Rewarding Value Creation via EVA
Featured In Compensation News Spring 1996
There is increased recognition of the need to develop accurate measures of performance
that can be used in determining incentive compensation, for the executive as well
as for individuals or teams. The concept of pay for performance, while often used
to reward value-adding results, can sometimes be misdirected, if the measures of
success are short-sighted.
A manager of a computer software company is awarded a bonus on the basis of achieving
a net income target. The shareholders are happy with their dividend and share price.
Three years later, this company finds its net income have dropped significantly,
as their new product developments have not kept pace with their competition and
they are now lagging behind. The shareholders are not happy with their diminished
dividends and reduced share price.
This is an example of What gets rewarded gets done! The CEO achieved
his profit goals through cutting costs, in particular, the R & D department,
thus reducing the ability of the organization to produce innovative products ahead
of the competition. The results are not unexpected; short-term gain causing longer-term
A NEW ERA
According to Frederic Cook, we have entered an era where the investment community
has a strong focus on return on capital, or shareholder value. Shareholders
expect that an venture in which they invest their capital, will provide them a return
at least as good or better that the return they would receive from investing in
WHAT IS CAPITAL?
It is the all of the money tied up in assets such as equipment, real estate computers,
etc., as well as, working capital which includes cash, inventories and receivables.
This capital enables an organization to operate and produce revenue, etc., resulting
in the increased value of that capital.
LINK BETWEEN VALUE CREATION AND CAPITAL CREATION
There is an obvious link between creating value in an organization and the resulting
capital creation. Value-addition provide temporary increases in income, while Value-creation
builds permanent increases in the income stream of the business. There are three
basic approaches to creating capital :
- Increasing revenues while maintaining profitability through new products, service
innovations, start-up or spin-off operations etc.
- Permanent reductions in expenses through strategies such as improved productivity,
waste reduction, distribution cost reduction or outsourcing.
- Permanent reduction in employee costs without reduction in the income stream.
Many current earnings-based incentive plans reward value addition, which is certainly
appropriate for short-term goals. However, some organizations have found that this
romance with earnings may not be the best measure of value creation in the longer-term.
The change in market value of share prices (& dividends) is the clearest indicator
to shareholders of the return that they can expect on their investment. Therefore
an easy way to align organizational goals and shareholder's expectation for capital
creation is use a financial measure that is linked to the changes in the market
value of shares.
A financial measure that is gaining favor as an indicator of Value Creation is Economic
Added Value or EVA. Several of the top 10 ranked US companies, such as Coca Cola,
Wal-Mart & A T & T, have employed EVA measures not only to assess the performance
of their business units, but as a component of their compensation strategies. A
number of Canadian organizations, particularly in the manufacturing and hi-tech
sectors, are also introducing EVA performance measures.
Company X with a capital base of $200 million, NOPAT of $25 million and a cost of
Capital of 10%:
EVA represents the value that the organization creates that is above what shareholders
could expect to receive from investing their money elsewhere in ventures of similar
risk. This is called opportunity cost. What makes EVA measures different from other
financial indicators based more strictly on upon Net Operating Profit, is that it
takes into consideration this opportunity cost of the capital invested in the organization.
WHY USE IT?
Numerous studies have shown that comparisons of year over year EVA calculations
closely correlate to the change in share price. According to James Mehan of AT&T's
long distance business: "We calculated our EVA back to 1984 and found an almost
perfect correlation with stock prices." This measurement allows the management
of a company to be aligned with their shareholders expectation of increased shareholder
value and focus on the goals of Value Creation that will lead ultimately to Capital
Creation. That EVA can be a good indicator of value creation in the longer term
encourages its use as:
- An excellent performance measure as a basis for incentive compensation, for both
short-term and longer-term plans.
- As a criterion for making business decision in which projects to invest capital.
- A tool in re-engineering or process improvement strategies that have value creation
as their goal.
Organization which employ EVA measures to assess the performance of business units
or departments are able to identify factors that do not use capital effectively
and have developed solutions which often include:
- Reduction in inventories
- Outsourcing of non-core services
- Process streamlining
EVA INCENTIVE PLANS
According to Bennett Stewart, who initiated the current EVA popularity, "If
you change the way a company measures performance, you will change executive behavior
and ultimately organizational behavior."
EVA measures can be used as a basis for incentive plans in several ways. The simplest
approach is as a fixed percentage of EVA.
The CEO of Company X is eligible for 2% of EVA for the corporation:
Annual bonus = 2% of $5million
If EVA increases to $8 million, his annual bonus would be:
Annual bonus = $160,000
If EVA decreases to $2 million, his annual bonus would be:
Annual bonus = $ 40,000
This indicates that the elements of variability and risk that are observed in share
prices also applies to EVA measures, so there is no guaranteed bonus payout. In
fact in most plans there is a negative payout that is banked against future earnings.
EVA measures can also be used for developing longer-term incentives where EVA earnings
are pooled over a 3 to 5 year period. There are other approaches that can be used
that include the use of:
- EVA improvement targets
- Assume the annual development of improvement over previous years, with no payout
added to the pool, if a target threshold is not achieved, and a potential for a
negative payout if there is a decline in EVA. A bonus bank
- Assumes that a portion of the earned payout is banked to cushion against negative
earnings in future year. The annual payout would then be based on a weighted average.
SOME OF THE ADVANTAGES OF EVA INCLUDE:
- To align organizational goals with shareholder expectations of value creation.
- Provides motivation for management and employees to step out and take calculated
risks in order to maximize shareholder value, with the potential for greater rewards.
- Particularly useful in organization which are privately held, thus employees, including
executive have limited access to purchasing stock.
- More effective in capital intensive than labour intensive organization.
- Can easily be applied to separate business units, etc.
ISSUES TO CONSIDER IN USING EVA MEASURES
Implementing EVA-based measures cannot be done overnight, as there are implication
for the organization. Besides the obvious need to have the executive understand
and support these performance measures, the impact on financial management and accounting
practices must be considered, as they are used to determine the EVA calculations.
Two issues are:
- The implication for cost accounting method used as the treatment of certain costs
can vary, depending whether a Full Cost Accounting, or Successful Efforts Accounting
methods are applied:
- For example, In the Oil & Gas industry, the costs of seismic services, or in
the manufacturing sector, there are R & D costs, that may be expensed or capitalized,
depending upon the accounting method used.
- Both types of expenditures add value within the first year because of increased
information and knowledge gained through the process, which can be applied to other
decisions. However the more tangible results may not be apparent until years later,
which could then be viewed as value creation.
- The basis on which the Return on Capital is calculated:
- Should the return on capital be determined by the consolidated group or should it
be adjusted for each individual business unit based upon the level of risk associated
with each unit?
- The type of capital structure that is used, may also be different for different
subsidiaries and again affect the calculations.
APPLICATION TO NOT-FOR-PROFIT OR PUBLIC SECTOR ORGANIZATIONS
There are also applications in the public sector. Although there are no shareholders,
in the same sense as in the market-driven sector, the concept of opportunity cost
as the basis of determining cost of capital still applies. The fact that EVA measures
tend to track the increases in capital creation of market-based shares can also
be applied to non-market based organizations. The need to choose the application
of available funds that will produce the most effective return is critical with
the current limitations on public funding. EVA can help to do this as well as being
a strong indicator of the value created through asset management, and productivity
improvements Particularly with the strong business focus required in all organizations
today, EVA is a method of measuring successful performance that can easily be employed
by the not-for-profit sector.
FOCUS ON VALUE CREATION
One of the biggest advantages of EVA measures that cannot be overstated, is the
ability to align the goals of not only, shareholders and executives, but all members
of the organization by focusing on Value Creation in all aspects of the enterprise,
as demonstrated in the model above. Through the integration of EVA-based measures
in performance and reward systems, an organization can clarify the path of success
and share the rewards of the value-creation with employees. This should result in
continuing commitment to building the future together. While Canadian companies
have only recently stepped on the EVA bandwagon, we can expect to see many examples
of success in the future through the focus on Value Creation.
ABOUT THE AUTHORS
Gail Evans is Principal of THE WYNFORD GROUP, a Calgary-based
consulting firm specializing in organization performance & compensation strategies.
Gail is also affiliated with Price Waterhouse.
Neil Robertson is Audit Manager with Price Waterhouse in Calgary, who specializes
in audit and business advisory.
Cook, Frederic, The Ascendancy of Capital" in American Compensation Association
Journal, Autumn 1993.
O'Byrne, Stephen, "EVA and Management Compensation" in American Compensation
Association Journal, Summer 1994.
Tully, Shawn, "The Real Key to Creating Wealth." Fortune, September 20,
Fisher, Jim, "How Effective Executive Compensation Plans Work," CMA Magazine,