The ultimate goal of companies has always been defined as maximising profit. Nowadays, with the increase of institutional investors especially those holding shares of companies listed on the stock exchange, the notion of 'value creation for the shareholders' gained importance. It generated several metrics mainly based on traditional accounting rules such as return on investment (ROI) in order to assess corporate performance.
'Economic Value Added' was a reaction to the distortions of many of these indicators. It aims to recover the limit of net income and many other accounting indicators such as the earnings before interest and taxes (EBIT), the added value or the cash flows. This objective was particularly highlighted in order to limit the manipulation of these metrics to the financial detriment of the stakeholders. This issue became fundamental especially after the sudden decline of credibility due to the series of scandals such as Enron and Xerox.
This essay will centre around three main parts. We will first define the EVA concept and investigate its value-relevance. Then, we will review the debates over the benefits of this indicator as a means of establishing corporate performance before examining the limitations of this metric.
Economic Value Added is a financial performance metric created in 1994 by the consulting firm Stern Stewart & company. However, this notion has been already explored in the 19th century by Alfred Marshall who said: 'there is no profit unless you earn the cost of capital' (Marshall, 1896). He explained the profit by being 'the residual income' that compensates the capital invested by the owner and his managerial effort that he called the 'business power'. Later, McKinsey suggested an approach of measurement of performance and value creation.
The EVA is based on the notion of value creation for shareholders. It aims to identify successful firms through their earnings compared to the cost of resources necessary to their functioning. Simply stated, EVA is the difference between the Operating profit after tax (NOPAT) and the capital charge. This charge corresponds to the weighting of the Debt and Equity by the overall cost of financing of a company which is the Weighted Average Cost of Capital. Using an operating approach, it can be formalised in this way:
EVA = Operating profit after tax (NOPAT) - (Investment in Assets * WACC) When the NOPAT is higher than the capital charge we obtain a positive EVA, it indicates that value is created. Symmetrically, when EVA is negative, the value is destroyed. EVA is not only a tool of calculation. It is the crossing of a strategy which consists in value creation and a technique which tries to assess firms.
Stern Stewart states that firms that implement EVA surpass their rivals in terms of performance. This advantage is due to many benefits of this metric compared to the traditional ones.
In fact, it integrates the weighted average cost of capital (WACC) that is based on Equity and Debt, the two sources of financing of a firm (Prober, 2000). Every company has to generate enough liquidity in order to cover the Debt cost and the opportunity cost of equity before thinking about 'value creation'. It increases managers awareness of the real cost in the balance sheet.
Moreover, traditional metrics are focused on the past while EVA integrates the cost of capital which depends on the risk determined by the market. Market parameters are based
on agents' anticipations about the future risks. Thus, EVA goes over the technicality of the tool and deals with the strategy of the value.
By calculating EVA as the difference between NOPAT and the charge of capital, we exclude the fiscal cost. The use of after-tax figures aims to identify the value creation or destruction, especially because value is a notion that has more sense after tax.
The opponents to EVA display the argument of its distortions. In fact, the first term of its equation, the NOPAT, is subject to some accounting distortions. However, according to Stern Stuart, they can be corrected thanks to 160+ potential adjustments and only some of them are exploited by companies. These distortions are usually linked to Research and Development (R&D), amortisation of goodwill, LIFO reserve, differed taxes or unusual profits and losses.
Indeed, R&D expenses may illustrate these adjustments. EVA integrates them in the balance sheet, they are capitalised and amortised during their useful life unlike the Generally Accepted Accounting Principles' (GAAP) treatment (Prober, 2000). It is important to specify that in order to calculate EVA, we apply an economic amortisation that reflects more the use of the asset instead of amortising on a linear basis. In the same vein, Stern Stuart suggests to use a 'modified depreciation schedule' in order to avoid an increase of EVA due to the ageing of assets (www.evanomics.com). Thus, a more accurate economic view of the company is achieved. This contribution is valuable as it breaks up with the traditional accounting approach of GAAP and aligns with the economic perspective of the International Financial Reporting Standards (IFRS) which are based on "fair value".
By decreasing these accounting distortions, EVA leads to a harmonisation and a comparability of the measures among international companies (Mayfield, 1997). On one hand, being able to confront its corporate performance with those of its competitors is one of the best ways for a firm to identify its weaknesses and improve its performance. However, the perimeter of this comparison must be defined. It has to include competitors given that they assume the same risk. On the other hand, the EVA has also the benefit of assessing the corporate performance at a divisional scale. Therefore, it improves business unit performance. In fact, every firm aims to identify its most productive divisions and the internal divisions compete in order to achieve the highest result. EVA is implemented within firms in order to point out which division creates more value and which one destroys it. Indirectly, managers are also appraised through this process. Consequently, every single individual have an incentive to work harder in order to improve the company's performance.
We have seen that EVA breaks with the accounting biased metric such as net income that create a conflict between shareholders' and managers interest. One of EVA's predecessors is the Return On Investment (ROI). By contrasting these two indicators, we will highlight some benefits of EVA. ROI is the quotient of Operating Income After Tax and Invested capital (ROI = Operating Income after tax/Invested capital). The compensation of the managers can be solely based on this indicator. Consequently, they act as self-interested individuals and make decisions that benefit them regardless of the interest of shareholders and the company as a whole. Moreover, it deprives the company of attractive opportunities of investment and innovation as managers tend to select only projects with the highest ROI compared to the cost of capital. This divergence of interest between managers and shareholders is solved by the EVA. Indeed, EVA integrates the cost of capital. Consequently, any investment having a positive EVA will be considered favourable. Thus, EVA conciliates the objectives of shareholders and managers and can therefore be considered as a tool of internal cohesion (Brewer, C.P., Chandra, G. & Hock, A.C., 1999).
Some companies have chosen to implement 'EVA-based compensation plans' that enable to assess and reward managers by indexing their wages to the realised EVA. The reward is considered fair as long as it is based on economic performance. This is a strong incentive that motivates them to work more efficiently in order to increase the firm's results and hence their compensation. However, this plan can be beneficial only if employees adhere to its objectives by understanding how their results are assessed based on the EVA (Prober, 2000).
Beyond the wages, allocation of bonuses can also be associated with the EVA through an 'EVA-bonus system'. Stewart Stern recommends delaying the payment of a part of these bonuses according to the long-term success of the project. This measure can promote long-term executives' devotion to achieve corporate objectives. It also neutralises the fluctuations of performance over time. Hence, EVA gains a practical dimension in addition to its theoretical contribution (Prober, 2000).
A part from its operating definition, EVA can be also associated to another financial indicator which is Market Value Added (MVA). MVA is the difference between the market value of a company and the capital invested. It can be also seen as the net present value (NPV) of the expected EVA (Weaver, 2006).
Under conditions of efficient markets, the benefit from this method is the fact that any project having a positive NPV - and hence a positive EVA- will increase the MVA of the firm. Consequently, the Market value of the company _which is the Book Value of Equity plus the present value of future EVA_ will also increase. Given that the main purpose of a firm is to create value and to maximise the shareholders' wealth, we can conclude that EVA serves the shareholders' interests and makes them converge with those of the managers. Moreover, according to Stewart Stern & Co, the managers 'can be assessed on EVA with confidence that their actions should lead to wealth creation' (Weaver, 2006). Thanks to the correlation of these two metrics, we can establish a relationship between the EVA and the stock price. The case of the giant Briggs & Stratton, the world's largest producer of air-cooled gasoline engines, can illustrate this idea. Before implementing EVA,
all its profit centres had a return on capital smaller than the cost of capital. Starting from its application, the company 'has been able to identify the below-par performers and has subsequently chosen to outsource their production. The stock market is applauding Brigg' efforts: in 1990 the stock price was 20$/share and in 1995 it neared 80$/share' (Lewis, 1995).
However, many limits of EVA as a means to establish corporate performance can be raised.
The EVA has the advantage of taking equity into account through the WACC that proportionately weights Debt and Equity by their respective costs. However, companies calculate the rate of equity using different approaches. The most common is the 'Capital Asset Pricing Model' (CAPM) especially for companies that are not listed on the stock exchange. The alternatives are numerous. Among them, Bennett Stewart proposes historical approach stating that investors receive an average of 6% premium as a return on stocks compared to long-term government bonds. By increasing the rate of these bonds by 6%, we obtain the cost of equity rate. Thus, depending on the method used, the cost of equity obtained will change leading to different EVAs. Consequently, these gaps make it difficult to establish relevant cross-company comparisons.
Although EVA eliminates the distortions of accounting metrics, the applied adjustments may remain very subjective. It would be useful to have a separate committee that intervenes to indicate whether these corrections are practically needed or not, especially in extraordinary situations. France Télécom, illustrates an aspect of the consequences of a mistake in adjusting provisions. The company was in the second position in the classification of wealth creation in France in 1999. But Bodie and Merton (2001) state that after correction, France Télécom was the 188th. Nevertheless, numerous investors were based on this classification. Thus, these adjustments aim to reflect the economic reality by getting closer to market values. However, when they are applied in a wrong way, the consequences can be dramatic for the economy as a whole.
Given that the EVA relies on accounting indicators, managers can manipulate these numbers by altering their decision making process (Hongren, et al., 1997). For instance, by reducing discretionary expenses such as training for employees, the expenses will decrease and EVA will be pushed up. However, such action would have a negative impact on workers' commitment and satisfaction which can negatively impact the company's performance. Another aspect of these damaging cost-cuttings is the custody of depreciated assets. Thus, the amortisation expenses are eliminated and the EVA increased. Nevertheless, the product quality is deteriorated and the consumer satisfaction is affected. Consequently, these actions can deter the corporate welfare and harm the relationship of the company towards its stakeholders who can perceive these practices as unethical behaviour.
Moreover, the EVA-based compensation plans can also encourage managers to manipulate the figures. Thus, they avoid to be penalized because of the performance reflected by EVA.
These plans can change dramatically the organisational management of companies and create a social gap between those paid on EVA basis and those who are not.
As discussed earlier, one of the advantages of EVA is that it selects any project that has a positive EVA. However, the managers may be confronted to a dilemma. They can decide to choose the innovative projects with long-term benefits for the company as a whole. But they will penalize themselves because these initiations involve high costs in the short term and hence a lower EVA. If they are paid according to their realisations in term of EVA, they will suffer from an insignificant pay-raise or even be deprived of a promotion. Usually, the adoption of EVA leads them to favour short term investment that reflects quickly the return.
Nevertheless, centring the debate only on the shareholders ignores the employees who are also central actors of the value creation process. Companies often have difficulties in inculcating them this value creation culture, even when it is introduced to them as an element of their compensation. Usually, the employee feels this pressure exercised by the value less as an incentive and more as a threat. Michelin illustrates this idea: the concomitance often observed between growth of the EVA and staff-cuts led the company to strengthen its attentiveness on this point.
Another point that has to be highlighted is the fact that EVA can also be seen as a degrading factor of the corporate performance as it does not take into account the size of businesses. Let's take the example of two independent divisions in the same company. By using a WACC equal to 10%, we obtain the following results in terms of ROI and EVA.
We notice that Division A has the highest EVA. Division B has the highest ROI but if it had been attributed an equal investment amount (7500000) as A, it would have obtained an operating income equal to 1425000 (Investment * ROI = 7500000 * 19%) which is higher than the A Division's income. De facto, EVA does not consider the size differences between companies' divisions while ROI does. Nevertheless, this limit can be overcome by calculating the quotient of EVA on investment (EVA/ Investment) or by comparing the differential between ROI and the Weighted Average Cost of Capital for the two divisions.
Nowadays, a company needs more than one financial indicator to measure its performance.
Using only EVA will not provide the managers with sufficient information. That is why Kaplan and Norton created a 'balanced scorecard' in 1996. Indeed, it is a framework with four perspectives that integrates features of sustainable success. They suggest the 'financial', 'the customer', 'the internal business process' and 'the learning and growth'. In fact, EVA does not incorporate a non financial dimension. By neglecting the environment and the stakeholders, how can a firm create value? Thanks to the proposition of Kaplan and Norton, these considerations can be taken into account. Thus, the company should adopt a strategic approach of value creation in the long term. This explains why policies of corporate responsibility and sustainable development gain more importance today. They are now among the keys of success for corporations.
Eventually, Economic Value Added is a means of assessing corporate performance and a tool to monitor it as well. This essay attempts to define the concept of EVA. It explores its origins and explains its calculation in order to approach critically its benefits and its limitations. Hence, EVA can contribute to the well-being of a company, it can also participate to its decline.
Many companies reward their managers based on EVA-compensation plans. These agents can use EVA to emit wrong signal on the market. These manoeuvres can be emphasized when they detain stock options for instance. It is the managers' responsibility to handle this tool with precaution in order to preserve the well-being of the market. By using this metric ethically, transparent information is provided to the stakeholders.
Moreover, the EVA has to be used concomitantly with non-financial indicators. In fact, these considerations gain importance in a context where intangible assets such as brands or goodwill contribute to the wealth of the firm.
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