UK: Smart cookies - The value factor in EVA.

UK: Smart cookies - The value factor in EVA. - EVA seems to be the flavour of the month with many managements as a way to boost shareholder value. We look at what it is, who's pushing it and what its limitations are

by ANDREW WILEMAN.
Last Updated: 31 Aug 2010

EVA seems to be the flavour of the month with many managements as a way to boost shareholder value. We look at what it is, who's pushing it and what its limitations are

What is it?

EVA stands for 'economic value added'. It is a way of measuring and setting targets for financial performance.

So it's a financial technique?

It is based on financial analysis - but its purpose is to change management behaviour and performance, and in particular to align management's goals more closely with those of shareholders. Focusing management on 'shareholder value' was a revolution in the US in the 1980s which is still spreading into the UK and the rest of Europe.

Can you summarise the technicalities?

EVA takes net operating profit after taxes and deducts a charge for the cost of the capital (debt and equity) that is invested in the business. (That's a very simplified version - in practice EVA makes many adjustments to the conventional calculation of 'net operating profit'.)

How does that help shareholders?

Historically, management could raise earnings and EPS (earnings per share) by overinvesting in new assets - such as acquisitions, new factories or stores - and could be earning an overall return that's below their real cost of capital. So earnings could be growing, but they would be destroying shareholder value, and would eventually damage the stock price.

EVA helps managers set demanding performance targets for the year, and make sound investment/divestment decisions. It can also help to drive a performance mentality throughout the organisation - to middle managers and on to junior staff.

When a company adopts EVA, the stock-market response is usually positive. If properly applied - and combined with good management on all other fronts (strategy, organisation, operating performance) - an EVA approach can make a substantial difference to profitability, return on capital and enterprise value.

Who are EVA's biggest fans?

The US-based consultancy Stern Stewart is the most evangelical - and has trade-marked the initials. Its well-known clients in Europe include Diageo, Siemens and SmithKline Beecham.

On the more general subject of shareholder value, all the leading consultancies (McKinsey, BCG, Bain, most of the big accounting firms) would stake a claim. Marakon was an early specialist, with an approach called 'value-based management' (VBM) - its better-known clients include Coca-Cola and Dow Chemical in the US, and Lloyds TSB and Boots in Europe.

Stern Stewart has defended its EVA trademark aggressively, with ironic results. In 1995 KPMG created a copycat EVM (economic value management) practice, led by a Stern Stewart defector. Stern Stewart sued for breach and theft of trade secrets - but lost the case.

The judge noted that it was hard to prove that EVA was a proprietary concept, and 'no evidence was advanced to show that Stern Stewart embarks upon a client analysis in any defined way different from the methods being used by its competitors'.

Are there any important objections or limitations to the use of EVA?

Not if you agree that management's purpose is to maximise shareholder value.

But there are important debates around practical details - and with EVA the devil is in the detail. For example:

Should expenses (R&D, software development or advertising) be capitalised if they create an asset for the future (products and loyal customers, for instance)?

Shouldn't 'invested capital' be taken as current market/disposal value rather than historical expenditure?

Shouldn't the focus be on cash-flow rather than on net operating profit?

The potential for subjectivity, manipulation and poor decision-making exists with EVA just as with traditional accounting. (For reference, our answers would be: no, yes and yes). And it can become simply a slogan to keep the analysts happy while performance remains mediocre.

One real limitation of EVA is that it works best in practice as a tool for the 'old economy' - mature, low-growth businesses with large tangible assets (such as manufacturing or branch retailing). 'New economy' businesses (software, media or e-commerce) often have few or no tangible assets, high growth and early-year operating losses, making EVA calculations less practical or relevant.

Andrew Wileman is a strategy and organisation consultant; e-mail: wilemanae@aol.com.

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