EVA Does It Really Work?

Howard Cook could hardly wait to get back to his corporate headquarters in Philadelphia, Pennsylvania, and share all the useful information that he had gathered on performance evaluation with his colleagues in the finance department. Howard was vice president of finance at Steadfast Manufacturing Company, a small firm with annual sales ranging from $4.5-5 million. The president of the company, Joe Mathis, had recently heard about the effectiveness of the economic value added (EVA) measure of corporate performance at an executive summit and was interested in exploring its use for Steadfast Manufacturing. He asked Howard to attend a two-day workshop entitled EVA It Really Works! hosted by Stern, Stewart, and Company at their headquarters in New York City. Howard had been impressed by the quality of the presentations put on by the staff of Stern, Stewart, and Company. One brochure in particular, he thought, summarized it all very well (see Exhibit 1). The list of companies that had adopted EVA as an evaluation measure was growing by leaps and bounds (see Exhibit 2). Furthermore, the empirical evidence linking the EVA performance yardstick with shareholder wealth creation was quite striking. One study on 66 of Stern, Stewarts clients reported that: On average, investments in the shares of these companies produced 49% more wealth after five years than equal investments in shares of competitors with similar market capitalization. Companies that used the full Stern, Stewart compensation architecture did even better. Investment in their shares produced 84% more wealth over five years than equal investments in their competitors. Overall, the Stern Stewart clients created some $116 billion more in market value than they would have if they had performed the same as their competitors. (Stern, Stewart & Co.) This finding, thought Howard, would be of particular interest to corporate headquarters, since plans were in the offing for taking the company public. He figured that he had better prepare an outline for the finance staff to use when calculating the firms EVA (see Exhibit 3). Howard knew that once the necessary financial details were worked out, the calculations would be easy to follow. He realized that, because it was a small company, many of the adjustments suggested by Stern, Stewart, & Company would not apply to Steadfast Manufacturing. What would apply, though, would be the adjustment of $45,000 in 2014 and $50,000 in 2015 paid as salaries to the owners as part of net operating profits before taxes, rather than as an expenditure, since it was an investment in the future of the firm. Howard glanced over the steps necessary to calculate EVA, which he had jotted down, and then at the latest annual financial statements of Steadfast Manufacturing (see Tables 1and 2). He realized that he would need to gather some more specific information before he could come up with a reasonably accurate measure of Steadfast Manufacturing Companys EVA. He decided that he would wait till he was back in Philadelphia.

Exhibit 1 -What Is EVA?**

Economic value added is the financial performance measure that comes closer than any other to capturing the true economic profit of an enterprise. EVA also is the performance measure most directly linked to the creation of shareholder wealth over time. Stern, Stewart, & Co. guides client companies through the implementation of a complete EVA-based financial management and incentive compensation system that gives managers superior informationand superior motivationto make decisions that will create the greatest shareholder wealth in any publicly owned or private enterprise.

EVA = Net Operating Profits After Taxes ($Capital Cost of Capital%)

Put simply, EVA is net operating profit minus an appropriate charge for the opportunity cost of all capital invested in an enterprise. As such, it is an estimate of true economic profit, or the amount by which earnings exceed or fall short of the required minimum rate of return that shareholders and lenders could get by investing in other securities of comparable risk.

Profits the way shareholders count them

The capital charge is the most distinctive and important aspect of EVA. Under conventional accounting, most companies appear profitable but many in fact are not. As Peter Drucker put the matter in a Harvard Business Review article, Until a business returns a profit that is greater than its cost of capital, it operates at a loss. Never mind that it pays taxes as if it had a genuine profit. The enterprise still returns less to the economy than it devours in resources . . . Until then it does not create wealth; it destroys it. EVA corrects this error by explicitly recognizing that when managers employ capital they must pay for it, just as if it were a wage.

By taking all capital costs into account, including the cost of equity, EVA shows the dollar amount of wealth a business has created or destroyed in each reporting period. In other words, EVA is profit the way shareholders define it. If the shareholders expect, say, a 10% return on their investment, they make money only to the extent that their share of after-tax operating profits exceeds 10% of equity capital. Everything before that is just building up to the minimum acceptable compensation for investing in a risky enterprise.

Aligning decisions with shareholder wealth

Stern, Stewart developed EVA to help managers incorporate two basic principles of finance into their decision making. The first is that the primary financial objective of any company should be to maximize the wealth of its shareholders. The second is that the value of a company depends on the extent to which investors expect future profits to exceed or fall short of the cost of capital. By definition, a sustained increase in EVA will bring an increase in the market value of a company. This approach has proved effective in virtually all types of organizations, from emerging growth companies to turnarounds. This is because the level of EVA isnt what really matters. Current performance already is reflected in share prices. It is the continuous improvement in EVA that brings continuous increases in shareholder wealth.

A financial measure line managers understand

EVA has the advantage of being conceptually simple and easy to explain to non-financial managers, since it starts with familiar operating profits and simply deducts a charge for the capital invested in the company as a whole, in a business unit, or even in a single plant, office or assembly line. By assessing a charge for using capital, EVA makes managers care about managing assets as well as income, and helps them properly assess the tradeoffs between the two. This broader, more complete view of the economics of a business can make dramatic differences.

Ending the confusion of multiple goals

Most companies use a numbing array of measures to express financial goals and objectives. Strategic plans often are based on growth in revenues or market share. Companies may evaluate individual products or lines of business on the basis of gross margins or cash flow. Business units may be evaluated in terms of return on assets or against a budgeted profit level. Finance departments usually analyze capital investments in terms of net present value, but weigh prospective acquisitions against the likely contribution to earnings growth. And bonuses for line managers and business-unit heads typically are negotiated annually and are based on a profit plan. The result of the inconsistent standards, goals, and terminology usually is incohesive planning, operating strategy, and decision making.

EVA eliminates this confusion by using a single financial measure that links all decision-making with a common focus: How do we improve EVA? EVA is the only financial management system that provides a common language for employees across all operating and staff functions and allows all management decisions to be modeled, monitored, communicated and compensated in a single and consistent way always in terms of the value added to shareholder investment.

Exhibit 2

Sample List of Companies Using EVA as a Performance Measure*

ADC Telecommunications

Allied Holdings

Alltrista Corporation

American Saw & Manufacturing

The Andrew Jergens Company Armstrong World Industries, Inc. Ball Corp.

Bausch & Lomb Best Buy Co., Inc Boise Cascade Corp. Bowater

Briggs & Stratton Corp. C. H. Heist

California Microwave

Calmat CalResources Case Corp.

Centura Banks, Inc. Cilcorp, Inc.

The Coca-Cola Co.

Columbus McKinnon Corp

Core Industries

Cowles Media Co. Crane Co.

CSX Corp.

Chicago Extruded Metals, Inc. Dresser Industries

Dun & Bradstreet Corp. Echlin

EG&G, Inc. Eli Lilly & Co.

ENTEX Information Services, Inc.

Equifax, Inc. Federal-Mogul

Fleming Companies, Inc. Furon Co.

Georgia-Pacific Corp. Griffith Laboratories Guidant Corp.

Herman Miller

Illinois Power Company Insteel Industries, Inc. International Multifoods JCPenney

Johnson Worldwide Associates, Inc. Kansas City Power & Light

Kao Corporation

KLLM Transport Services Knape & Vogt Manufacturing The Manitowoc Company Material Sciences Corp. Millennium Chemicals Monsanto

Montana Power

The Moore Company

Noble Drilling

Olin Corp.

Premark International, Inc. Pulte Corp.

R.P. Scherer

R.R. Donnelley

Rand McNally & Co. Rubbermaid Inc.

Ryder System, Inc. Sanifill Inc.

Shaw Industries

Silicon Valley Bancshares

Sprint

SPX Corp.

Standard Motor Products Inc. Steelcase

Strategic Minerals Corp.

Toys R Us

A.M. Todd Group U.S. Postal Service W.C. Bradley

W.W. Grainger, Inc. Waste Management Weatherhead Industries

Webster Financial

Whirlpool

Exhibit 3

Steps Involved in Calculating EVA

1. Review the companys income statement and balance sheet.

2. Identify the companys capital sources and magnitudes ($Capital)

$Capital = Total Liabilities - Non-interest bearing liabilities. Marketing Outlays, R&D costs and restructuring charges should be treated as capital investments (add back to NOPAT) rather than expenses.

3. Determine the companys weighted average cost of capital (WACC).

WACC = (Cost of Debt Weight of Debt in Capital Base) + (Cost of Equity Weight of Equity in Capital Base) Cost of Debt = Prime Rate + Bank Charges Cost of Equity = 10-year bond yield + Risk Premium

4. Calculate NOPAT

NOPAT = Net Income + Total Adjustments Opportunity loss of tax savings on Adjustments

5. Calculate EVA

EVA = NOPAT - (WACC $Capital)

Exhibit 3

Steps Involved in Calculating EVA

1. Review the companys income statement and balance sheet.

2. Identify the companys capital sources and magnitudes ($Capital)

$Capital = Total Liabilities - Non-interest bearing liabilities. Marketing Outlays, R&D costs and restructuring charges should be treated as capital investments (add back to NOPAT) rather than expenses.

3. Determine the companys weighted average cost of capital (WACC).

WACC = (Cost of Debt Weight of Debt in Capital Base) + (Cost of Equity Weight of Equity in Capital Base) Cost of Debt = Prime Rate + Bank Charges Cost of Equity = 10-year bond yield + Risk Premium

4. Calculate NOPAT

NOPAT = Net Income + Total Adjustments Opportunity loss of tax savings on Adjustments

5. Calculate EVA

EVA = NOPAT - (WACC $Capital)

Table 1

Steadfast Manufacturing Company

Income Statement (in thousands of dollars)

	2015	2014
Sales	4500	4700
CGS	2813	3008
SG&A Expenses	1396	1504
Income from Operations	291	188
Other Income	20	10
EBIT	311	198
Interest Expenses	35	30
Pretax Income	276	168
Taxes (40%)	110	67
Net Income	166	101

Table 2

Steadfast Manufacturing Company Balance Sheet (in thousands of dollars)

	2015	2014
Cash	28	31
Accounts Receivable	879	842
Inventory	1121	977
Prepaid Expenses	43	47
Other Current Assets	34	34
Total Current Assets	2105	1931
Computer Equipment	100	92
Furniture and Fixtures	20	21
Motor Vehicles	39	34
Equipment	207	184
Other Fixed Assets	29	38
Total Fixed Assets	395	369
Total Assets	2500	2300
Accounts Payable	671	645
Short-Term Debt	137	131
Accrued Expenses	250	231
Total Current Liabilities	1058	1008
Long-Term Debt	653	603
Total Liabilities	1711	1611
Common Stock	33	27
Retained Earnings	757	662
Total Owners Equity	789	689
Total Liabilities & Owners Equity	2500	2300

Questions: PLEASE ANSWER ALL THE FOLLOWING QUESTIONS CORRECTLY AND SHOW WORK!

1.Calculate and interpret Steadfast Manufacturing Companys key liquidity, profitability, turnover, and leverage ratios. What do the ratios indicate about the performance and condition of the firm?

2.Calculate the firms NOPAT for both years. $50,000 of the owners salary was considered to be a reinvestment for future growth of the firm.

3.What are the relative proportions of debt and equity in Steadfast Manufacturing Companys capital structure?

4.Calculate the firms cost of debt and equity. The prime rate is currently at 7% per year, and the bank charges prime plus 2% for commercial loans. The company is in the 40% tax bracket. Ten-year treasury notes are currently yielding 5%, and the risk premium for Steadfasts equity is 8%.

5.Calculate the firms EVA for both years. What does it indicate about the performance of the company?

6.Do your conclusions regarding the firms performance, based on EVA, concur with those from the ratio analysis? Explain.

7.What are the main advantages of using EVA as a performance evaluation measure?