANY AND BLUE NILE

SUMMING UP THE EVA MARGIN

Chapter 7: Setting EVA Targets

Chapter 8: Put Momentum into Planning

EVA MOMENTUM IS A PERFECT PROXY FOR THE QUALITY AND VALUE OF FORWARD PLANS

Chapter 9: Dividing Multiples into Good and Bad

Chapter 10: Put EVA into Capital Decisions and Acquisitions

PRICING ACQUISITIONS

EPS DOESN’T COUNT; IT IS OFFSET BY P/E

Chapter 11: EVA and the Buy Side

Chapter 12: Become a Best-Practice EVA Company

Appendix A: The Best-Practice EVA Software Toolkit

Appendix B: Corrective Accounting Adjustments

EVA PENETRATES ACCOUNTING DISTORTIONS TO REVEAL ECONOMIC TRUTH

Appendix C: Accounting for Corporate Charges in Detail

EVA BEFORE GOODWILL AND UNUSUAL ITEMS

GOODWILL AND UNUSUAL ITEMS CHARGES

Glossary

About the Author

Index

Bonus Material

MORE PRAISE FOR BEST-PRACTICE EVA FROM FINANCE LEADERS

“I pride myself on being an early “EVA disciple.” I have seen it applied with great success in management and incentive applications over many years. Even so, the new EVA-ratio framework covered in this book has challenged me to take my performance-management thinking and leadership to the next level. Best-Practice EVA is a stimulating, innovative and common sense playbook for any executive that genuinely cares about creating sustainable value for their stakeholders.”

—Mark A. McCollum, Chief Financial Officer, Halliburton Company

“Ball’s 20-year EVA journey has resulted in a disciplined capital allocation model, a shareholder-aligned incentive compensation program and significant long-term value creation for our shareholders. Bennett Stewart’s new book explains the logic behind EVA and how it has helped us. It provides the most-up-to-date and practical roadmap that any CFO can use to adopt EVA and drive better business investment decisions and create more value. It’s a winner.”

—Scott Morrison, Senior Vice President and CFO, Ball Corporation

“We’ve used EVA to create a value-focused culture that pervades our company and that has been a real asset in communicating with our investors. I am excited about integrating the next generation of “best-practice” EVA metrics into our investor communications.”

—Ann Scott, Director, Investor Relations, Ball Corporation

“We adopted EVA more than a decade ago and continue to employ it for investment decisions, measuring performance and providing incentives to a substantial percentage of our employees. It’s been a great help to us, and yet I see that Best-Practice EVA takes EVA in important new directions. Once again, Bennett Stewart is several steps ahead of the rest of us in thinking through the best ways to align corporate performance, strategy and culture with creating wealth. My advice—read it, study it, and do it.”

—Ken Trammell, Chief Financial Officer, Tenneco Inc.

MORE PRAISE FOR BEST-PRACTICE EVA FROM INVESTMENT EXPERTS

“The neglect of cost-of-capital is a truly remarkable shortcoming of traditional profitability measures. Bennett Stewart reveals a powerful solution, developed as a management tool over decades and now applied as well to investment management. Better still, he makes his case with highly readable case histories. Best-Practice EVA will give you a whole new perspective on how value is created.”

—Martin Fridson, co-author of Financial Statement Analysis: A Practitioner’s Guide

“Best-Practice EVA provides a powerful lens to view and value corporate performance. It combines all the essentials of financial statement analysis into a framework with economic profit at its core. There is nothing wrong with this, and much to like about it.”

—Frank J. Fabozzi, CFA, Editor, Journal of Portfolio Management, Professor of Finance, EDHEC Business School, and Visiting Fellow, Princeton University, Department of Operations Research and Financial Engineering

Best-Practice EVA plainly shows how to convert accounting data into useful and reliable measures of true economic performance. The new EVA metric framework is a valuable innovation that will undoubtedly help business managers to make better operating and investment decisions

—Roger J. Grabowski, FASA, Managing Director, Valuation Services, Duff & Phelps LLC, and co-author of Cost of Capital: Applications and Examples.

MORE PRAISE FOR BEST-PRACTICE EVA FROM GOVERNANCE AUTHORITIES

“In this authoritative guide, Bennett Stewart demonstrates how CEOs can deploy EVA as a potent tool to measure and foster real economic value. It is clearly and convincingly written, and it filled with examples that will resonate with senior business leaders the world over.”

—Wayne Cooper, Executive Chairman, Chief Executive Group

Bennett Stewart expands the repertoire of financial metrics available to executives and directors that want tie their strategies and incentives to creating shareholder value. The new EVA metrics may gain a footing in the compensation arena because they appear to capture all the key elements of the total performance story and can be applied in a fashion that can be relatively easy to understand and analyze. Bottom line – any practitioner, director, consultant, analyst or investor will derive a great deal of value from reading his new book. It’s an excellent and important work

—James C. McGough, Partner, Meridian Compensation Partners, LLC

MORE PRAISE FOR BEST-PRACTICE EVA FROM BUSINESS EDUCATORS

There has long been a need to reconcile corporate finance and business strategy, and this book shows how to do it. It shows how EVA can be used to develop a culture that cares about allocating and managing capital as a core competency, how EVA Momentum can be used to focus attention on the right growth opportunities, and how EVA Margin can help ensure that strategy execution is truly a value-creating proposition. Bravo.

—John Percival, Adjunct Professor of Finance, The Wharton School

“This book reflects two decades of refinements of EVA that make it a still more practical solution to value-based corporate management while still preserving the essential insight – if you focus on value creation using the right performance tools, good things follow.” 

—John D. Martin, Carr P. Collins Chair and Professor of Finance, Baylor University, and co-author of Value Based Management with Corporate Social Responsibility, Oxford University Press.

“Best-Practice EVA is an instant classic and the definitive must-read roadmap for anyone serious about acquiring a deep understanding of value-creation analysis. It is highly recommended for executives, security analysts, and business educators worldwide.”

—Rob Weigan, Professor of Finance and Brenneman Professor of Business Strategy, Washburn University School of Business

“Bennett Stewart’s Best-Practice EVA goes right onto my required reading lists for my MBA and executive education courses. It’s a real eye opener for anyone who wants to understand how value is created, and the best way to measure it and achieve it.”

—Terry Campbell, Clinical Professor of Accounting, Kelley School of Business, Indiana University

“Bennett Stewart has transformed EVA from a money measure of economic profit into a ratio-analysis framework for corporate investment analysis, planning and valuation that is powerful and practical. This book clearly spells out and illustrates the new and improved version of EVA that has a legitimate shot at bridging the corporate and investing worlds and becoming a new standard in corporate value-based governance.”

—Donald Chew, Editor in Chief,The Morgan Stanley Journal of Applied Corporate Finance

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Cover image: Juliana Falloon Cover design: John Wiley & Sons

Copyright © 2013 by G. Bennett Stewart, III. All rights reserved.

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ISBN 9781118639382 (Hardcover) ISBN 9781118645291 (ePDF) ISBN 9781118645277 (Mobi) ISBN 9781118645314 (ePub)

To Ling and Lauren, for loveTo Jerome, for strengthTo Al, for wisdomTo John, for faithTo Joel, for pointing the way

Preface

This book makes the case that there is a new and significantly better way to measure and maximize shareholder value that involves replacing traditional financial metrics and valuation tools with new ones. The framework I describe and illustrate can be used profitably by finance leaders, business operators, board members, and institutional investors alike. In fact, one of my prime objectives is to create a common ground—a new standard and shared vocabulary that will bridge value-based corporate management and stock market equity research and give all stakeholders in the corporate governance debate a better way to carry on the conversation. Right now, finance is a mishmash of measures that tell half the truth or hide the truth, with no agreement on any one of them. The market and management talk past each other, and directors and the media are caught in the cross fire. What is desperately needed is one measure and one framework that can accurately weigh all businesses and business decisions on a single scale, and gain common currency. That scale is EVA.

For the reader who may not be familiar with it, EVA,1 pronounced E-V-A, for economic value added, is simply a different way to measure corporate profit that is better than all others. It measures profit according to economic principles and for the purpose of managing a business, and not by following accounting conventions; it is computed as net operating profit after taxes (NOPAT) less a charge for tying up balance sheet capital. Beyond that, EVA is a great way—I will argue it is the best way—not just to measure value, but to assist management in setting plans and making decisions that will maximize the net present value (NPV) of an enterprise.

EVA isn’t new, of course. It has been a little over 20 years since I formally introduced EVA to the business community with my prior work, The Quest for Value (HarperBusiness, 1991). But most of the material in this book is new, and reflects a huge advance in the EVA framework that has taken place over the past six years. For the first time, I lay out in comprehensive detail a set of important extensions to EVA that make it far easier to understand and use, and much more effective and wide ranging in its applications, than ever before. If you were exposed to EVA in the past but decided not to use it, this book will show you why you should reconsider your decision. And if you are new to EVA, don’t worry—I cover all the basics as well as the enhancements. Indeed, this book is intended to function as a user’s manual. It is a complete how-to guide to the very best and most practical techniques for measuring performance, valuing companies, choosing strategies, and running any business for maximum value. It is a book I hope you will want to refer back to again and again.

Let me roll back the clock and explain how we’ve arrived at this point. Although it is no longer the final word on the subject, The Quest for Value served the purpose of putting EVA firmly on the map when it was released in 1991. Up to then, almost no companies or investors were using EVA or anything like it. Measures like earnings per share (EPS), return on equity (ROE), profit margin, and cash flow dominated the financial landscape. But The Quest argued that EVA was a better financial management mousetrap, and it succeeded in convincing a number of early adopters to put it in place as the focal point of their management. The results were so impressive that the editors of Fortune magazine made EVA the cover article in the September 22, 1993, issue, with the tagline “EVA—it’s the real key to creating wealth.” That exposure, that imprimatur, was priceless. It brought about a tsunami of EVA adoptions the world over, which led the Fortune editorial board to develop a second tagline a few years later—“EVA is today’s hottest financial idea, and getting hotter.” Business schools incorporated EVA into their curricula, the Chartered Financial Analyst (CFA) exam that is the standard for stock research professionals required knowledge of it, and the level of interest in EVA was at a fever pitch. The Stern Stewart consulting organization of which I was a founding partner, and under whose banner I had published The Quest, expanded from 35 professionals to 235 five years later, with offices around the globe to help companies of all sizes, public and private, in virtually every industry, put EVA in place. Hundreds of companies adopted it and tied incentive pay to increasing it, and the results were usually quite stunning.

After all, what gets measured gets managed, and you do tend to get what you pay for. Confronted with the balance sheet charge that EVA imposes, managers understandably devoted considerable energy to animating the value of their assets. They also seeded more growth in profitable businesses that had been treading water to maintain existing high margins or high rates of return, which became irrelevant on the EVA scorecard. There are many other ways that EVA helps a business to operate more efficiently and effectively, and they will be chronicled in this book and substantiated with case studies. But the point is that managing for EVA was, and remains, a proven and universally applicable formula for running a business for better value.

Still, for all its phenomenal success through the 1990s and into the early 2000 decade, I began to notice a few chinks in the armor, deficiencies that were inhibiting EVA from being much more widely adopted. I knew that EVA had the potential to become the global standard of financial management and valuation excellence, but frankly, the uptick was much slower than it needed to be. I have the scars to prove it. After much soul-searching, I figured out why EVA was harder to adopt and harder to use than it should have been. Let me go over that list now, and then I will tell you how we licked every last one of those deficiencies to forge the new and improved version of EVA that is the subject of this book.

SHORTCOMINGS WITH FIRST-GENERATION EVA

The first and most glaring deficiency was that EVA was traditionally just a money measure of economic profit. Managers were simply being asked to increase the profit that they earned over the cost of capital as much as possible over a three- to five-year horizon. That was the essence of the message, and correct as far as it went. But EVA lacked a companion ratio indicator or, better, an entire ratio framework, to bring it to life. Let’s face it. Ratios rule the business world, and the absence of EVA in a ratio format was a severe handicap.

For example, CFOs could not use EVA to compare performance over time and across lines of business or against public peers that differed in scale, so they tended to fall back on conventional ratio metrics instead. EVA also lost credibility with corporate directors who were unable to use it to calibrate bonus plans or reach informed judgments about the adequacy of business plan goals submitted by their management teams. How could they reach the right conclusions when they lacked the relevant statistics?

The ratio absence also meant that line managers found EVA a lot harder to understand and use than it should have been. They were unable to trace EVA to familiar levers and performance drivers, to connect it to measures like sales growth, gross margin, working capital days, plant turns, and the like. As a money measure, EVA was opaque when transparency was really needed. As a money measure, EVA tended to stand apart from the familiar performance ratio indicators when it needed to be joined to them at the hip.

The ratio deficiency was also a showstopper for investors. At the outset, many of them found EVA intellectually superior to the traditional financial metrics they were using, like earnings per share. Goldman Sachs and Credit Suisse First Boston started to run EVA calculations in their research departments, published primers about using EVA in stock valuation, and hosted conferences where I was invited to introduce EVA to their fund manager clients. Some fund managers, like Eugene Vessell of Oppenheimer Capital, began to recommend EVA to the companies in which they held major investments with the conviction that EVA would help the management teams improve the stock price and make everyone a winner.

But the investment community’s interest in EVA was stillborn. To an even greater degree than business managers, investors require ratio indicators to compare, rank, sort, screen, and decide which stocks look relatively better to buy or sell across a broad universe of ever shifting opportunities. As a money measure, EVA failed that test. It was ill suited to fit into the decision processes employed at the major money houses. And one consequence of that failure was that even the most EVA-ardent CFOs and CEOs worried that if they spoke the EVA language, they would not be understood on Wall Street. Frankly, the evidence is overwhelming that EVA is the best measure to explain and drive share value, as I will show. But I can sympathize with the corporate managers who were reluctant go out on an EVA limb without assurance that investors would catch their drift.

EVA was also set back by a number of practical problems. Every company had to create its own software plumbing to calculate, track, analyze, and value EVA, which was time consuming, expensive to maintain, and error prone. An authoritative data file of EVA metrics covering public companies did not exist. EVA was a number, a data point, personal to each company. It was not a statistic computed according to a standard set of rules that boards, managers, investors, and consultants could trust and use with confidence.

Please do not misunderstand me. For all its shortcomings, the original EVA was leagues better than the alternatives, and many companies benefited immensely from putting it in place. As a measure of profit, EVA consolidates income efficiency and asset management into one net profit score. It is the only profit score that fully and correctly increases when balance sheet assets decrease. It is the only profit measure that builds in accountability for capital investments, because as more capital is invested, the charge for using it automatically ratchets up. The most important property is that the present value of a forecast for EVA is always exactly the same as the net present value of discounted cash flow. By its nature, EVA sets aside the profit that must be earned to recover the value of any capital that has been or will be invested, and thus it always discounts to net present value—to value net of invested capital. To increase EVA as a profit measure is to increase the net present value of the business and the wealth of the business owners, by definition.

The opportunity, then as now, is to focus on increasing EVA as the key corporate goal, applicable to all business units and all business decisions. The mission has been clear, but as I’ve said, the methods for using EVA and extracting the most value from it were not as effective as they needed to be. EVA could never become the global standard of financial excellence until the deficiencies I have outlined were addressed.

INTRODUCING THE NEW BEST-PRACTICE EVA MODEL

I left Stern Stewart in March 2006 to set up a new firm, EVA Dimensions. My objective was to start fresh and to figure out how all of the deficiencies I’ve outlined could be addressed head-on. I believe that we have succeeded. Innovations from EVA Dimensions have spawned a new and radically improved version of EVA, and a flourishing new ecosystem nourishing it, that now makes the adoption of EVA a far easier and more rewarding decision than it ever was before. It is not just a next-generation step worthy of a techy 2.0 designation, but a quantum leap forward. That’s why I call it Best-Practice EVA. The goal of this book is to explain it in convincing detail.

The biggest advance is a set of headline EVA ratio statistics and a way to take them apart and elegantly trace them in steps to all the business performance factors that are moving the EVA needle. That has made EVA an open book that is brimming with managerial and valuation insights. It’s fully transparent, and connected to business drivers in ways that are gaining a lot of converts in line operations where before there was resistance.

The new EVA metrics give CFOs an opportunity to streamline and amplify their management equations. The new ratios measure profitability performance so thoroughly and accurately, and they so closely align decisions to shareholder value, that all other financial ratio measures become obsolete. The old standbys, like gross margin, return on investment (ROI), or working capital turns, can be discarded or subordinated to the EVA cause. CFOs can also use the new EVA ratio framework as a superior method for analyzing and improving performance and stoking up the value of business plans—far more so than with the status quo financial technology. These may sound like exaggerated claims. But read the book and see if you don’t end up agreeing with me.

A second major advance is the development of software tools that automate the Best-Practice EVA framework. It is now possible to test-drive, implement, and maintain EVA at world-class standards at a far lower cost and with more integrity than ever before. Related to that, EVA Dimensions now maintains a data file of EVA metrics covering 9,000 global companies over a 20-year history, with daily updates. It is a terrific research tool for corporate strategists and academic scholars. Frankly, this book could not have been written without the push-button access to EVA data that informs so many of the cases presented.

More important, the data file provides reliable reference points that turn EVA into a legitimate statistic for the first time. With it, directors can rate plans, judge results, and set goals through an EVA lens with trust and confidence. They can challenge management to perform up to a defined and documented market standard. A CFO can assess the company’s EVA performance in light of the trends and accomplishments of public peers. The CFO can harvest irrefutable evidence about the company’s relative standing and spotlight specific trends and improvement initiatives—ranked in terms of impact on value—to spur the company’s line teams into action.

EVA Dimensions also is the source of a stock rating and analysis system that is gaining considerable traction in the professional investment community. Known as PRVit2 (pronounced “prove it” and standing for the performance-risk-valuation investment technology), the model anticipates stock price movements on the premise that they are magnetically drawn to their fundamental EVA values. It’s an important step in demonstrating that EVA applies to investors’ buy and sell decisions just as well as it does to corporate decisions.

This is not just a theoretical exercise. The ratings have been featured on Bloomberg since 2006, and Fidelity Investments has made an abbreviated version available to online retail customers since 2008. More important, a rapidly growing number of institutional investors at the largest active U.S. equity managers are using EVA analysis in their buy and sell decisions. An institutional equity research service that EVA Dimensions launched at the beginning of 2012 has already established regular conversations with nearly 150 portfolio managers and research analysts, and the client roster is growing weekly. In the process of delivering valuation insights to clients, the research team is educating the buy-side community about the new ratio-based version of EVA and is helping to close the communication gap. Forward-looking CFOs and CEOs will start to talk the EVA language before their investors start asking them about it.

OUTLINE OF THE BOOK

This book is structured to tell the new EVA story from the ground up. It covers EVA essentials—the classic economic profit version of EVA—in the first three chapters. In Chapter 1, you learn how simple and intuitive EVA really is, how it is defined, and why it is better than all other measures of corporate profit and cash flow. You discover how it naturally guides managers into making all the right decisions—the ones that will maximize value. You even see how to use it in profit-sharing bonus plans that create the powerful incentives of an owner.

The next chapter shows how EVA can be used to determine—and improve— the intrinsic value of a business and the share price of a company. It also presents a precise formula that uses EVA to explain total shareholder returns, and proves that it works. This has been a missing link, and now it is firmly established: EVA, and changes in expectations for EVA, are the true drivers of shareholder returns. Cash flow and cash yield simply transmit the return that is in fact generated exclusively by the EVA performance ratios.

A major conclusion is that managers should stop making decisions according to cash flow analysis. I demonstrate why cash flow is not the answer—actually, why cash flow analysis is a big problem in corporate management—and why CFOs should start using forecasts for EVA to measure and improve the value of their plans, projects, acquisitions, and decisions.

The final foundational chapter provides a heavy indictment of conventional accounting profit measures along with what I hope is compelling evidence to convict them. The truth is that measures like earnings, earnings per share (EPS), earnings before interest and taxes (EBIT), and earnings before interest, taxes, depreciation, and amortization (EBITDA) so misrepresent economic value and so contradict commonsense business logic that they frequently lead managers way off the mark, and sometimes horribly so. The answer is not to start from scratch—that would be wildly impractical— but to repair the accounting flaws with a set of corrective adjustments that are built right into EVA and bring the real value of business decisions to the surface. Properly accounting for value may seem a dull topic best left to the finance crowd. It isn’t. If you want to become a more informed director, a smarter manager, or a better investor, you will want to understand the decision traps cooked into accounting profit figures and how to avoid them.

Rate-of-return measures, in contrast, are beyond repair. They are so flawed, so misleading, and so dangerous that you should just put them aside. In Chapter 4 I show why ROI-minded managers have made some of the most tragic strategic and capital allocation blunders in business history and why you will surely make similar mistakes by using them.

If ROI or return on capital (ROC) isn’t the right ratio to use, what is? The answer is EVA Momentum. It is introduced in Chapter 5, which is where the Best-Practice EVA framework first takes a bow. It is calculated by taking the change in EVA versus the prior period, and dividing by the revenues in the prior period. It measures the growth rate in EVA, scaled to the sales size of the business. It is the only corporate performance ratio where bigger always is better, because it gets bigger when EVA does, which means it should be every company’s most important financial goal, the one ratio metric that everyone aims to maximize as the key measure of corporate success.

EVA Momentum is also the basis for an incredibly revealing diagnostic tool. It unfolds in stages to reveal all of the underlying performance factors that determine corporate value. It not only shows how much value has been created, but where and why. It is at once the measure that really matters and a portal to the many that can be managed. What’s more, it is possible to determine the forward-looking EVA Momentum growth rate that is baked into share prices, and use that as a more reliable estimate of performance expectations than the old standbys, like consensus earnings per share. In this introductory chapter, I explain EVA Momentum in depth and why it is such a terrific answer to so many financial management questions, and illustrate it with an application to Amazon, which has been an amazing—and instructive—EVA Momentum performer.

Chapters 6 through 11 go through the nuts and bolts of Best-Practice EVA. They kick off with an in-depth look at EVA Margin, which is EVA expressed as a percentage of sales. It measures a business’s true profit margin. It is a key productivity metric and my candidate to replace ROI. I call it the Momentum upshifter because analyzing it and improving it is a great way to put EVA Momentum into a higher gear. I look at it in depth for the Fifth Avenue jeweler Tiffany & Co., and take it apart like a fine watch to expose its inner workings.

Next up is the question of how to set corporate performance targets, a tedious but vital activity. Get the targets wrong, or set targets for the wrong measures, and bonus plans won’t work, business plans won’t be as good as they could be, and performance will not add to value. I show how to use the new EVA ratio metrics to get the targets right. I also show in detail how to put EVA Momentum into planning in truly effective ways. EVA Momentum is the single best measure of the quality and value of a business plan, and it is also a terrific tool—I would say the best one—for x-raying a business plan and seeing how to make it more valuable by making it more EVA capable. Best-Practice EVA also includes a new set of valuation multiples that can provide important reality checks on valuations and plan projections. They aren’t perfect, but they are far, far better than the slippery and deceptive P/E ratio and EBITDA enterprise multiples that most finance departments use today.

A present-value version of EVA Margin, called NPV Margin, helps management to use EVA for more mundane tasks, like rating capital projects and evaluating any business decision where cost-benefit trade-offs spread out over time and across income statement and balance sheet effects. In the process, the old warhorse internal rate of return (IRR) is excused from service. It too has become obsolete and has no role to play in the Best-Practice EVA program. I also show why it is best to think of acquisitions as involving an exchange of value rather than the exchange of earnings that seems to be the fixation of the investment banking community, and how to use EVA to put a precise and accountable value on synergies.

The last link in the Best-Practice program is PRVit—the EVA market score report. In Chapter 11 I show how to read and interpret the report, how the score is determined, and why investors are turning to it to screen and rate stocks. I also show why it is finding a home with CFOs and investor relations (IR) directors who want insights into how the market is pricing their stock.

The book concludes with battle-tested tips from the firing line, practical suggestions for how you can test-drive and adopt Best-Practice EVA at your company, along with a checklist that investors can use to tell if a company is really on EVA or is only going through the motions.

THE BEST-PRACTICE EVA AGENDA

There is an underlying theme running through the book that I want to alert you to. I am calling on CFOs to put their financial management practices on a stringent diet, to slim them down and go really lean, and to resolutely focus on adding value by discarding an abundance of redundant and inferior measures and practices that have accumulated over the years. I am calling for CFOs to start fresh and end simple, with EVA at the core. There is a real logic and real value to adopting EVA as the key corporate mission, to using it as the prime decision tool, and to tossing out or at least subordinating all the conventional financial ratio metrics in favor of the EVA ratio metrics we’ve developed at EVA Dimensions. The consistent use of EVA for all those purposes will make it even simpler and even more effective as a corporate management framework. Even if you disagree, I think you will find much to like and take away from the Best-Practice EVA program outlined in this book.

In the past, EVA was something of a closed system, available to the select few. Now it is open architecture. All are welcome to join the Best-Practice EVA initiative. I call on investors and business consultants of all stripes, along with business school professors in finance, strategy, and general management, to join the cause. You can be incredibly influential change agents. And we, EVA Dimensions, have the software tools, reference data, training, and research services that can put you right on the cutting edge.

Bennett StewartJanuary 2013

1 EVA® is a registered service mark of EVA Dimensions LLC in the fields of corporate management software, financial data and rankings, valuation modelling, and investment management and research) and of Stern Stewart & Co. in financial and incentive consulting.

2 PRVit® is a registered service mark of EVA Dimensions LLC

CHAPTER 1

EVA 101

Many people think EVA (for economic value added) is just a performance measure. It is that, but it is a lot more. EVA has an application to every facet of corporate performance management. It is a technique for improving the planning process, and a framework for valuing decisions, gauging investments, and shaping strategies. It’s the basis for bonus plans that turn managers and employees into charged-up, informed, enlightened owner/operators. It’s a great way for a management team to credibly communicate its commitment to creating value to its investors. Using EVA pervasively—for all those applications and in substitution for other measures and methods—is what ultimately makes it so simple, so accountable, and so powerful. But true enough, EVA does begin as a performance measure, as simply a better way to gauge the true economic profit a business is earning. So let’s begin there, with EVA 101—the money measure of EVA.

At its barest essence, EVA is a simple three-line computation of profit that anyone can understand:

What remains is EVA. It is sales less operating costs less the full cost of financing business assets, as if the assets had been rented. It consolidates income efficiency and asset management into one net profit score. Increasing EVA is the name of the game. It’s that simple. End of the story.

Well, not quite. To aerate a bit, observe that EVA starts with sales. Some critics have said EVA will motivate managers to shortcut customers. But how can that be? EVA cannot exist at the bottom line without generating sales at the top line, and there can be no sustained increase in EVA without sustained sales growth. Customer satisfaction, repeat business, innovation, and growth are essential to putting points on the EVA scorecard. But even that is not enough. EVA demands more. It is a higher calling. It is the most challenging measure of profit performance.

Operating costs must be covered, of course. Operating costs include all the materials and production costs, overhead and administration costs, and people and programming costs, but they also include depreciation and amortization and taxes. Physical assets wear out or become obsolete, and intangible assets are competed away and must be replaced, so true costs have to include an allowance for the consumption of both tangible and intangible assets. Corporate income taxes must also be paid before profits can really be counted. Note, however, that interest expense and any other financing charges are not included in this category; they are contained in the overall cost of capital, discussed next.

Most companies stop here or about here when they measure profit. They forget, or act as if they forget, that there is another critical cost to cover—the cost of using capital.

Capital is the total money that has been raised from lenders or shareholders or retained from the company’s earnings and is used to finance the company’s business assets. In other words, capital is the amount of money tied up in working capital such as inventories; in financing property, plant, and equipment; and in sundry business assets, including the goodwill premiums paid to acquire companies. And because balance sheets must balance, every time line teams go out and acquire more assets or increase inventories or purchase equipment or invest in writing software code, the treasury department must raise additional capital from lenders or shareholders, or retain more earnings instead of paying them out. The asset buys must be financed with capital sources. And to induce investors to put or leave their money in the business, a company must offer them a competitive return on their investment that stacks up favorably against other available opportunities on the market.

The cost of capital, in other words, is not a cash cost you can see and touch. It is not a cost that accountants actually deduct or ever will. It is an opportunity cost— the cost to the lenders and shareholders of giving up the returns they could otherwise expect to earn from investing their money in a stock and bond portfolio that has a risk profile the same as the company in question. Or put another way, capital has a cost because it is scarce; it is limited in the aggregate to the amount of money people and companies worldwide choose to save (less savings siphoned off to fund government deficits). For a company to create value, it must outperform the marginal project that is also competing for funding in the global capital markets.

Fortunately, the cost of capital can be determined without surveying investors or rank ordering investment projects. The market has already done the work for us, and the cost of capital is reflected in measurable market prices. Without going into the details, the cost of capital always starts with the prevailing yield on relatively safe long-range government bonds (to approximate the indefinite life of a business)—which today is about 2.5 percent in the United States, well below historic norms as it happens—plus a premium, an extra bump up in the rate of return to compensate investors for bearing the added risk of the business. The risk premiums generally range from 2 percent to 8 percent, depending on how exposed a company is to business cycles. Regulated electric and gas utilities, staples retailers like Wal-Mart and Costco, and established everyday food giants like Kellogg and General Mills that are comparatively isolated from business cycles (we all want to be warm and fed) come in at the low end, while home builders and semiconductor fabricators and theme park operators—companies that get whipsawed in a downturn—come in with very high costs of capital.

Though invisible to the naked eye, and out of the counting zone of the accountants, the cost of capital is a real cost that can be estimated with reasonable accuracy using modern financial techniques. Certainly we can do better than assuming that the cost of capital is zero, as profit measures like earnings before interest and taxes (EBIT) and earnings before interest, taxes, depreciation, and amortization (EBITDA) effectively do. Those measures assign no charge for using assets. Those measures provide no protection for the owners’ interests. Those measures motivate managers to squander capital, when managers should be motivated to use scarce capital sparingly, imaginatively, and intelligently to achieve business goals. The truth is that until a company is covering the full cost of its debt and equity capital, it is really losing money no matter what the accountants may say. Investors, and that’s all of us, expect a return on their investments, and that return requirement becomes an unavoidable cost faced by any company that uses capital in its business.

With this as background, let’s now run a basic EVA calculation:

Sales$1,250Customer satisfaction, innovation, growth– Operating costs$1,100Pricing power, purchasing power, efficiencyNOPAT$ 150Net Operating Profit After Taxes–Capital costs (Cost of capital [%] × [$] Net business assets)10% × $1,000Working capital turns, plant productivity

The simple sample company shown above—let’s call it SSCo—generates $1,250 in sales with $1,100 of operating costs, leaving a $150 remainder called net operating profit after taxes (NOPAT). NOPAT is a resting point partway down the EVA schedule. It is the firm’s operating profit, net of depreciation and amortization to make it sustainable, and after taxes on the operating profit are deducted. With NOPAT now defined, we can say that EVA is equal to NOPAT less a charge for capital.

The capital charge is computed by multiplying the cost of capital rate times the capital—that is, times the amount of money invested in the firm’s net business assets, which is all the assets used in the business, net of, or less, the money advanced by trade suppliers. That being the case, the more a company is able to finance its working capital with interest-free credit from its suppliers, the less capital it will need to obtain from lenders and shareholders, and the higher its EVA will be.

Some may say it is not worthwhile to go into details like that and it would be better just to keep it simple. I disagree. I’ve seen real value in teaching team members about what goes into EVA and providing company-specific examples of how they can win. It’s the simplest way to spread financial literacy company-wide and stimulate a lot of good thinking around how to improve performance in ways that may not have occurred to anyone before they were thinking in terms of EVA. Once they understand that trade credit reduces the capital charge, for instance, employees will naturally lean on suppliers for better terms without the need for constant prodding from the CFO. Granted, it takes some effort to instill EVA literacy, but it typically pays off in many ways, including saving the CFO for really strategic stuff. The bottom line is that EVA training is not an obstacle. It is a tremendous opportunity to improve performance.

To go back to the example, let’s assume that SSCo’s overall weighted average cost of capital is 10 percent, given its risk and capital structure. That is high by current standards but it is an easy figure to use. With $1,000 tied up in net business assets and a 10 percent cost, the firm must earn $100 in NOPAT to just break even. It’s simple math. You just multiply the amount of capital times the cost of capital to determine the charge for the capital.

Now EVA can be computed. SSCo is earning $150 in NOPAT. The capital charge is $100. Therefore, its EVA is $50, the difference. That alone is telling us something very important. The company is earning a positive economic profit after covering all resource costs, something that is true of only about half of the public companies in the economy at any time. The other half generates negative or negligible EVA, yet many of those companies don’t even know it. And even in profitable firms there are almost always EVA-sapping divisions that look great on other measures, like sales growth, operating margins, EBITDA, cash flow, and so on, but are actually destroying value. The bottom line is that EVA is a decidedly different and more accurate measure of performance that leads to profoundly different and more reliable impressions about where to invest and grow and where to restructure and retrench.

Before moving on, let’s take a moment to appreciate how important and helpful the capital charge is. For one thing, there would be no point in working to reduce working capital or to improve plant turns if not for the charge. Why would management even bother and why would investors care, if capital had no cost? But with the charge, a whole new world of opportunities is opened for line teams to create value by better managing balance sheet assets. What at first appears daunting is very soon exhilarating and liberating. There are more levers to pull, more trade-offs to consider, and more ways to win.

A second point is that the capital charge is where accountability enters the EVA system. In many companies, getting a capital project approved is viewed as a win. With EVA, the approval of capital spending creates a visible ongoing obligation to cover the cost of the added capital.

A third insight is that the capital charge represents the amount of NOPAT profit that a company needs to earn in order to pay the interest due on its borrowed capital, after tax, while leaving a profit remainder that gives its shareholders a competitive return on the equity money they’ve invested in the firm. In other words, the firm’s financing costs are not separate considerations outside the purview of EVA; they are baked right into the capital charge. As a result, operating people need not be concerned with interest payments, debt amortization, dividends, share buybacks, and the like. If they simply focus on covering the capital charge in the decisions they make, they are doing their job, and the financing costs will take care of themselves.

Moreover, if a firm raises capital and invests it in ways that increase its EVA, it is guaranteed to generate enough operating profit to pay interest on the money it borrowed and to provide share owners the minimum return they seek, and then some, on the additional capital they’ve funneled into the firm. EVA growth is always self-financing—it always attracts the capital needed to finance it.

A fourth point about the capital charge is that it establishes what is effectively a target for NOPAT that automatically rises or falls as more or less capital is invested in the business. The operating profit target contained in EVA, in other words, is not set by the board or the budget or by negotiation. Rather, it is an objective standard that is obtained by benchmarking the business against all other opportunities on the market, and asking: How much NOPAT profit must the firm earn, given the amount of capital it uses and the risk it takes, to just stand on a par with its capital market competitors? And the operating profit target represented by the capital charge is applicable even for private companies. They too should be asking: How do our operations stand up in the global marketplace for capital?

Board directors devote a lot of time to benchmarking with peer companies, assessing their firm’s performance, and establishing financial goals to grade the management team. But in so doing, most neglect to investigate the most essential benchmarking of all, which is: Are we meeting the market-set standard of excellence? In other words: Are we earning an EVA profit and are we increasing it over time at an acceptable pace, relative to our competitors and relative to expectations factored into our stock price? No other indicator establishes so bright a line between acceptable and unacceptable performance, because EVA is the only one that is benchmarked against the global market standard for investing and using capital, and the market price for bearing risk. This notion will become even more practical after EVA has been turned into a set of performance ratios that abstract the performance from the size of the company.

A key feature of the NOPAT profit target is that it automatically changes as capital changes. The NOPAT performance bar is set higher as more capital is invested in a business, and the capital charge is automatically set lower as capital is withdrawn. With all other measures, an appropriate target has to be established or reestablished as circumstances or capital change, and that is not easy. How much should sales increase as additional capital is invested, or how much margin expansion should be sought to compensate for an increase in capital intensity, for example? Absent EVA, there really is no objective standard or simple way for revising targets on the fly for measures like sales growth and operating margins, because measures like those and all others are incomplete; they have blind spots and tell only part of the story.

EVA is different. Since EVA is operating profit net of a market-set target, a sustained increase is real progress, a persisting decrease is real deterioration, and sideways movement is truly just spinning wheels. In light of this, every management team in every business can have one simple mission: to increase its EVAas much as possible. No other measure enables management to espouse so simple and meaningful a goal. Making a negative EVA business less EVA negative is just as valid a way to improve performance and create value as making a positive EVA more positive. Like venerable Total Quality Management (TQM) programs that emphasize the continuous improvement in products and processes, the goal of an EVA program is the greatest sustainable improvement in EVA over time. Improving a tough turnaround business is given the same recognition in EVA as making a star performer shine brighter. The improvement goal is applicable across the board, regardless of the legacy assets or inherited baggage that is there at the start. It provides all the right incentives.

What are the incentives, though, and do they make sense? How are managers guided into making better decisions? The short answer is: in all the ways that matter and none that don’t. While there are countless ways that performance can be improved and wealth created, depending on the business and the times, all the possible ways at all times conveniently fall into one of three key categories that are readily recognized by EVA, which are:

1. Operate efficiently. Intelligently cut wasteful costs. Increase NOPAT without increasing capital. Almost all measures get this one right, but EVA gets it right, too. It’s important, and it’s there. Go for it.

2. Grow profitably. Invest capital, and build the business, but be sure to cover the full cost of the invested capital. In truth, the only way a company can increase its EVA over the long term is by investing, by growing, and by innovating, but the return on the new capital must exceed the full cost of raising the capital. The incentive, in short, is to take on as many positive net present value (NPV) projects as possible, but only positive NPV projects. Investments and strategies that don’t cover the cost of capital and that diminish the firm’s NPV are absolutely discouraged and penalized, as they should be. There is a real deterrent to misallocating or misusing capital, but there is also a real reward for all growth over the cost of capital.

3. Purge ruthlessly. The last big improvement category is to stop pouring money into, or to liquidate assets from, the uneconomic activities that can’t cover the cost of capital. Find ways to turn working capital faster; to increase production yields and uptimes; to sell assets worth more to others; to bring technology and products to market faster; to prune marginal or unprofitable lines of business, plants, product lines, and customers; and outsource or restructure where it is economic to do so. By putting a charge on assets, EVA puts a visible premium on superior asset management and lean business models.

No other metric so succinctly, accurately, and completely captures all of the ways that performance can be improved and wealth created in any business. And that is why EVA, and EVA alone, can be used in an incredibly simple but extraordinarily powerful profit sharing bonus plan. Let’s take a short but scenic detour to explore the contours.

In the classic plan, the bonus consists of a base bonus award—a certain percentage of base pay that is needed to bring the participant’s total pay package up to a competitive market standard—plus a bonus kicker that is some set percentage of the EVA earned in the year less a target for EVA that is set by a formula. The simplest formula sets the EVA target to the prior year’s EVA, so that the bonus kicker just is a percentage of year-over-year change in EVA. Other variations include incorporating a growth goal into the EVA target or adjusting the target to reflect for the performance of peers—I will cover those variations in more detail in Chapter 7, where setting targets is formally discussed. For now, though, just think of the bonus as a competitive base bonus award plus a percentage of delta (change in) EVA. That actually works fine for most companies.

No matter what form it takes, though, the bonus plan message is the same—more EVA is good, and less EVA is bad, so make EVA go up. It’s extremely simple, it provides all the right incentives, it clearly links pay to performance, and it reinforces the message that managers should really use EVA in reporting, planning, and decision making. It is the one bonus plan where a bigger bonus is better all around, because when EVA gets bigger, the stock price get bigger, as I will establish very clearly later on. The underlying theme is: Let’s create wealth by sharing the wealth with the people who create the wealth.

The plan also has a number of unique and interesting properties that are worth playing out. For example, if a company just earns the cost of capital on incremental growth and its EVA goes sideways, its managers will earn the base bonus from the plan. Said another way, when the owners break even and just obtain the minimum return they expect on incremental investments in the business, then the firm’s managers break even, too, and just earn the normal bonus they expect. That’s fair and sensible, but missing from most bonus plans.

Suppose now that management does succeed at increasing EVA compared to the prior year. Then, great, the team is rewarded with a premium bonus, as it should be. The team added value by increasing EVA in some way. But there’s a catch.

In the next year, the prior year’s elevated EVA automatically becomes the new standard of excellence. The EVA performance target is reset higher by operation of the formula. Management is unable to rack up another large bonus unless it manages to increase EVA once again, piling even more EVA on top of the prior year’s improvement. Even the simplest EVA bonus plan builds in a double protection for the shareholders. EVA requires more profit be earned as more capital is invested, and the bonus plan requires more EVA as management proves it can produce it. And if the management team was able to increase EVA year after year and earn supersized bonuses according to the bonus formula, nothing would please shareholders more, because that would undoubtedly send the share price higher (be patient—I will definitely show this). In exuberant moments I have said that I am prepared to make the managers rich—so long as they make the shareholders filthy rich. The important point here is that EVA bonuses are always self-financing. They are paid out of and are a fraction of the added value, which is true of any real pay-for-performance incentive plan, but most incentive plans fail that basic test.

What happens if EVA takes a tumble? The bonus kicker turns negative and is deducted from the base bonus. The bonus could fall all the way to zero, depending on how far EVA fell. There is a definite penalty for a downturn in EVA, and that hurts, as it should. The incentive is: be prepared to react fast, increase fixed costs reluctantly, establish contingency plans to hold the EVA line in case bad things happen, and never think that good times last forever. Those are all terrific incentives for managers that shareholders would applaud and that boards should be prepared to provide. The downside is that managers are exposed to business risk, but should it be otherwise? Isolate managers from risk, and there will be no real risk management. Expose them to risk, and they will anticipate and manage risks. Take risk out of the picture, and it is impossible to link pay to performance. It sounds draconian, but there are good reasons why even corporate managers should prefer it above and beyond the fact that it does provide them with all the right incentives.

The first argument is that the cost of capital can often be dramatically simplified by using a bonus plan like this one. Knowing that their bonuses are linked to producing EVA, managers in riskier divisions will naturally want to factor a more sizable return cushion into the capital projects they propose. As a result, CFOs aren’t necessarily forced to gin up the cost of capital for riskier divisions. Many find they can get away with using just one company-wide cost of capital rate or use just a few as a simplification. The general rule is that a well-constructed EVA bonus plan is often a better way to encourage managers to think about and manage risk than to engage in what is often a politically charged and ineffectual debate over ratcheting the cost of capital up or down.