Talk about real economic value …

Most investor relations people have run into fund managers who aren’t satisfied with the tables in the 10-Q. Donning green eyeshades, these investors want to slice and dice operating cash flows, cost of capital, and returns on capital in pursuit of … well, their own metric.

They’re after some version of a shareholder-oriented performance measure known as “economic value added” (EVA) or economic profit. To build value, the approach says, a company must earn a rate of return greater than its cost of capital.

Bennett Stewart, one of the originators of EVA, continues to promote its benefits for companies that are truly committed to building shareholder value. Speaking today to a Financial Executives International gathering in Kansas City, Stewart argued other metrics like free cash flow and even return on capital can create perverse incentives for managers – while improving EVA invariably creates real shareholder value, the kind a shareholder sees in the share price.

Essentially, EVA is a non-GAAP calculation of net operating profit after taxes (a cash flow measure) minus a capital charge (the firm’s cost of capital times capital deployed). You can look at EVA as a spread between return and cost of capital, compile a detailed EVA P&L, look at EVA margins at each level, and consider changes in the trend. You can get lost in an endless stream of alphabet-soup abbreviations.

Stewart says “EVA momentum,” a ratio of change in EVA to trailing-year sales, is highly predictive of market value for public companies.

To confess my bias, I’ve have always liked the EVA approach. Stewart’s book The Quest for Value (HarperBusiness, 1991) is one of my favorites in the finance genre. Its shareholder-oriented insights are relevant in developing messages on, say, a proposed merger or new initiative – even for companies that don’t formally use EVA.

Stewart, who left EVA consulting firm Stern Stewart & Co. to start EVA Dimensions in 2006, now is working to “commoditize” the management approach with a software package, a stock rating tool and a hedge fund using EVA methodology. The EVA Dimensions website offers a variety of articles – and, yes, promotion – on using the approach to manage for results.

Stewart offers innumerable proof cases for EVA, but two of our best-known corporate giants offer a good contrast:

  • Wal-Mart. Managers minding only the P&L might focus on raising margins, but Wal-Mart chose a low-margin pricing strategy to pull consumers in, driving faster turns of inventory and higher returns on capital. And it invested in profitable growth. Stewart wrote WMT up as an EVA champion in 1991; since then it has continued to build value.
  • General Motors. When Fortune wrote the carmaker’s early obituary this fall (“GM: Death of an American Dream”), a bar graph showed eight straight years of negative EVA – and a TTM figure of minus $11.5 billion. Oddly enough, GM also was getting horrible marks for negative EVA two decades earlier when Quest for Value was written.

As if to emphasize the relevance of EVA in the Internet era, Stewart also cites Google’s high EVA momentum and stock-price appreciation. So investment in profitable growth and careful management of capital work in the new economy, too.

For companies burdened by the recession, Stewart says, “The first message of EVA in these tough times is don’t go cutting and slashing and burning … We should cut where we should cut, and we should invest where we should invest [in projects and businesses where the numbers show positive economic returns].”

The decision on whether to use EVA as a management tool is typically an issue for CEOs and CFOs. Accountants also have something to say about it. (One FEI member today asked a controller sitting at our table, “So are you ready to start keeping two sets of books?” referring to GAAP accounting plus EVA.) Investor Relations communicates whatever management adopts.

If a company uses EVA, the IRO needs to work diligently on how to communicate the shareholder benefits clearly. Focus on intuitive concepts like earning returns greater than the cost of capital, generating cash and increasing the productivity of assets. Benchmark EVA communications. And don’t bury investors in jargon.

The EVA body of knowledge suggests important principles for investor communication. Most companies, for example, don’t do a good job of talking about the relationship between the income statement and balance sheet. We need to discuss cash and what happens to it. We need to explain (and quantify) management’s effectiveness in using assets to create value.

An IR approach driven only by disclosure requirements is likely to obsess over GAAP accounting – to “worship at the altar of EPS,” Stewart would say. Instead, we should explain performance in terms of real economic value for shareholders. Assuming we really are in the shareholder-wealth business.

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2 Responses to “Talk about real economic value …”

  1. Mark Meierhoffer Says:

    I enjoyed your summary of a very complicated topic. The “cost of capital” term means many different things to different people. I am sorry I missed the program. We were on our way back from California. Take care, Richard.

  2. Dick Johnson Says:

    Good thought on different approaches to estimating cost of capital. To me, a major point of the EVA approach is that management should at least be thinking about returns in relation to cost of capital (including how to best calculate same). And when management TALKS about returns in relation to capital and other opportunities for deploying it, they reinforce their commitment to steward the shareholders’ money – a message I think resonates with investors.

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