Stern Stewart & Co believes they have the answer: EVA, or economic value added, is the proprietary tool they have developed to end inefficient use of capital. The crux of EVA is to effectively put a cost to equity capital and make it a pre-tax charge while calculating returns. In effect, a company is said to be EVA-positive as long as its net operating profit after tax (Nopat) is higher than the cost of the capital.
Says Tejpavan Gandhok, managing director of Stern Stewart India: "If you seek to maximise EVA in the long run, the fundamental performance of the business improves. Capital efficiency will improve because there is a more explicit capital charge; the capital structure will be more optimal because there is greater awareness of the cost of equity. People will be much more bottomline conscious - and conscious about sustainable results - because their own incentives are tied to getting a part of the action."
Many companies are beginning to be convinced. The Godrej Soaps group of six companies, headed by Adi and Nadir Godrej, is of them. The group's experience in just one year: four of the six companies have outperformed on stretch targets, and most employees are awaiting huge bonus payouts. As EVA aligns employee goals with shareholder interests, flagship Godrej Consumer Products has been busy handing over dividends hand over fist and buying back shares to bring down the cost of capital.
Tata Consultancy Services has put almost all its 15,000-plus employees into EVA-linked variable pay under which performance above EVA targets fetches you bonuses every year. The only employees excluded are entry-level employees who are yet to complete a year in service, says S Mahalingam, executive vice-president of TCS, and the main spearhead for the EVA initiative in the organisation.
Others have customised EVA for their own purposes. Marico Industries, makers of Parachute coconut oil, has worked out a simplified version of EVA (styled Seva) but uses it more as a signalling device to tell people that capital is important, that investments and acquisitions must have a justification in terms of shareholder value. At Infosys, EVA is used as a tool to calculate the value delivered to customers. Infosys reasons that if it can tell its customers that what it is delivering in terms of value is higher than what the customer pays Infosys for the service, the customer will be less worried about price alone.
Pharma major Dr Reddy's Laboratories does not use EVA as a measuring device to reward performance. However, it uses EVA as a qualifying criterion for granting performance-based rewards such as variable pay, performance bonuses and stock options (ESOPs), says Saumen Chakrabarthy, senior vice-president (HR). "We use EVA as a qualifying criterion for the grant of ESOPs. Maximising EVA is the basic objective of a business," says Chakrabarthy.
Other companies acknowledge the existence of EVA, but go no further. Hindustan Lever and Satyam Computer are two such companies. Satyam has estimated it's EVA for the year ended March 2002 at Rs 170.11 crore, which is marginally higher than the Rs 167.42 crore value added during the previous year. Some companies feel that they can do without EVA, thank you. Says TVS Motors President C P Raman: "TVS Motors does not use EVA as a measuring device to reward performers. But we have introduced variable pay for senior managers which is based on the targets for the company and that of individuals."
CALCULATING EVA
Internationally, multinationals like Coca-Cola, Siemens, Bausch & Lomb and Dun & Bradstreet have been sold on EVA for long. Back home, though, EVA's allure is less than captivating primarily because it is a difficult animal to understand. Most companies probably can't make it effective on their own. It begins by looking simple, but as you get deeper into it the calculations begin to look daunting. EVA is defined as a company's net operating profit after tax (Nopat) minus the weighted average cost of capital (WACC). Nopat is a no-brainer, and the cost of debt (the interest rate) is simple to understand. So far, so good.
But try calculating the cost of equity. The real cost of equity is the expected return on it, after working in the risk premium. Clearly, it has to earn more than debt, or else shareholders wouldn't be investing in it. So you have to add the risk premium to the equity part of capital. But this premium would again depend on the kind of industry you are in: if you run a pharma business, the risk premium may be higher than if you were running a cement business.
IMPLEMENTING EVA
When a company decides to adopt EVA as a corporate performance measure, here is what it must do:
Step 1: Run an EVA analysis of the company, its publicly traded peers and business units
Step 2: Draw up a definition of EVA that is simple and meets the company's information needs, existing accounting data, organisation and management
Step 3: Work out a compensation scheme that fits into the company's business and culture. The incentive plan has to marry the EVA design with traditional concerns of shareholders and directors
Step 4: Train all employees on the basics of EVA and how it affects shareholder value
Step 5: Demonstrate the difference between EVA-led decisions vis-à-vis conventional methods through computer simulation exercises
Then again, if you make investments in R&D, you can't just write it off in one year. That way, a CEO seeking to maximise EVA will just avoid spending on R&D during his watch since this will push up his costs. To avoid this, the EVA-ngelists make adjustments by treating spending on R&D or training as capital expenditure which should be amortised over the anticipated period of its useful life.
And that's just for starters, when you are trying to calculate EVA for the whole company. But try cascading EVA targets to divisions, business units and individuals, and you could have a nightmare on your hands. Says S Venkatesh, associate professor, finance and control, at the Indian Institute of Management, Bangalore: "A typical EVA implementation adds a large amount to confusion in terms of accounting adjustments, the definition of business units for which EVA would be measured, the bonus plan, the bonus bank, etc.".
EVA SCORECARD - What'S HOT, WHAT'S NOT
EVA positives
* No ceiling on the amount managers can take home as incentive pay
* Managers think like, act like and are paid like owners.
* Targets are set over a time horizon that is more than one year - usually three to five years - forcing a long-term view into managerial decision-making
* Cuts capital cost and inculcates financial discipline among employees
* Increasing EVA directly benefits the shareholder and has been found to have a positive influence on a company's stock price
EVA negatives
* Involves lots of complexity. Globally, Stern Stewart is said, in some cases, to make as many as 165 adjustments to work out the weighted average capital cost of companies
* Works better at the individual level than team level, unless goals are appropriately structured.
* May make companies risk-averse. New investments that look risky or difficult to quantify in terms of expected payback may never be made using EVA.
On the key to making EVA successful.
For successful implementation of EVA, top management commitment, patience and perseverance to see through a complex implementation process is important. TCS is going through this. Failure of implementation is hard to define. Some large software companies publish EVA in their annual reports. They do not allow EVA to influence any decisions internally. For such companies there is no question of any failure.
