Nowadays, companies face more complex and challenging changes in the business environment. Johnson et al. (2005: 31) stated that 'Innovation is seen as the ability to "change the rules of the game"'. Thus, it is vital for companies to implement strategies that give them competitive advantages whilst creating value for its stakeholders. New performance measures such as Economic Value Added (EVA), Market Value Added (MVA), and balanced scorecard have been introduced commercially as a tool to support strategic actions, as compared to traditional performance measures. This report evaluates EVA in terms of its role, merits and limitations as a performance measure.
Business Strategy
"Strategy is the direction and scope of an organisation over the long-term: which achieves advantage for the organisation through its configuration of resources within a challenging environment, to meet the needs of markets and to fulfil stakeholder expectations" (Johnson, Scholes and Whittington, 2005: 9).
To develop a strategy, a company needs to first understand its strategic position. Porter's Five Forces Model, introduced by Michael Porter, 'defines an industry's structure and shapes the nature of the competitive interaction within an industry' through identifying the five forces (Porter, 2008) as shown in Figure 1.
Figure 1 Porter's Five Forces Model (Porter 2008)
Once a strategy is implemented, it is vital for companies to keep reviewing and evaluating the strategy to make sure their performance is on the right track using financial and non-financial analysis tools such as EVA, balanced scorecard, Return on investments (ROI) and customer satisfaction etc.
Balanced scorecard is a framework with a set of performance measures based on four perspectives - financial, customer, internal business process, and learning and growth. Interpreting a company' mission and strategy, it can be used in comparing actual performance with target performance (Bhimani et al 2008).
Why Measure Performance?
The idea behind measuring performance is to provide managers some feedback regarding to its strategic implementation and goals, and ultimately to improve the financial performance of the firm.
Economic Value Added
Economic Value Added (EVA), which is a registered trademark of Stern Stewart & Company, shows the true economic profit of a firm by taking the cost of capital (both the cost of debt and equity) away from the net operating profit (NOP) (Grant, 2003; Young and O'Byrne, 2000).
EVA can be expressed as follow:
EVA= NOPAT -[WACC Ã- (TA- CL)] (1)
Where NOPAT = Net Operating Profit after taxes
WACC = Weighted- Average Cost of Capital
TA= Total Assets
CL= Current Liabilities
NOPAT
It is the amount of profit earned from the company's continuous operations and is calculated by deducting taxes from NOP, which can be simply expressed as
NOPAT = NOP ð± (1- tax rate) (2)
WACC
It is calculated by weighing the cost of each capital element proportionately at its market value relative to the company's capital structure, as shown below.
(3)
EVA formula illustrates the two fundamental rules of finance into manager's daily decision-making process. The first one is that all companies should aim to maximise shareholder wealth and the other one is that investor's expectations of future earnings beyond or under the cost of capital determines the value of a company (Houle, 2008). Using EVA as a measurement system enables company to make corporate decisions in favour of its shareholders.
The famous British economist, Alfred Marshall (1890: 142 cited in Grant 2003: 17) defines a business owner's real economic profit as: 'What remains of his profits after deducting interest on his capital at the current rate may be called his earnings of undertaking or management', underlying the fundamental principle of EVA.
EVA vs. Return on Investment (ROI) & Residual Income (RI)
RI takes away the required rate of return for an investment from the operating income while ROI, also called the accounting rate of return, is the profit or loss resulted from an investment in relative to the investment capital. It is calculated as Earnings before interest and taxes (EBIT) divided by the cost of investment (Bhimani et al, 2008: 647). The difference between RI and ROI is that RI is expressed as a value while ROI is a percentage.
ROI concentrates on earnings before interest and taxes and ignore the cost of capital while RI includes the required rate of return but ignores the conservative bias under Generally Accepted Accounting Principles (GAAP). These issues are addresses in EVA. To increase RI and ROI in the short run, managers might take actions that will damage the long run competitiveness of the business such as through cutting down advertising and research. This conflicts with the idea behind EVA of creating value (Bhimani et al, 2008). Moreover, companies using ROI might ignore an investment opportunity that will enhance the firm's value since it damages the current level of return.
Evidence of EVA adoption
Since the launching of EVA in 1989 by Stern Stewart, it has been adopted by over 300 companies worldwide such as Coca-Cola, SPX and Siemens (Young and O'Byrne, 2000). Grant (2003) stated that 'A growing number of financial houses are now using the EVA framework in their company reports, to supplement more traditional analysis. Among them are Goldman Sachs, Credit Suisse First Boston, Morgan Stanley'.
Benefits of EVA
EVA is simple and easy to use and is calculated using solid data instead of projections. Since managers' bonuses are tied to EVA where corporate performance is measured by real economic profit, it associates manager's interests with those of shareholders, breaking down the divergence of interests between them. Under EVA, companies are encouraged to finance their investments through fulfilling the value improvement requests of investors. EVA is adaptable not only on the top level of management but also on the divisional level (Grant, 2003). EVA shifts the manager's attention to managing assets, allocating resources, and structuring capital. According to Brabazon and Sweeney (1998 cited in Abdeen and Haight, 2001), there is 'a strong correlation exists between it and the share market value of the related company'. This emphasizes the main goal of EVA to create value for the firm.
EVA: a perfect performance measure?
EVA takes account of the cost of capital at all levels and differs from cash flow analysis due to the fact that it is not based on predictions. Adopting EVA as a measurement tool and compensation system discourages managers from over-investing on capital to maximise the firm's net income even though the return on that investment is less than the opportunity cost of capital. As a result, EVA helps to protect the firm's value.
The comprehensiveness of EVA is damaged by interdependence when decisions and actions made by one sub-unit will have influences on other sub-units, creating externalities. Since the value created by a joint project cannot be fully reflected in EVA, it weakens the motivations to search joint efforts but encourage managers to pursue projects that benefit themselves. However, this problem is not narrowed only to EVA but also other profitability measures. One solution is to emphasise joint EVA, but at the expense of shifting manager's attention on searching for opportunities at their own level. Another solution would be having a senior manager to be responsible for projects opportunity but comes at the expense of processing information and obtaining local knowledge.
Some argue that value creation is the unique point of EVA, but Easton et al. (1992) proved it to be wrong, stating that accounting earnings and market value are linked, at least in the long run, with his study showing "over a return period of ten years, earnings explain more than 60 % of the variance in market return" (Bouwens and Spekle, 2007: 257).
Successful and Unsuccessful Users
EVA can act as a tool for changing managerial behaviour in term of mind-sets. Incorporating value creation into their operations involves mutual acceptance and understanding among all managers, not only on the importance of value creation but also the underlying financial concepts (Young and O'Byrne, 2000).
The extent of benefits EVA offers to a company depends on its organisational structure, as shown in Table 1.
Successful Users
Unsuccessful Users
Autonomous business units
One large business unit
Matrix organisation
Substantial shared resources
Strong managerial wealth incentives tied to business unit performance
Excessive emphasis on stock options
Discretionary approach to compensation
CEO is an enthusiastic advocate
CEO doesn't realize what he/she signed up for
Business unit heads stay put
Short job tenure for business unit heads
Table 1: A Profile for Successful and Unsuccessful users of EVA (Young and O'Byrne, 2000)
From Table 2, it is fair to say that companies with different organisational structure will benefit from EVA to a different degree.
A successful case study to illustrate this is SPX. Since the new CEO John Blystone in charge of SPX in 1995, the firm has been experiencing improvements due to the adoption of EVA, with an EVA of $130 million in 1999 up from -$50 million in 1995. This success was mainly due to setting EVA as value-based business culture in all main management process and systems and having firm compensation system tying manager bonuses to EVA targets motivated managers to maximise EVA (Young and O'Byrne 2000).
As a result, adopting EVA is the first step, but it is necessary for employees across all levels to put value creation as their ultimate goal and feel motivated in carrying out this culture. Stern et al. (2001) states that 'without question, the attitude of the chief executive is the primary determinant of the success or failure of the program', again reinforce the importance of attitudes within the firm, especially of higher level since they have great authority on decision-making.
However, Hogan and Lewis (1999 cited in Bouwens and Spekle, 2007: 263) suggested that the huge improvement in the operating performance for underperforming firms after adopting EVA is because of the efforts in strengthening the relationship between bonuses and performance and thus the rising popularity of EVA in recent years is due to impressive marketing rather than providing new ways for managerial motivation. From this study, it is fair to say that EVA has no superiority over traditional performance measure. However, it is argued that this study only concentrates on operating performance and ignore the ultimate aim of EVA, which is value creation (Bouwens and Spekle, 2007).
Conclusion
EVA is not a fairly new concept as it is what economists named as economic profit. The accounting adjustments make it more complex as a measurement tool and might deter companies from taking the full usage due to lack of specific accounting knowledge. The limitations of EVA in terms of decentralisation and interdependence needs to be taken into account by companies in determining appropriate measure for their performance. There is a mixed controversy in terms of the effectiveness of EVA in measuring performance. In my opinion, EVA can be used as a value creation tool alongside with traditional performance measures to give a whole picture of the firm's situation. Also, ongoing research is required to demonstrate the usage of EVA recently.
