Bennett Stewart Explanation of EVA | Cash Flow | Accounting

In this article we will discuss about the Bennett Stewart explanation of Economic Value Added (EVA).

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 × 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 that 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 manager 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 in cohesive 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 modelled, monitored, communicated and compensated in a single and consistent way – always in terms of the value added to shareholder investment.

The Comparative Stock Market Performance of Stern Stewart Clients:

Evidence continues to build that Stern Stewart’s EVA clients substantially outper­form their peers. What’s more, the latest findings show that the amount of outperformance varies in step with the degree to which companies use EVA, and Stern Stewart’s special incentive-plan architecture, as the basis for compensation. These findings come from the first annual update – and a major refinement – of an ongoing study of the stock-market performance of Stern Stewart’s publicly owned U.S. clients.

The study, like its predecessor, analyzed total returns to shareholders for up to five years after companies began to implement EVA with Stern Stewart’s assistance. On average, investments in the shares of these companies produced 49% more wealth after five years than equal investments in shares of competitors with similar market capitalizations.

Companies that used the full Stern Stewart compensation architecture did even better. Investment in their shares produced 84% more wealth over five years than equal investments in their competitors. Overall, the Stern Stewart clients created some $116 billion more in market value than they would have if they had performed the same as their competitors.

The study includes 66 publicly owned U.S. clients for which at least 24 months of stock-performance data were available. The starting date for each comparison is the month that a company began to implement EVA®. Clients that were acquired by other companies within five years of the starting date were excluded, as were their industry peers, because those returns are biased upwards by takeover premiums. Clients with market capitalizations below $100 million also were excluded from the comparisons.

The performance comparisons were made against competitors in the same four-digit SIC codes as the EVA companies. The competitors used in the study, which we call comparators, were the ten closest in market capitalization to the EVA company at the starting date. In a handful of cases, fewer than 10 comparators were available. Using companies in the same industries and with similar market capitalizations eliminates as much “systematic” risk as possible, so that comparisons reflect specific company performance to the greatest extent possible.

Since the starting date for each comparison is the month that a company began to implement EVA, the returns cover varying periods ending as late as March 31, 2000. A variation of this methodology was first suggested to Stern Stewart by Professor Robert Kleiman of Oakland University, who conducted similar comparisons and reached similar conclusions.

Studies by consultants of their own clients always are suspect, of course. For that reason, we have included a list at the end of this document of all the companies in the study and the months that they began to implement EVA. Those who doubt the findings are free to conduct their own comparisons.

Here’s how the EVA companies stack up. As we said above, an investment in Stern Stewart clients produced an average of 49% more wealth after five years than investments in each company’s competitors. But that’s just the beginning. To get a closer look at what is driving that performance, we divided the client companies into three groups based on the way they set incentive compensation.

Stern Stewart believes that it is essential to tie incentive compensation to changes in EVA in order to capture the full potential of the system to transform behaviour. We also believe that the design of the incentive plan is crucial to its effectiveness. The results strongly support both views.

The first client group, with 31 companies, used the complete incentive-compensation architecture invented by Stern Stewart, including uncapped bonuses and bonus banks for extraordinary awards. These companies produced an average of 84% more wealth after five years than their competitors.

The second group, of 25 companies, used EVA in determining incentive awards, but without the full Stern Stewart architecture. These companies produced 33% more wealth than their competitors. The third group, with 10 companies, did not use EVA for compensation and produced a scant 1% more wealth than their competitors.

We also looked at a fourth group of 22 companies that Professor Kleiman identified as having adopted EVA-type incentive plans, but without being clients of Stern Stewart. We call these the “do-it-yourself” group. They produced an average of 26% more wealth than their competitors, indicating that EVA® and EVA incentives can be a powerful elixir even for the do-it-yourselfers, but not nearly as powerful as the full Stern Stewart program.

We calculated relative performance by comparing the total stock-market return (dividends plus price appreciation) of each EVA company against the return on an equally weighted portfolio of the company’s ten comparators. We then compared the terminal, or ending, wealth positions that an investor would have achieved by investing an equal amount in the EVA company or the portfolio of its comparators. We define the percentage spread between the terminal wealth positions as the degree of “excess return.”

For example, if $100 invested in the comparators would have grown to $200, while $100 invested in the EVA company would have grown to $300, the “wealth relative” of the EVA company is 150% of its comparator group ($300 is 150% of $200) and the “excess return” is 50%.

Note that this does not mean the EVA company produced an extra 50 percentage points of total return. In fact, the company in the example produced an extra 100 percentage points of total return, expressed as a percentage of the initial investment ($200 of gain for the EVA company, versus $ 100 of gain for the comparator group). As the example suggests, both the “excess return” and the “extra” percentage points of total return depend on the total returns of both the peer group of comparators and the EVA company.

For the total sample of 265 comparison years (66 companies for 2, 3, 4 or 5 years each), the average annual “excess return” was 8.25%. This means that at the end of one year an investment in an EVA company was, on average, worth 8.25% more than an equal investment in a portfolio of competitors. The annual “excess return” figures for each company in the study are listed in the table at the end of this article.

We also calculated the actual amount of extra wealth the EVA companies created as a group. We did this by calculating the market capitalization that each company would have grown to if its total return had been equal to that of its comparator group over the 2 to 5-year periods, and subtracting that from the actual market cap of each EVA company at the end of its comparison period. The difference is a thumping $ 116 billion. That is equal to 28.5% of the aggregate market capitalization of the EVA companies at the end of the comparison periods.

It should not come as a surprise that companies using Stern Stewart’s EVA frame­work for financial management and incentive compensation outperform their competitors.

First, EVA is tailored to eliminate economic distortions in generally accepted accounting principles, so that managers using EVA look beyond mere accounting numbers and base their decisions on real economic results.

Second, EVA’s explicit charge against operating profits for the cost of invested capital allows managers to assess how decisions affect the balance sheet as well as the income statement, and to accurately weigh tradeoffs between the two.

Most important, Stern Stewart’s special EVA incentive plans are decoupled from budgetary targets. By giving them an uncapped share of sustained EVA improve­ment, managers are strongly motivated to use the new analytical tool to achieve the very best results possible.

When used to its fullest, EVA permeates all aspects of managing and planning. It provides a singular focus to align and speed decision-making, and to enhance communication and teamwork. Even so, the degree of out- performance found in this study, and its predecessor, is striking.