t e c h ni c a l
‘Economic Value Added’ (EVA™) is a trademark of the SternStewart consulting organisation. Stern Stewart maintains that theimplementation of a complete EVA™-based financial managementand incentive compensation system gives managers both betterinformation and superior motivation to make decisions that willcreate the greatest shareholder wealth in any publicly-owned orprivate organisation.
It is argued that linking performance to profit breeds a short‑termistboom–bust culture. For instance, a firm might adopt a cost minimisationprogramme to increase profits and, to this end, make immediateredundancies. This short‑term decision would most likely triggerproblems in the medium to long‑term for the business. This is one ofthe concerns that EVA™ directly addresses, and the principal successof EVA™ as a performance metric is the link with long‑term wealthmaximisation and discount factor techniques. Studies have shown thatcompanies that adopt EVA™ as a performance measure outperformedtheir peers by 8.5% annually, and for those companies operating in adeclining market this jumps to over 12% per annum.The real benefits are realised when EVA™ is further linked tomanagement compensation packages. In this scenario it was found thatcompanies outperformed their peers by 57% over a five‑year period(Stern Stewart, 2005).Stern Stewart argues that EVA™ is the financial performance measurethat comes closer than any other to capturing the true
profit ofan organisation, and is the performance measure most directly linked tothe creation of shareholder wealth over time. EVA™ is an estimate of theamount by which earnings exceed or fall short of the required minimumrate of return that shareholders and debt holders could get by investing inother securities of comparable risk. The formula is as follows:
EVA = net operating profit after tax - WACC x book value ofcapital employed
economic value added
relevant to ACCA Qualifcation Papers P4 and P5
Stern et al (ed 2001) suggest that ‘when fully implemented’ EVA™ willbe ‘the centerpiece of an integrated financial management system thatincorporates the full range of corporate financial decision making’. It isargued that the following advantages can be gained from the adoption ofan EVA™‑based approach to performance measurement:
profits are shown in the way shareholders count themcompany decisions are aligned with shareholder wealth
a financial measure is used that line managers understandthe confusion of multiple goals is ended.
Profits, the way shareholders count them
The capital charge is the most distinctive and important aspect of EVA™.Under conventional accounting, most organisations appear profitable,but many, in fact, are not creating value. A simple example would bethat of a firm deciding to invest $50m cash in a bank account. At aninterest rate of 5% per annum the firm would generate interest of $2.5meach year. In this scenario, the firm will create additional profit, but it isextremely unlikely that this will create any value.Peter Drucker has suggested in a
Harvard Business Review
article,that ‘until a business returns a profit that is greater than its cost ofcapital, it operates at a loss’. This is in spite of the fact that it still paystax as if it had a genuine profit. Drucker observes that such organisationsreturn less to the economy than they consume in resources, and thatinstead of ‘creating’ they are in fact destroying wealth. EVA™ explicitlyrecognises that when managers employ capital they must pay for it in thesame way that they would pay other operating expenses.By taking all capital costs into account, including the cost of equity,EVA™ shows the amount of wealth a business has created or destroyedin each reporting period. In other words, EVA™ represents profit the wayshareholders define it. If the shareholders expect, say, a 10% return ontheir investment, they ‘gain’ only to the extent that their share of after‑taxoperating profits exceeds 10% of equity capital.