UK: EVA FEVER. - Economic value added may be the flavour of the month, yet little has been made of its implications for corporate debt.

by Alistair Blair.
Last Updated: 31 Aug 2010

Economic value added may be the flavour of the month, yet little has been made of its implications for corporate debt.

'How do you know a company is doing well?' asked the Financial Times's Lex column in May. Too cool explicitly to endorse EVA, still less the hypercharged claims made on its behalf, Lex did deign to make an approving implicit nod in the direction of economic value added: 'a useful tool in the shareholder's kit bag. The more it is used, the better capitalism will work,' it said of ROI, which it acknowledged to be the starting point for EVA.

According to its chief promoters, New York consultants, Stern Stewart, EVA is your net operating profit after tax less your cost of capital.

But don't rush to get your calculator out; you may need to make up to 164 adjustments to your audited figures before you'll have either component of the equation.

EVA also stands for another kind of bonus system. A crucial aspect of EVA, says Stern Stewart and its clients, who include Coca-Cola, AT&T, LucasVarity and Burton Group, is that it should be used to determine pay throughout the company. They present EVA as a lubricating agent that's meant to be used by everyone in the company on a day-to-day basis. It should move them off their traditional - and traditionally conflicting - fixations; the sales force off sales, the production director off output, the chief executive off earnings per share, and get them all focused on the same measuring rod, the one that really translates straight into shareholder wealth ... EVA. Once everyone's focused on EVA, everyone can be paid on it too, from the caretaker upwards.

A lot of the commentary on EVA has centred on some surprising estimates it has made about true profits. Williams Holdings, the engineering conglomerate, may be a bit stodgier these days than when Nigel Rudd and Brian McGowan were building it up, but it is still a pretty sensible company, isn't it? Not so, according to analysts at NatWest Markets. In 1995, its EVA was minus £41 million on capital of £2.3 billion. Puzzlingly, only a few months before, Stern Stewart had arrived at a positive EVA for Williams against capital of £1.4 billion.

Confusions like these abound even if the province is left to Stern Stewart itself. Alongside EVA, the firm attaches great significance to calculating and publicising MVA, or market value added.

This cousin of EVA purports to show how much wealth a firm has created or destroyed since the day it was set up. It throws up some spectacular numbers (ICI, it appears, has solemnly destroyed £3 billion since it was set up in the 1920s), but little of significance. An MVA includes years old and now irrelevant gains and losses aggregated on a pound-for-pound basis with last year's results and today's hope or despair, as expressed in the share price. Surely, what we are interested in is current performance, or if we're going to be determinedly historic, performance since the current top management team got its hands on the controls. And it is difficult to fathom why Stern Stewart should calculate British Telecom's MVA in 1993 as £46 billion, and in 1995 as only £6 billion.

However, enough of this negativism. Although the aggressive marketing of EVA hypes it into absurdity from time to time, the underlying themes are not to be dismissed. If they were, Stern Stewart would not have attracted 250 clients and expanded eightfold in the last three years. And one of EVA's most thought-provoking themes is debt. The rush to appraise the merits of the new financial tool has so far paid little attention to this aspect.

'Some say I like debt more than I like sex. That is untrue, although I do like debt very much,' says Bennett Stewart, senior partner of the New York consultancy and EVA's co-author. Certainly, Stewart's book, The Quest for Value, is an impressive volume. Running to 700 pages, it sets out EVA and its application in persuasive and surprisingly readable detail.

Almost 300 of those pages are devoted to debt, and why it should be high.

Recent converts to EVA, including Burton Group and small engineer BWI (formerly Barry Wehmiller International), may be contemplating massive changes to their financing structures if they're going to take on board the full Stern Stewart philosophy. Unilever's new co-chairman, Niall Fitz-Gerald, although not known to be a Stern Stewart client, was recently heard to endorse EVA. If he imbibes the full glass, the consequences will be momentous.

The virtues of debt finance are implicit in EVA's basic formula. The cost of capital it uses is the weighted cost. That's the cost of your debt plus the cost of equity times their relative proportions in your balance sheet. Debt, as long as you use it sensibly, is in almost all cases cheaper than equity. That's partly because the interest on debt is tax deductible, whereas dividends are not. So debt costs you 7% or 8% less the corporate tax rate of 33%, say 5%.

But your dividend costs only 2% or 3%, when divided into your share price? Don't kid yourself. That's only because investors expect your share price to rise. If they didn't, you'd be paying plenty more. Look through the share price pages.

There are plenty of companies whose dividend yields are 6%, 7%, 9% even.

Why? Because, correctly or not, investors don't expect much share price appreciation. It's quid pro quo: dividend yield or price appreciation.

It varies from industry to industry and from time to time, but, by and large, your cost of equity, taking dividend and expected share price appreciation together, is unlikely to be much short of double figures. And that's not a Stern Stewart estimate, but a pretty widely accepted number. Remember too that if interest rates rise, so will shareholders' expectation of what constitutes a reasonable reward for the risks they are taking with their capital.

So you can see the virtues of debt. Unless you're a cash-burning drug or technology company, the first pound of debt will always be cheaper to service than your equity. The second pound, too.

And so on, for a very long way. You should therefore have lots of debt.

More or less up to the point where the market decides you might default and makes you pay a higher rate of interest to compensate. So how much is that?

Stewart sets out a conventional answer as well as his preferred, aggressive, one. To get at the first, think about bond ratings: triple A, double A, investment grades, junk grades (which start at double B) and all that. Those who follow such things may think of triple A as the proud mark of a firm which is considered almost as good a risk as the Government itself. Something to aspire to. Without being quite so blunt, Stewart in effect says that's nonsense. In his view, the normally coveted triple A is an expensive luxury that does not serve shareholders' interests (unless the firm has a pressing need for new capital, in which case it should anyway look to equity, not debt). Although the triple A borrower pays less for the company's debt, the benefit is outweighed by the fact that the firm does not use enough of it. Stewart points out that a triple B borrower pays at most 2% more for debt than a triple A, and that's still cheaper than equity. Says Stewart, the amount you should borrow is however much will reduce your rating to, say, borderline single A. That still leaves you with the flexibility to raise more debt on investment grade terms should you happen to need it.

And when you've got there, he says, then stay there. Don't regard debt as something to be raised when you want to finance a new project and paid down afterwards. Tell the market that your preferred debt:equity ratio is x, and keep it there. When you have spare cash, pay a special dividend or buy in your shares. At all events, do not spend spare cash on an acquisition simply as a way of using it up. Acquisitions may be fine, but make them purely on their own merits, not as a means of addressing an excess of cash. When you need cash, raise debt and equity in the proportions that will maintain your precious ratio.

Stewart suggests that a reasonably stable business of top FTSE-100 stature should be over 100% geared. In roundish terms, that would seem to suggest that Unilever, currently a triple A borrower with about 40% gearing, should raise around £1.5 billion of debt and use it to buy in an equivalent amount of equity. That would give the markets something to chew on. And even if you're not in the bond-issuing and rating class, the message is clear. Debt is good, and more is better. Here's a taste of Stewart's second, preferred, answer to the debt question. If 'like Ulysses lashed to the mast', management lashes itself to its debts, the consequences are, he says, 'magical'. Operating profits are sheltered from tax to the extent of the cost of debt; 'the risk of an unproductive reinvestment is eliminated' because cash flow is largely dedicated to debt service; and management and employees get a far greater incentive to perform well, encountering obvious penalties for failure.

Do the clients buy it? According to Scott Olsen at Stern Stewart, 'There's the theoretical side and the practical side. We've really only had one example of a client buying fully into our debt philosophy, and that was Equifax (a US consumer credit rating firm which underwent a thorough-going renaissance in the early '90s). But Coca-Cola, our first client, moved to substantially higher levels of debt after it adopted EVA, even if not going right up to Bennett Stewart's frontiers. The debt side is really a theme of our implementation - it's not the central thrust. Most clients confirm to us that they see the debt argument. It's something they might move to over time.'

Mike Ashton, finance director of BWI, has spent much of the last year implementing EVA. 'It's not rocket science,' he says, 'but it is a good lingua franca that does indeed get everyone back to basics, makes them understand better the cash consequences of their own actions and, further, makes them address other departments' problems, not just their own. Within each of our businesses we don't incentivise, for example, the sales director on sales and we don't incentivise the finance director on cash generation. The whole management team is incentivised on EVA and that means they are all pulling in the same direction and have to liaise better.

'Do we buy fully Stern Stewart's debt philosophy? I'll tell you that looking at EVA seriously is certainly a stern and valuable reminder that equity isn't cheap. At the moment we have zero gearing and that's inefficient.

You won't see us moving up to 100%, however. In any case, taking in the trading characteristics of our business, Stern Stewart wouldn't advocate that. But we may take ourselves to somewhere in the region of 30% to 40% and certainly doing acquisitions for cash is a very strong preference.

Assuming EVA continues to settle in well here, we regard it as a valuable tool towards maximising shareholder value over the medium term.'

At Burton Group, Martin Clifford-King, the EVA project controller, says, 'We've been running EVA for just the first 12 weeks of our financial year.

We see it as an operational tool. In the past, stores used to be targeted on sales, then we moved to profit, and EVA is a further refinement of this approach, taking into account the cost of the capital tied up in the business.

'The debt side is less important to us. Our main use of EVA is not to reduce our weighted average cost of capital. At our year end we were 12% geared, but accounting convention ignores our property leases. Add those in and it's as if we were servicing more like £1 billion worth of debt against our market capitalisation of £2.2 billion.'

While the logic of Stern Stewart's debt argument may be devastating in theory, Clifford-King's reaction seems to reflect the views of those who are well acquainted with both the vagaries of business and the faddishness surrounding financial controls. Such veterans, while admitting the strength behind the case for debt, prefer to keep a certain distance between themselves and the knife-edge risk:reward strategy theorists recommend.

Calculating the Cost of Equity - Easy if you know your alpha and beta and beta.

Remember beta? The cost of equity is a favourite topic in business schools but gets less exposure outside. The starting point is the difference between long-term returns on equities and government debt. In Quest for Value, Bennett Stewart, senior partner with Stern Stewart and EVA's co-author, puts $1, in 1925, into US Treasury bonds and into the S&P 500. By 1988, the dollar in bonds turns into $17.30, the dollar in equities into $534. In other words, the bonds returned 4.5% annually, the equity $10.3%.

Higher risk, higher return

Why the gap? Because every few years, lenders would have lost some money in bonds, but in equities, there were numerous occasions when investors would have lost a lot. For shouldering that risk, equity investors extract a higher return.

Where that gets us to is that at any particular point, investors expect equities on average to earn whatever is on offer from government bonds, plus the market risk premium. In the UK that's reckoned to be around 8%.

Beta's part in the equation

To calculate your individual company's cost of capital, you need to work out how its shares performed against the market's, over the last five years or so. Using fancy mathematics, this may be broken down into two chief components, known as alpha and beta.

Alpha measures whether you went up or down against the market. Alphas are rarely stable from one five-year period to the next. But betas are. Beta measures how your shares swing compared with the market. The market's beta is 1. A beta of 1.2 means that if the market moves x%, whether up or down, your shares move by 1.2 times x. Betas range between 0.5 and 2. Beta is a crucial component in your cost of capital.

You don't have to work it out yourself. The London Business School's Beta Book is all you need, or REFS, Jim Slater's monthly share guide, or research from any good stockbroker. Burton's beta in REFS, for example, is 0.92. Once you've got your beta, just multiply it by the market risk premium and add the answer to the current expected return on government debt. There's your cost of equity.

Figures forever changing

So, with a current risk-free rate of around 3% (above inflation) and a market risk premium of 8%, Burton's cost of equity is 3 + (0.92 x 8) = 10.36% plus inflation.

Simple, isn't it? Trouble is, betas and the market risk premium are forever changing, and no one genuinely knows what they are at a given point. Not to mention that there are competing methods of calculation. As calculated by BZW, Burton's beta is 1.95.

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