Journal of Applied Corporate Finance

S U M M E R 1 9 9 4 V O L U M E 7. 2

EVA™: Fact and Fantasy

by G. Bennett Stewart III,
Stern Stewart & Co.
EVA : FACT
TM
by G. Bennett Stewart III,
Stern Stewart & Co.
AND FANTASY

erhaps you were one of the many

P corporate managers whose curiosity

was piqued by a cover story article in
Fortune Magazine last September 27th featuring a

picture of AT&T CEO Robert Allen and a caption

reading: “EVA—The Real Key To Creating Wealth.”
The article was about a new financial measure called

Economic Value Added, or EVA for short, which was

developed by my firm, Stern Stewart & Co. After
relating the impressive improvements EVA helped to

bring about at firms as diverse as AT&T, Briggs &

Stratton, CSX, Coca-Cola, and Quaker Oats, Fortune
concluded by labelling EVA “today’s hottest financial

idea and getting hotter.”

If you were like many other corporate manag-
ers, you and your colleagues may have begun to ask

questions about EVA and its relevance for your firm.

You may have run EVA estimates for your company.
You may even have heard a consultant of one stripe

or another give you his or her read on EVA. But you

may still be confused or at the very least uncertain
about a number of important facets of EVA. This

paper will attempt to correct some of the practical

and theoretical misconceptions surrounding EVA.

71
BANKAMERICA
JOURNAL JOURNAL
OF APPLIED
OF CORPORATE
APPLIED CORPORATE
FINANCE FINANCE
EVATM CONCEPTS
Basic corporate finance and microeconomic
theory tells us that the prime financial directive of any
firm ought to be to maximize the wealth of its
shareholders. This objective not only serves the
interests of the firm’s owners; it is also the rule that
ensures that scarce resources of all kinds are allo-
cated, managed, and redeployed as efficiently as
possible—which in turn maximizes the wealth of
society at large.
This fundamental precept is generally under-
stood and accepted by business managers. But it is
not widely appreciated that maximizing the share-
holders’ wealth is not the same as maximizing the
company’s total market value. The reason is simple:
a company’s total value could be maximized sim-
ply by investing as much capital in it as possible.
Shareholders’ wealth is maximized only by maxi-
mizing the difference between the firm’s total value
and the total capital that investors have committed
to it. We call this difference Market Value Added,
or MVA:
MVA = Total Value – Total Capital
Consider a firm with a market capitalization of,
say, $500 million, and that has raised from investors
and retained from its earnings a sum total of $400
million in capital. Its MVA is thus $100 million. That
spread represents the difference between the cash
that the firm’s investors have put into the business
since the inception of the company and the present
value of the cash they could get out of it, if only by
selling their shares. By maximizing that spread,
corporate management maximizes the wealth of its
shareholders relative to other uses for their capital.
To illustrate, consider a company that decides
to retain $100 million from earnings to invest in a
project. Assume further, however, that the market
expects the present value of the future cash flows
from that project to be only $80 million. Even
though the project will cause the total market value
of the company to be $80 million higher than if the
$100 million had been distributed as a dividend,
the shareholders’ wealth will be reduced by $20
million. That’s because the shareholders could have
invested the funds in a portfolio of stocks and
bonds valued at $100 million if the funds had been
distributed to them rather than retained in the
business.
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VOLUME 7 NUMBER 2
With $100 million added to the retained capital
as a result of undertaking the project, but only $80
million added to company’s value, the firm’s MVA
will fall by the $20 million difference, thereby
correctly registering the erosion in the shareholders’
wealth. It is thus MVA, and not value per se, that is
the correct measure for management to maximize.
MVA and Net Present Value
Fortunately, there is a well-established deci-
sion-making rule which can aid managers in their
goal of maximizing MVA and the wealth of the
shareholders. That rule, which is the heart and soul
of value-based planning, is to take those actions and
adopt those strategies that are expected to maximize
the net present value, or NPV, of future cash flows.
Quite simply, a project’s or strategy’s NPV is just what
it can be expected to add to or subtract from the
sponsoring company’s MVA.
In the foregoing example, for instance, the
present value of the future cash flows was assumed
to be $80 million, or $20 million less than the
requisite investment. Thus, the proposed project has
an NPV of –$20 million, which is precisely the
amount by which the firm’s MVA and the sharehold-
ers’ wealth would fall as a result of undertaking it.
Moving now from an individual project to an
entire company, we would view a firm’s MVA at any
point in time in a different light. Besides reflecting
the wealth of the shareholders, it also represents the
stock market’s estimate of the net present value of a
company considered as a whole. A company’s MVA
communicates the market’s present verdict on the
NPV of all its current and contemplated capital
investment projects. Thus, MVA is a significant
summary assessment of corporate performance—
one that shows how successful a company has been
in allocating, managing, and redeploying scarce
resources to maximize the NPV of the enterprise and,
thereby, the wealth of its shareholders.
Warren Buffett, the highly-regarded chairman
of Berkshire Hathaway, and an investor of legendary
success and sagacity (not to mention a personal net
worth in excess of $8 billion), also defends MVA as
the correct basis for judging corporate performance:
We feel noble intentions should be checked
periodically against results. We test the wisdom of
retaining earnings by assessing whether retention,
over time, delivers shareholders at least $1 of market
SUMMER 1994
 MVA is a significant overall summary assessment of corporate performance—one
that shows how successful a company has been in allocating, managing, and
redeploying scarce resources to maximize the NPV of the enterprise and the wealth
of its shareholders.
value for each $1 retained. To date this test has been
met. We will continue to apply it on a 5-year rolling
basis.
Warren Buffett, Letter To Shareholders
1984 Annual Report of Berkshire Hathaway
The “Buffett Test” is equivalent to saying that increas-
ing MVA is the ultimate measure of corporate
performance.
As further testimony to the growing acceptance
of MVA as the definitive corporate benchmark,
another Fortune article entitled “America’s Best
Wealth Creators” (December 27, 1993) published an
excerpt from the Stern Stewart Performance 1,000,
which contains our annual ranking of 1,000 of
America’s largest companies on the basis of year-end
MVA. This ranking is now being used increasingly by
portfolio managers and activist shareholders for
screening good and bad performers. At the same
time, some corporate executives are making their
company’s MVA ranking a key corporate goal. For
example, David Whitwam, CEO of Whirlpool, the
global appliance manufacturer, has established a
target of reaching and maintaining top quartile MVA
performance for his company.
EVATM: The Key to Maximizing MVA
If we accept that the prime financial objective of
any company ought to be to maximize the wealth of
the shareholders, and that NPV is the decision-
making tool best suited to guide actions and strate-
gies to that end, then a new question arises: How can
the energies of operating people be directed most
effectively to maximizing NPV? Stern Stewart devel-
oped EVA with just this purpose in mind.
EVA is an estimate, however simple or precise,
of a business’s true economic profit. EVA thus differs
from accounting profit in three principal respects.
First, EVA is the residual income remaining after
subtracting the cost of all the capital that has been
employed to produce the operating profit. It thus
integrates operating efficency and balance sheet
management in one measure accessible to operating
people.
Second, EVA is charged for capital at a rate that
compensates investors for bearing the firm’s explicit
business risk. The assessment of business risk is
based upon the Capital Asset Pricing Model, which
allows for a specific, market-based evaluation of risk
for a company and its individual business units using
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JOURNAL OF APPLIED CORPORATE FINANCE
the concept of “Beta.” In addition, the tax benefit of
debt financing is factored into the cost of capital, but
in such a way as to avoid the distortions that arise
from mixing operating and financing decisions. To
compute EVA, the operating profit for the company
and for each of the units is charged for capital at a
rate that blends the after-tax cost of debt and equity
in the target proportions each would plan to employ
rather than the actual mix each actually uses year-by-
year. Moreover, operating leases are capitalized and
considered a form of debt capital for this purpose. As
a result, new investment opportunities are neither
penalized nor subsidized by the specific forms of
financing employed.
Third, EVA adjusts reported accounting results to
eliminate distortions encountered in measuring true
economic performance. In our published rankings
and illustrations we have chosen to make only a
handful of such adjustments in the calculation of
EVA and MVA—typically those which can be made
with information contained in the Compustat® da-
tabase and easily explained to the general business
reader. By so doing, we may have inadvertently
given the impression that EVA is derived in a
mechanical fashion by applying a sterotypical and
limited range of adjustments.
But that could not be farther from the truth. In
defining and refining its EVA measure, Stern Stewart
has identified a total of 164 performance measure-
ment issues, including methods of addressing short-
comings in conventional GAAP accounting for: in-
ventory costing and valuation; seasonality; deprecia-
tion; revenue recognition; the writing off of bad
debts; the capitalization and amortization of R&D,
market-building outlays, restructuring charges, ac-
quisition premiums, and other “strategic” investments
with deferred payoff patterns; mandated investments
in safety and environmental compliance; pension
and post-retirement medical expense; valuation of
contingent liabilities and hedges; transfer pricing and
overhead allocations; captive finance and insurance
companies; joint ventures and start-ups; and special
issues of taxation, inflation, and currency translation.
For most of these accounting issues, we have crafted
a series of cases to illustrate the performance mea-
surement problem, and devised a variety of practical
methods to modify reported accounting results in
order to improve the accuracy with which EVA
measures real economic income.
Of course, no one company is likely to trigger
all 164 issues. In most cases, we find it necessary to
address only some 20 to 25 key issues in detail—and
as few as 5 to 10 key adjustments are actually made
in practice. We recommend that adjustments to the
definition of EVATM be made only in those cases that
pass four tests:
Is it likely to have a material impact on EVA?
Can the managers influence the outcome?
Can the operating people readily grasp it?
Is the required information relatively easy to track
or derive?
The important point here is that, contrary to the
impression that may have been given by the Fortune
article, Stern Stewart advocates no one particular
definition of EVA. For any one company, the defini-
tion of EVA that is implemented is highly customized
with the aim of striking a practical balance between
simplicity and precision. Moreover, once that defini-
tion of EVA has been reached, it should be scrupu-
lously followed. Consistent application builds cred-
ibility and conditions managers to concentrate on
running their businesses instead of seeking special
dispensations. In sum, we want to establish a rule of
laws, not a rule of men, as the basis for corporate
governance.
EVA, then, is a superior measure of performance
because it charges management for using capital at
an appropriate risk-adjusted rate, and it eliminates
financial and accounting distortions to the extent it
is practical to do so. But besides being a superior
measure of performance, EVA is also a superior
measure of value. The final link in the chain of rea-
soning that provides the conceptual basis for EVA is
this all-important relation: the NPV of a project, strat-
egy, or acquisition candidate, and what amounts to
the same thing, the contribution to the MVA of the
company, is by definition equal to the present value
of the EVA it can be expected to generate in the future.
Shareholders’ Wealth = Market Value Added
= Total Value – Total Capital
= Net Present Value
= The Present Value of Future EVA
By subtracting the cost of capital, EVA automati-
cally sets aside a return sufficient to recover the value
of the capital that has already been or will be
invested. For this reason, it automatically accounts
for any premium over or discount under the capital
1. The reader interested in more detail on this equivalence can refer to Chapter
8 in my book, The Quest For Value (HarperBusiness, 1991).
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VOLUME 7 NUMBER 2
employed, a spread that is exactly the NPV of a
project or the MVA of a company.1
The EVA Financial Management System
To reinforce this vital link between EVA and
shareholder wealth, we recommend that capital
budgeting manuals, valuation procedures, and plan-
ning reviews be revised to emphasize the projecting
and discounting of EVA in place of the projecting and
discounting of cash flow. The NPV is the same whether
discounting EVA or cash flow—an important equiva-
lence—but there are real benefits to be derived when
capital budgeting and financial planning, goal set-
ting and performance measurement, and shareholder
communication and incentive compensation are all
structured around just one measure.
As Quaker Oats CEO William Smithburg puts it:
Our operating managers are much happier now
that we have a single measure that embodies all of the
things we want them to think about in running their
business. Before we used a whole variety of measures
and procedures for different purposes, and that only
served to confuse our managers rather than to clarify
their mission.
The advantages of using EVA as the centerpiece
of a completely integrated framework for financial
management and incentive compensation are echoed
by Francis Corby, CFO of Harnischfeger Industries:
We have not had a single capital budgeting
project turned down since adopting EVA. With EVA
as the basis for capital budgeting calculations, per-
formance evaluations, and bonus determinations,
our managers are now spending money like it’s their
own, and that’s paying big dividends for us in many
ways.
Besides the theoretical case for EVA, what has
also given these and growing numbers of other
senior corporate executives the confidence to adopt
EVA is the knowledge that the conceptual link
between EVA and shareholders’ wealth has been
supported by empirical research into actual stock
price behavior. If, as the theory suggests, a company’s
MVA at any point in time is equal to the present value
SUMMER 1994
 For any one company, the definition of EVA that is implemented is highly
customized with the aim of striking a practical balance between simplicity
and precision.
of the EVATM it can be expected to generate in the
future, then we would expect to observe that the
change in EVA over a given period is strongly related
to the change in MVA over the same period. If so,
this would indicate that EVA is a reliable internal
measure to guide management in choosing actions
and strategies that create shareholder wealth.
Our analysis of the companies that make up the
Stern Stewart Performance 1,000 indicates that the
changes in their EVAs over a five-year period
account for nearly 50% of the changes in their MVAs
recorded over that same time. By comparison,
growth in sales explained 10% of the MVA changes,
growth in earnings per share just 15% to 20%, and
return on equity only 35%. Thus, EVA is almost 50%
better than its closest accounting-based competitor
in explaining changes in shareholder wealth, a
significant improvement.
The reason the explanatory power of EVA is not
more than 50% is simply because stock prices are
forward-looking, thus creating a fundamental mis-
match between the time perspective of EVA and
MVA. In our test, we asked how well the change in
EVA over a given five-year period accounted for the
change in MVA over the same five years. The
problem is, the MVA at the end of the five-year
interval will already be reflecting the outlook for the
five years after that. That changes in EVA explain 50%
of the changes in MVA over the same period
suggests, in effect, that a company’s stock price at
any point in time is half-determined by the EVA over
the first five years and half-determined by the
expected EVA for all future years after that.
My point in citing this statistic, then, is that even
though the mismatch inevitably limits the explana-
tory power for all measures in a difficult test of this
type, EVA stands well out from the crowd as the
single best measure of wealth creation on a contem-
poraneous basis. As such, it can be adopted with
confidence as a company’s primary internal financial
performance metric.
EVA MISCONCEPTIONS
There are a number of common objections to
EVA, almost all of which are based on misconcep-
tions. The objections I hear most often are the
following six:
EVA is just a financial measure that doesn’t tie to
our business, our customers, or our employees.
EVA is too complex.
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JOURNAL OF APPLIED CORPORATE FINANCE
EVA is short-term.
EVA is based upon book value.
EVA is affected by book depreciation.
EVA doesn’t explain shareholder returns as well as
some other financial measures.
In the remainder of this article, I will attempt to set
the facts straight, one issue at a time.
EVA is Just a Financial Measure?
It is sometimes said that a focus on a financial
measure such as EVA can distract managers from
addressing issues of customer satisfaction, produc-
tivity, employee relations, innovation, and other
important business concerns. In reality, the only
reliable way for a company to produce EVA is to
address these issues more quickly and effectively
than its competitors.
A good example is Emerson Electric, number 35
in terms of MVA in our most recent Performance
1,000 ranking and a consistently strong EVA per-
former—even though the company manufactures
such prosaic items as fractional horsepower motors,
process controls, and HVAC components. After adopt-
ing the EVA system nearly 20 years ago, Emerson in
the early 1980s embraced and brilliantly executed a
three-pronged strategy with the following goals:
1. World Class Manufacturing (including focused
factories, quality, employee involvement, and a
commitment to spending the capital necessary to
bring about the transformation);
2. Globalization (a commitment to expand sales
internationally and so face the challenge of achiev-
ing best practices and lowest costs worldwide);
3. Innovation (a goal that sales from new products
would increase to 25% of total sales, and a commit-
ment to increasing R&D spending).
Far from stifling management initiative, EVA
enhanced it. Emerson today spends 3.5% of its $8
billion in revenues on engineering and develop-
ment, up from 2.9% a decade ago. “You would think
that with this EVA discipline, you would reduce
every cost category,” says Charles Peters, Emerson’s
vice president of development and technology.
In fact, we have increased engineering and
development as a percent of sales every year. That
increased investment has generated something of a
new product boom at Emerson. We used to have 50
new products come out every year. Now we’re sud-
denly looking at 85 or 90 new products each year.
 Emerson’s story is testimony to the power of to key operating metrics and strategic objectives. In
EVATM to reinforce a business focus on strategies that fact, allowing EVA to stand alone as an isolated
build value all around—for customers, employees, performance measure may well backfire by giving
suppliers, and shareholders. More broadly, there is managers the wrong impression.
a high correlation between how high a company For this reason, we have developed a manage-
stands in terms of its EVA and MVA performance and ment tool called “EVA Drivers” that enables manage-
its standing in Fortune’s Most Admired survey, a ment to trace EVA through the income statement and
ranking based upon an assessment of such criteria as balance sheet to key operating and strategic levers
quality of products and services, innovation, and available to them in managing their business. This
commitment to human resource development. Con- framework has proven to be quite useful in focusing
sider, for example, the top and bottom 10 MVA management attention, diagnosing performance,
performers and the strength of the correspondence benchmarking with peers, enhancing planning, and
of their MVA rankings with their Most Admired in helping people up and down the line to appreciate
rankings in their respective industries. Eight out of 10 the role they have to play in improving value. It can
of the top MVA companies are the number one or also help guard against an excessive preoccupation
two most highly regarded in their industries, and with improving individual operational metrics to the
seven out of 10 of the lowest MVA performers are detriment of overall performance. For example, a
seventh or lower in reputation in their respective single-minded drive to increase productivity could
industries. lead to unwarranted capital spending or to shifts in
product mix that result in less EVA and value, not
THE MOST VALUABLE ARE ALSO THE MOST ADMIRED more. In the end management must be held account-
THE TOP TEN (AS OF YEAR-END 1992) able for delivering value, not improving metrics.
It is not a question of whether you need EVA
Company

Most Admired Industry Rank

Performance 1000 Rank

(out of 10)

1 Wal-Mart Stores 1 or operational and strategic excellence: you clearly

2 Coca-Cola 1 need both. But if you ask me, of the two, EVA
3 Philip Morris 6 ought to come first. The Soviet and Chinese Com-
4 General Electric 2 munists were renowned for their meticulous plan-
5 Merck 1 ning, but their plans never worked in practice
6 Bristol-Myers Squibb 5 because they lacked the incentives, the account-
7 AT&T 1 ability, and the price system necessary to make it
8 Johnson & Johnson 2 happen. The best-laid plans of mice and men
9 Procter & Gamble 1 invariably disappoint unless they are formed and
10 PepsiCo 2 executed in an environment in which managers
THE BOTTOM TEN (AS OF YEAR-END 1992) focus on creating value in the first place, and
know in advance they will be rewarded or penal-
Company

(out of 10)
Performance 1000 Rank

Most Admired Industry Rank

991 United Technologies 7 ized for their success or failure.

992 Time Warner 2
993 Champion International 8 EVA is Complex?
994 Occidental Petroleum 10
995 McDonnell Douglas 10 I often ask managers which financial measure
996 RJR Nabisco 5 they believe their operating people will grasp most
997 Digital Equipment 7 easily—earnings, returns, or cash flow. The over-
998 Ford Motor 1 whelming majority feel operators relate most readily
999 General Motors 9 to earnings. And this adds to the appeal of EVA, since
1000 IBM 9 EVA is just another measure of earnings—one that
can be presented in its essence in this simple format:
Establishing Links with Operating Efficiency.
Although the above evidence suggests that general Sales
corporate excellence and EVA go hand in hand, the – Operating Expense (including tax)
full performance benefits from using an EVA perfor- – Financing Expense (cost of capital × capital)
mance evaluation framework come when it is linked EVA

76
VOLUME 7 NUMBER 2 SUMMER 1994
 The full performance benefits from using an EVA performance evaluation
framework come from linking EVA to key operating metrics and strategic objectives
through the use of EVA drivers. In fact, allowing EVA to stand alone as an isolated
performance measure may well backfire by giving managers the wrong impression.
In effect, EVATM converts the balance sheet into
another expense (“capital costs”) that may be com-
pared directly with and managed in the same way as
normal operating expenses. For this reason, compa-
nies that have a tradition of managing for earnings
find it relatively simple in practice to switch the focus
of their managers to EVA.
While most would concede that the concept of
EVA is easy, it is the potential adjustments to the
reported income statement and balance sheet that
are cause for greatest concern. But, as I mentioned
earlier, such adjustments to GAAP results are made
only when they pass four stringent tests designed to
achieve an appropriate balance between simplicity
and precision. Additional information always has an
additional cost. The critical question we ask our-
selves is this: Do the expected benefits of the new
information justify the costs of providing it? The
objective is to optimize the trade-off between the
cost of making the adjustments and the benefits of
greater precision.
It is also easy to lose sight of the fact that EVA
is intended to be more than just a financial perfor-
mance measure. Its real purpose is to serve as the
centerpiece of an integrated financial management
and incentive compensation system. Most compa-
nies take an opposite tack. They use seemingly
simple and well-established measures and prac-
tices—for example, discounted cash flow for capital
budgeting; earnings for setting goals, communica-
tions with investors, and performance measurement;
and budgets for bonuses. But this proliferation of
measures and practices makes the system as a whole
needlessly complicated and disjointed, with a loss of
comparability and accountability. Moreover, in cases
where the measures conflict (for after all earnings,
returns, cash flows and budgets are not the same),
the system becomes divisive.
With EVA, by contrast, all principal facets of the
financial management process are tied to just one
measure, making the system overall far easier to ad-
minister and understand. Although the process of
coming up with the right definition of EVA for any
given firm, and explaining its applications to the
operating people, is admittedly a complicated and
time-consuming one, the measure itself, once estab-
lished, then becomes the focal point of a simpler,
more integrated overall financial management sys-
tem—one that serves to unite all the varied fiefdoms
and functions within a corporation, and to make them
clearly accountable to the mission of creating value.
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JOURNAL OF APPLIED CORPORATE FINANCE
Charles Peters of Emerson again hits the EVA
mark when he says: “It’s a very simple measure and
it steers people to look at investment on an incre-
mental basis. You can use the measure at any level
and look at 50 different plans within our company
and make some judgment about their value.”
EVA is Short-Term?
It is sometimes said that a drive to increase EVA
will encourage managers to give short shrift to the
longer-term ramifications of current decisions. But
this fear is belied by the long-term success of such
EVA companies as Coca-Cola and Emerson Electric.
More concretely, many of the adjustments to
EVA are intended to encourage managers to give
proper consideration to long-term as well as short-
term costs and benefits. For example, in setting up
EVA systems, we sometimes advise companies to
capitalize portions of their R&D, marketing, training,
and restructuring costs. In cases of other “strategic”
investments with long-deferred payoffs, we have
also developed a procedure for keeping such capital
off the books (for internal evaluation purposes) and
then gradually readmitting it into the manager’s
internal capital acount to reflect the expected payoffs
over time. As these examples are meant to show,
EVA actually encourages a more far-sighted corpo-
rate investment policy than traditional financial
measures based upon GAAP accounting principles;
indeed, EVA is designed in part to combat such
accounting-induced myopia.
Moreover, EVA is used in practice for more than
just annual performance measurement. It is also
employed for capital budgeting, strategy reviews,
and an incentive plan that rewards management for
both the current and cumulative increase in EVA
over time with an “at-risk, bonus-bank” system.
These practices serve to keep management focused
on longer-term value building.
The EVA bonus program also works best when
it is coupled with “Leveraged Stock Options,” or
LSOs. In an LSO plan, a portion of each year’s EVA
bonus is automatically used to purchase special stock
options. Such options would be purchased slightly
in-the-money (say, 10%), and the exercise price would
increase at a rate designed to set aside a minimal
acceptable return for the shareholders before man-
agement begins to participate. The management
incentives provided by such options are equivalent
to those held out by EVA in that management must
generate a return for the shareholders above the cost
of capital before they begin to participate. More to
the point, because such options are purchased in
effect out of the annual EVATM bonus, and because
they are not exercisable for three years, managers are
motivated to focus on long-term value building. Com-
panies including Briggs & Stratton, Centura Bank,
CSX, Fletcher Challenge (the largest industrial com-
pany in New Zealand), LongHorn Steaks, R.P. Scherer,
Varity, and Vigoro have implemented LSO plans.
EVA is Based Upon Book Value?
In calculating EVA, we generally find it more
cost-effective to use the book values of (net) assets—
even though they may be based on now meaningless
historical costs—than to use estimates of current
market or replacement values. Our reasons for not
using market values are two. First, to be theoretically
correct, the market values would have to be updated
on a regular basis; and for nontraded assets, the
volatility of such values and the inevitable subjectiv-
ity in estimating them would impose large costs on
any accounting system (including, in some cases, the
need to hire independent appraisers).
The second reason we use book values is that
we have found a way of circumventing the problem
of historical costs—namely, by tying management
rewards not to absolute measures of EVA, but to year-
to-year changes in EVA. Just as total quality manage-
ment focuses on continuous improvement in prod-
ucts and processes, an EVA system focuses on
continuous improvement in financial performance.
If you reward managers for improving EVA, it
doesn’t really matter what value you initially assign
to the assets. Why? Because the three principal ways
to increase EVA have nothing to do with the existing
asset base. EVA can be increased by increasing profit
without investing more capital, by investing new
capital in projects expected to earn above the cost of
capital, and by withdrawing capital from activities
and assets where it is earning an unattractive return.
To repeat, none of these decisions would be influ-
enced by whether you chose to assign book or
market values to the current asset base.
The emphasis on withdrawing capital as op-
posed to assets is crucial, for it is the source of much
of the confusion. For instance, one of the 164 EVA
performance measurement adjustments is to add
back to both earnings and the balance sheet the after-
tax charge associated with a writedown or restruc-
78
VOLUME 7 NUMBER 2
turing. Our reason for recommending this adjust-
ment is to encourage managers to focus on the
incremental costs and benefits of a restructuring
decision without having to worry about the impact
of recognizing sunk charges, which are irrelevant.
There is also a second major benefit to keeping such
assets on the balance sheet: this way MVA is not
affected by the mere act of writing off assets (since
both market and book values remain unchanged);
nor are the returns on capital (or ROEs) artificially
inflated in subsequent years by such asset writedowns,
a (presumably) unintended consequence of GAAP
accounting.
To illustrate how EVA would work in such a
situation, suppose a company has a non-productive
asset on its books at a stated value of $50 million. Let’s
assume this asset is not expected to produce a nickel
of profit in the future (at least under its current
owner). If we assume the cost of capital (c) is 10%,
then the non-productive asset reduces the company’s
EVA by $5 million per year.
EVA = Op Profit – c × Capital
$–5 = $0 – 10% × $50
Suppose, furthermore, an opportunity arises to
sell the asset to another firm with a different view of
the asset’s potential and thereby generate $20 million
(including tax savings from the write-off). Now let’s
consider the effect of alternative accounting treat-
ments on managers’ incentives to make this value-
adding decision.
Even though there is a clear value gain (of as
much as $20 million) to shareholders from the
decision to sell the asset, conventional accounting
would record a $30 million loss on disposal as the
$50 million asset is written off the balance sheet
against the $20 million proceeds. Such a charge
would thus have a large one-time negative effect on
management’s P&L, perhaps leading them to put off
the decision.
Now, an EVA framework based upon book
accounting might also show the same loss of $30
million in the period of disposition:
EVA = Op Profit – C × Capital
$–30 = $–30 – 10% × $0
If so, management might be similarly deterred
from making the right decision—and so the earlier
failure to mark down the value of the asset to zero
SUMMER 1994
 Many of the adjustments to EVA are intended to encourage managers to give proper
consideration to long-term as well as short-term costs and benefits. For example, in
setting up EVA systems, we sometimes advise companies to capitalize portions of
their R & D, marketing, training, and restructuring costs.
would have led to the wrong decision. But, as I
demonstrate below, in applying EVATM in such
circumstances we would recommend making one of
our many possible adjustments.
EVA with Full-Cost Instead of Successful Ef-
forts Accounting. The real source of the problem
with conventional accounting here is the principle of
“successful efforts” accounting, which stipulates that
the costs of unsuccessful efforts be expensed against
earnings and hence taken off the balance sheet.
Accountants defend this method as a conservative
way to measure both earnings and capital. But, as we
have already seen, by bringing irrelevant sunk costs
to bear on a current decision, it can deter managers
from pursuing value-adding asset disposition and
restructuring opportunities. Moreover, by producing
a permanent reduction in the balance sheet, such
accounting also overstates subsequent performance.
A better principle to guide performance mea-
surement and incentive systems is that of “full cost”
accounting. This method recognizes that, in any
risky business, an inevitable cost of finding winners
is funding losers along the way. The cost of finding
a well drilled in a field with a 20% success ratio is the
cost not of one but of five; hence, the investment in
all five should go on the balance sheet to be
amortized against the earnings produced by the one
successful well over its productive life.
To convert our example from successful-efforts
to full-cost cash accounting, the $30 million non-
cash bookkeeping loss should be excluded from
the income statement and be added back to the
balance sheet. This way EVA increases by $2 million
(from –$5 million to –$3 million):
EVA = Op Profit – C × Capital
$–3 = $0 – 10% × $30
It is the $2 million increase in EVA, rather than
the fact that it remains negative, that is the measure
of the annualized value added by the decision to sell
the asset; as such, this measure should also be the
basis for rewarding and motivating management.
As this example is meant to illustrate, then, the
fact that the initial EVA is based upon book value is
not a problem so long as full-cost cash accounting is
used to measure the earnings and capital arising from
2. This treatment is clearly spelled out in my book, The Quest for Value, in two
places: first, in Exhibit 4.6, “The EVAnalysis of a Restructuring Plan,” on pages 141-
150, and second, in Chapter 5, covering the Stern Stewart Performance 1,000, in
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JOURNAL OF APPLIED CORPORATE FINANCE
subsequent business decisions. Ironically, some
protest this treatment by pointing out that the $30
million now on the balance sheet is not associated
with any particular asset. But that $30 million in
capital should still be there if you believe, as I do,
that part of the investment base that should be
associated with a successful on-going business is the
net cash outlays associated with losers.2
In practice, adopting this full-cost variant of EVA
has enabled companies to pursue value-adding
restructurings on the basis of their economic merits
alone. For instance, Varity Corporation (the succes-
sor to Massey Ferguson, the struggling farm-equip-
ment producer) has seen its stock price appreciate
by over 50% since adopting EVA two years ago.
During that period, the company underwent signifi-
cant restructuring activities with major charges to the
bottom line. Under the company’s internal EVA ac-
counting, such charges were capitalized—and man-
agers were rewarded for making the right decisions.
One last word on book values: An EVA system
based upon achieving improvements together with
book values adjusted for full-cost cash accounting
will work well in most cases involving operating
assets. In cases involving non-operating assets such
as real estate and timber holdings (i. e., those whose
value is not registered in current earnings), however,
it may well pay to mark assets to market to force
management to make the best asset ownership
decisions. In such cases, the benefits of using market
values are very likely to exceed the costs. Fletcher
Challenge, for instance, has defined EVA for their
timber holdings based in part on the change in their
appraised value.
EVA is Affected by Depreciation?
It troubles some that EVA is measured after
subtracting depreciation from the income statement
and the balance sheet. The basis for the confusion
seems to be the notion that depreciation cannot be
an economic charge because it is a non-cash charge.
But the depreciation suffered by assets through
wear-and-tear and obsolescence must be recovered
from a company’s cash flow over time in order to
provide investors with a return of their capital before
they can enjoy a return on their capital.
particular on pages 181-188, in which the calculation of MVA for Warner Lambert
includes adding back to capital a $688 million after-tax restructuring/asset
writedown charge.
 The easiest way to appreciate this fact of life is
to recognize that if an asset were leased, the lessor
would charge the lessee for a recovery of the asset’s
cost through the lease payment. In fact, the present
value of the lease payments (ignoring tax shields for
simplicity) should equate to the cash outlay to
purchase the asset, or else the lessor would not be
able to recover the principal outlay and the interest
incurred in purchasing and financing the asset on
behalf of the lessee. Depreciation is thus an eco-
nomic charge, because it is a cash equivalent charge
(in the sense you would pay for depreciation in cash
if you leased the asset instead of owning it).
BCG/HOLT, a financial advisory arm of the
Boston Consulting Group, feels so strongly that
depreciation is a non-cash charge that they advo-
cate use of a measure termed CFROI, or cash flow
rate of return. CFROI is an annual performance
measure that is computed by solving for the inter-
nal rate of return that equates the up-front invest-
ment, period cash flow, and residual value. It is
claimed that this measure avoids the distortions
introduced by depreciation.
But what is ironic is that depreciation is implicit
in all internal rate of return measures, CFROI in-
cluded. Implicit in the mathematics of solving for the
rate of return is that the shortfall between the money
laid out to purchase an asset and the money to be
recovered from its residual value must be gotten
back from the intervening operating cash flows
before investors begin to earn a positive return on
their investment. If that sounds like depreciation,
that’s because it is, and it has the same characteristics.
For instance, the greater the shortfall between the
residual value and the up-front investment, and the
shorter the time interval between them, the greater
the intermediate operating cash flows would have to
be before the computed IRR or CFROI turns positive.
This is no different from saying the asset is depreci-
ating quickly. Although it may appear as if an IRR
measure such as CFROI is a pure cash measure that
is unaffected by non-cash depreciation, in fact
depreciation is simply buried in the mathematics of
solving for the return.
Problems with Straight-Line Depreciation. It is
true, however, that there is a problem with basing
3. Actually, sinking-fund depreciation records a steady rate of return only
when the IRR equals the cost of capital, and the NPV is zero. If the IRR is above
the cost of capital, and the NPV is positive, then the rate of return measured with
sinking-fund depreciation actually increases each year, and vice versa. Rather, it
is the EVA that sinking-fund depreciation makes constant over the life of the project.
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VOLUME 7 NUMBER 2
EVATM, or any financial measure for that matter, on
straight-line depreciation, which is the method most
companies employ for book reporting purposes.
To cite an example, suppose a company pays
$10,000 for an asset that has an economic life of 10
years, and that is expected to generate an even
$2,000 cash flow stream in each of those 10 years.
With straight-line depreciation of $1,000 per year,
the net-of-depreciation profits will be an even $1,000
in each year. The rate of return on capital in the first
year is thus 10% ($1,000 of profit divided by the
original $10,000 in capital), but by the fifth year it
would be 20% ($1,000 in profit divided by $5,000,
which is the original $10,000 asset value reduced by
$5,000 of accumulated depreciation).
As the example illustrates, rates of return based
upon straight-line depreciation will tend to under-
state the true internal rate of return in the early years
and overstate it in later years. That’s because taking
a steady depreciation charge against steady cash
flows leaves steady earnings against an asset base
that declines with depreciation. This bias in mea-
sured returns can make managers reluctant to ac-
quire new assets when they should and cause them
to retain old assets beyond the point of an economic
return. This problem is real, but the culprit is not
EVA. The problem is basing depreciation on ac-
counting as opposed to economics.
A Better Way: Sinking-Fund Depreciation. An-
other of the 164 EVA performance measurement
issues is to weigh the merits of introducing an
economic depreciation schedule, known as the
“sinking fund” method, which entirely eliminates
this distortion. Under sinking-fund depreciation, an
asset is written off in the same way that a banker
amortizes the principal on a mortgage. This means
that in the early years most of the cash the asset
generates is used to provide for the return on capital,
and only a small portion amortizes the capital
balance; whereas in the latter years only a little cash
is needed to provide for a return and the bulk applies
to amortize the remaining principal. This schedule
records little depreciation early on and more later on,
and thus more earnings early on and less later on, but
a steady rate of return and hence EVA is recorded
over the life of the asset.3
That is, the rate of return climbs each year to just offset the decline in capital arising
from the accumuated depreciation, leaving EVA flat. This reveals another
philosophical distinction. The right objective should be to measure EVA steadily,
not returns, because EVA is intended to be an annuitized measure of the NPV to
be realized over the life of the project or company.
SUMMER 1994
 A focus on maintaining or improving rate of return inadvertently sets up the current
rate of return as the hurdle for accepting new projects rather than the cost of capital.
For this reason, rate of return is a wholly inappropriate for evaluating managers of
either a project or an entire company.
Once again, in our published rankings and illus-
trations we have chosen not to adjust for sinking-
fund depreciation, inasmuch as this is difficult to obtain
from the Compustat® data base, which is based upon
reported financial data. It is thus most unfortunate
that most accountants recommend against using sink-
ing-fund depreciation for financial reporting because,
by front-end loading the earnings and back-end load-
ing depreciation, it is not considered to be an appro-
priately “conservative” method. But there is nothing
to prevent a company from adopting sinking-fund
depreciation for the purpose of tracking EVATM inter-
nally. By adopting sinking-fund depreciation, or ready
approximations to it that we have devised, compa-
nies can avoid or minimize the distortion that arises
from using straight-line depreciation.
This said, however, most of our clients decide
after studying the issue that the distortion is imma-
terial so long as they have a reasonably steady capital
spending program calling for continuous growth
and replacement.
EVA Doesn’t Explain Stock Prices Well?
The relation between corporate financial per-
formance and stock price performance is an inher-
ently confusing proposition. For example, EVA does
not directly tie to total shareholder returns, as you
might think it should. That’s because EVA ties to a
more important measure—shareholder wealth—
which is related to, but not the same as, total
shareholder returns.
The dual concepts of maximizing the share-
holders’ wealth and using net present value as a
principal planning and decision tool are fundamen-
tal, but somehow these basic propositions are often
forgotten. It is easy to fall into the trap of thinking that
rate of return measures are somehow more impor-
tant than wealth maximization.
Let me concede that internal rates of return, or
IRRs, are often introduced in corporate finance
textbooks as a useful adjunct to the net present value
rule. IRRs have the merit of indicating whether a
project is worthwile, in that an IRR above the cost of
capital represents a positive NPV project, an IRR
equal to the cost of capital is a zero NPV project, and
an IRR less than the cost of capital is associated with
a negative NPV project. Thus, operating managers
often find it convenient to calculate a project’s IRR
as an indication of its merit that is easily communi-
cated and compared with the IRRs of other projects.
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And yet, as any corporate finance textbook will
urge in the strongest possible terms, even though IRR
may be a convenient basis for ranking projects,
maximizing the IRR of a project and, by extension,
of a company, is not the theoretically correct objec-
tive. Rather, the shareholder’s wealth is maximized
when NPV, and hence the present value of EVA, is
maximized.
The classical textbook example of the problem
in using IRR instead of NPV concerns the decision as
to how high to build a skyscraper. Reflecting the
typical pattern of increasing and then diminishing
returns, let us assume that if the building is con-
structed to a height of 10 floors, it will have a positive
NPV and an IRR above the cost of capital; if built to
the 20th floor, it will have a still higher NPV and an
even higher IRR; if built to the 30th floor (we are
obviously talking about New York City real estate
here), it will have an even higher NPV but a lower
IRR; and if it is built to the 40th floor, it will have a
lower NPV and lower still IRR.
10th positive NPV IRR > C
20th higher NPV higher IRR
30th higher NPV lower IRR
40th lower NPV lower IRR
Question: how high should the building go?
Answer: to the 30th floor! Even though the overall
IRR, and thus the ratio of value to capital, is
maximized at the 20th floor, the absolute dollar
spread between value and capital, or NPV, is maxi-
mized at the 30th floor—and that is what maximizes
the shareholders’ wealth (even if additional share-
holders must be carved in to fund the project).
To see this even more clearly, let’s break the
proposed 30-story building into two projects: first, to
build to the 20th floor, and second, to build from the
21st to the 30th floor. Accepting both projects is
worthwhile, given the facts of this example, because
each of them has a positive NPV and IRR above the
cost of capital considered individually (if the 30-story
project has an NPV above the 20-story project, the
NPV from the 21st to 30th floor must be positive). The
fact that the second project has a lower IRR than the
first project is an irrelevant consideration, so long as
the IRR is above the cost of capital in its own right.
Incidently the EVA of the project would also
peak at the 30th floor, because the incremental
earnings derived from the tenants on the 21st to 30th
floors is assumed in the example to more than cover
the cost of raising the capital to support an extension
of the building from the 20th to the 30th story
(because the incremental IRR is still above the cost
of capital). Beyond the 30th floor, however, the
incremental revenue would be more than offset by
the additional capital charge, and both EVATM and
NPV would fall (because the incremental rate of
return is below the cost of capital). Thus, maximizing
EVA and NPV give the correct and mutually consis-
tent answer to the textbook problem. Unfortunately,
IRR or CFROI does not get a passing grade.
Using rates of return as a performance measure
is also ill-advised when applied to a whole business.
As but one indication of how serious this shortcom-
ing can be in practice, the CEO of a prominent
company told me several years ago that, with
considerable pain, he had switched the company’s
managers from a focus on growing operating earn-
ings to improving the returns on capital employed in
their units. But despite the best intentions, the focus
on maximizing returns on capital had unexpected
consequences. It made the business units that were
already earning high rates of return reluctant to
spend aggressively and grow, for fear they would
dilute the high returns they already had; and it
encouraged those business units earning low returns
to keep coming back for more money in the hope
they could spend their way out of their hole. “Funny
to say,” said that CEO, “we ended up starving our
stars and feeding our dogs. I didn’t think that was the
way it was suppossed to work.”
He was right. A focus on maintaining or improv-
ing rate of return inadvertently sets up the current
rate of return, rather than the cost of capital, as the
hurdle for accepting new projects. Thus, any rate of
return measure, CFROI included, is a wholly inap-
propriate measure for judging either a project or a
company. What is right, in both theory and practice,
is EVA and NPV.
Problems with Total Shareholder Returns. Mea-
suring rates of return at the shareholder level is also
problematical. First of all, is the return measured
assuming dividends are or are not reinvested? In
theory, we should assume the dividends are not
reinvested in the firm itself, because the shareholders
as a group could not do so. And yet, total shareholder
return (TSR) measures as quoted often do assume
such reinvestment.
4. [1 + 50%] × [1 – 50%] – 1 = –25%.
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VOLUME 7 NUMBER 2
Moreover, as conventionally calculated, TSR
measures the return realized only by those share-
holders who held shares over the entire interval. It
fails to reflect the returns experienced by investors
who sold part or all of their holdings back to the
company in a share repurchase program or bought
new shares from the company over the measure-
ment period. This can be a major shortcoming, as the
case of Exxon suggests. During the 1980s, the
company bought back over $20 billion of its com-
mon stock at prices that were rising throughout the
decade. TSR calculations effectively ignore all large,
non-dividend distributions; by so doing, they signifi-
cantly overstate the amount of shareholder value
created in cases like Exxon’s (because many shares
were retired at prices lower than the ending price).
Calculations of MVA, by contrast, would give
proper treatment of such distributions because the
shares retired would be taken out of value at the
prices actually paid over the interval. Moreover, MVA
will not be distorted by a one-time large share repur-
chase at premium prices that may in turn reduce the
price and apparent return realized on the non-ten-
dered shares. Take the case of Goodyear, whose
share price and hence MVA rose dramatically with
the announced intent to buy in $2.5 billion of stock
at a premium price in 1986. The share repurchase,
however, left the remaining shares at essentially the
same price as they traded before the announcement,
giving the appearance of a zero TSR. The MVA, by
contrast, would have remained at the same high level
it reached with the original announcement, because
the share repurchase itself would have reduced both
the book value and the market value of the company
in equal and offsetting amounts.
In contrast to TSR, then, MVA reflects the return
that a company generates on behalf of all of its
shareholders as a group. Because companies should
maximize the wealth of their shareholders, and not
of a shareholder, MVA is the superior measure.
A dependency on the specific time interval over
which they are measured is yet another problem
encountered in using TSRs as corporate perfor-
mance measures. A company that generates a return
of, say, +50% appears to be performing very well
indeed. But if the return in the preceding period was
–50%, the shareholders’ wealth would be reduced
25% from where it started.4 Contrariwise, a firm that
SUMMER 1994
 The better fit with stock returns claimed by BCG/HOLT for their CFROI measure is
almost entirely the result of using a forecast for their performance measure rather
than a past realization of it. To be somewhat facetious, if BCG/HOLT is discounting a
projection of expected future performance, why can’t they explain 100% of current
stock prices?

produces a –25% return may not be performing
poorly at all if in the previous period its return was
+100%; the firm’s shareholders are still 50% ahead.
Because the length of time over which the return was
calculated in those examples is arbitrary, rate of
return over any interval can never adequately reflect
a company’s cumulative performance over time.
Said differently, stock market rates of return mea-
sured over a given historical interval depend far
more on when the market first recognizes that value
is apt to be created than on whether value is being
created in the first place.
Wal-Mart, for instance, produced stellar returns
for shareholders over the decade of the 80s and into
the early 1990s, putting the firm first in terms of MVA
by the end of 1992. But since then, the stock has
fallen somewhat as the market has re-evaluated the
firm’s longer term prospects. Still, Wal-Mart remains
one of the most value-adding companies in the
world as indicated by its still very high MVA.
The advantage of MVA is that it measures the
cumulative value added or lost since the inception
of the company. As a measure of the shareholders’
cumulative return, it is unaffected by the particular
historical period in which the market first recog-
nized that value would be created or destroyed.
Furthermore, by measuring the change in MVA
over a period of, say, the past five years, an
indication of recent progress in building value can
be obtained. With MVA you can have your cake
and eat it too—current and cumulative perfor-
mance assessments.
So if TSR is so clearly flawed as a measure of
shareholder value added, why did the U.S. Securities
and Exchange Commission require companies to
report TSR in comparison with a relevant industry
and market index? It is for the same reason that
corporate managers like to compute IRRs on projects
when NPV is really correct—it facilitates the making
of comparisons. But we should not let the conve-
nience of IRRs, CFROIs and TSRs cloud the fact that
they are conceptually flawed as performance mea-
sures. The correct measures of performance are
absolute measures of shareholder wealth creation:
namely, MVA, NPV, and EVATM!
Correlating Share Price Returns with Operat-
ing Measures. We have already discussed the fact
that changes in EVA account for nearly 50% of the
changes in MVA over a five-year interval, an explana-
tory power nearly 50% better than the nearest
accounting-based competitor, and why this relation
cannot be higher in a test of that kind. But it is
confusing to say the least when, for example, BCG/
HOLT claims that CFROI explains 80% to 90% of
share prices, with the implication that it is a more
reliable performance measure than EVA. The prob-
lem is that the statistics BCG/HOLT cite are not
directly comparable to the EVA results.
First, the BCG/HOLT method attempts to ex-
plain stock prices at one point in time by discounting
a projection of expected future performance. The
Stern Stewart method, on the other hand, relates
actual past changes in EVA to actual past changes in
MVA. The better fit claimed by BCG/HOLT for their
CFROI measure is almost entirely the result of using
a forecast for their performance measure rather than
a past realization of it. To be somewhat facetious, if
BCG/HOLT is discounting a projection of expected
future performance, why can’t they explain 100% of
current stock prices?
Moreover, rather than using a risk-adjusted cost
of capital as computed from the Capital Asset Pricing
Model or Arbitrage Pricing model, as academic
theory recommends, BCG/HOLT solves for the cost
of capital that produces the highest correlation with
current share price data, given the forecasts they
project. This is circular reasoning, it inflates the
apparent statistical significance of the relation, and
it makes the cost of capital depend upon the specific
forecasting method they choose to employ. It is also
troubling that their approach does not enable spe-
cific hurdle rates to be established for individual
business units within a company, even when the
differences in their business risks and capital struc-
tures would clearly warrant using distinct costs of
capital by lines of business.
In another set of statistical tests, BCG/HOLT at-
tempts to explain historical total shareholder returns,
and again concludes that CFROI is better than EVA.
The comparison is misleading for three reasons:
First, even though their analysis seems to use only
historical information, BCG/HOLT assumes that each
company’s CFROI and growth rate will fade to a long-
run norm at a rate that is solved for so as to give the
highest fit. Even in this test, the statistics appear to be
circular, and to incorporate an implicit forecast—an
advantage denied EVA in the computations.
Second, we suspect the definition of EVA em-
ployed in the tests incorporates only a crude and
limited set of adjustments, rather than the broad
and specific ones that companies might implement
in practice.

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 Third, and most fundamental, EVATM is not in-
tended to explain total shareholder return, but rather
increases in shareholder wealth (i.e., MVA). As far as
EVA is concerned, the dependent and independent
variables in the regression are mismatched. Per our
tests, EVA should be regressed against MVA, not TSR.
That EVA should not have a direct relation with
total shareholder return is consistent with the
longstanding academic assertion, first formulated by
Nobel laureates Merton Miller and Franco Modiglianni
in a 1961 paper, that “dividends do not matter.” To
see this, suppose a company pays a dividend. What
happens to its MVA, the measure of the shareholders’
wealth? The answer is: Nothing! The book value of
the firm’s equity falls by the reduction in retained
earnings triggered by the dividend payment. Like-
wise, the value of the company’s shares falls by the
amount of the dividend, once the shares go “ex-
dividend” (otherwise there would be arbitrage prof-
its). With the share value and book value both falling
in the amount of the dividend, there is no effect on
MVA or on the shareholders’ wealth.
As the academic theory asserts, the sharehold-
ers cannot be made wealthier by the receipt of a
dividend if to get it means they must end up holding
a share of stock worth less than otherwise in the
amount of the dividend. To draw an analogy, would
you be better off if you withdrew $5 in cash from a
savings account that had $100 in it to begin with?
Whether you left the money in or withdrew it, you
would have $100 in total value in either case. By
withdrawing cash from the account, only the form,
not the amount, of your net worth would be changed.
The problem, then, is this: even though the
shareholders’ wealth, MVA, and, by extension, fu-
ture EVA are all unaffected by the payment of a
dividend, the dividend must be accounted for as part
of the total return the shareholders receive from their
BENNETT STEWART
is Senior Partner of Stern Stewart & Co.
EVATM is a trademark of Stern Stewart & Co., New York, NY.
Compustat® is a registered trademark of Standard & Poor’s Compustat Services, Inc.
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VOLUME 7 NUMBER 2
stock holdings in the company. Indeed, it is precisely
because EVA ties to the wealth of the shareholders,
which is unaffected by the dividend, that it does not
do a better job of explaining the total return to the
shareholders, which includes the dividend. But this
is not cause for concern; so long as management
focuses actions and strategies on increasing the
present value of EVA, which is the same as the firm’s
NPV, the wealth of the shareholders will be maxi-
mized, and the rate of return will take care of itself.
SUMMARY
EVA is a powerful new management tool that
has gained growing international acceptance as the
standard of corporate governance. In essence, EVA
is a way both to legitimize and to institutionalize the
running of a business in accordance with basic
microeconomic and corporate finance principles. In
this regard EVA is like the proverbial Trojan Horse.
What is wheeled in appears to be an innocuous new
financial management and incentive program, but
what jumps out is a new culture that is right for times
of rapid change and decentralized decision-making.
As a concept, EVA starts simple, but in practice
it can be made as comprehensive as necessary to
accommodate management’s needs and preferences.
EVA is most effective, however, when it is more than
just a performance measure. At its best, EVA serves
as the centerpiece of a completely integrated frame-
work of financial management and incentive com-
pensation. The experience of a lengthening list of
adopting companies throughout the world strongly
supports the notion that an EVA system, by provid-
ing such an integrated decision-making framework,
can refocus energies and redirect resources to create
sustainable value—for companies, customers, em-
ployees, shareholders, and for management.
SUMMER 1994
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