a response to the eva critics · financial intelligence for measuring, managing and maximizing...

The path to financial truth

EVA® is a registered service mark of EVA Dimensions LLC (in the field of financial data, valuation modelling, and investment management and research) and of Stern Stewart & Co. (in the field of financial and incentive consulting) Copyright © 2014 by EVA Dimension LLC. All rights reserved

The Path to Financial Truth

A Response to the EVA CriticsFinancial intelligence for measuring, managing and maximizing value

EVA® is a registered service mark of EVA Dimensions LLC (in the field of financial benchmark data, executive decision support software, valuation modelling, and investment management and research)and of Stern Stewart & Co. (in the field of financial and incentive consulting) Copyright © 2015 by EVA Dimension LLC. All rights reserved


What is EVA, in Brief? EVA is economic value added, an estimate of a firm’s true economic profit. EVA measures profit after deducting a full cost of capital charge on the net

assets used in the business. It turns the balance sheet into an operating cost. It’s the only profit measure that fully and correctly increases when assets

decrease. It motivates managers to turn assets faster and develop leaner business models, but only up to the point where that adds value, not beyond.

EVA will increase only if new investments cover the full cost of capital; Unlike EPS or EBITDA, EVA protects the owners with a priority return, and makes managers truly accountable for earning a decent recent on new investments.

EVA increases with any new investments that return more than the cost of capital. It’s pro-profitable growth, where ROI isn’t.

EVA is the only profit measure that discounts to value. To be specific, the present value of a forecast for EVA is mathematically identical to the net present value of forecast cash flows—because EVA sets aside the profit that must be earned in each period to recover the value of capital that has been or will be invested.

The result: If EVA is zero, then NPV is zero. Why would investors pay a premium over book value if the firm cannot earn a return over its cost of capital? But the more EVA profit a firm earns, and the faster it grows, and the longer it endures, the more value will be added on top of the capital invested in the business.

Every company’s goal should be to increase EVA as much as possible over time. That’s the key to creating wealth and driving TSR – by definition!

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EVA® is a registered service mark of EVA Dimensions LLC (in the field of financial data, valuation analytics, and investment management) and of Stern Stewart & Co. (in the field of financial and incentive consulting) Copyright © 2014 by EVA Dimension LLC. All rights reserved

The path to financial truth.

Common Misperceptions About EVA

We don’t need EVA because we’re already using return on capital and they’re essentially the same thing

We don’t need EVA because we’re already using discounted cash flow and NPV, so what’s EVA bring?

We don’t need EVA because we’re already focused on all the ingredients – we get that margins, asset turns, and growth are important, so EVA doesn’t add insights

EVA is complicated; our managers won’t understand it

EVA is a short-term measure and will motivate short-term decisions

EVA is not recognized by Wall Street investors; our value is determined by more conventional metrics

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We’re doing EVA already, we’re using return on capital ROI is profit divided by capital, it’s a ratio, where EVA is operating profit minus the

cost of capital, it’s a net profit figure, and the idea is to increase it. The two measures use the same ingredients, but are not at all the same in practice.

EVA increases—and a firm’s NPV increases—whenever new investments earn more than the cost of capital. ROI increases when new investments return more than whatever existing investments are earning, which is completely irrelevant.

ROI is like judging a basketball player by shooting percentage. The incentive is to take a sure layup and shoot no more. In business, a goal to increase or even just maintain a high ROI encourages managers to under-invest, under-innovate, and under-scale, even at the project level, and to leave valuable growth on the table, which doesn’t happen when managers aim for, and are paid for, increasing EVA.

EVA is value additive. Whenever a business unit initiates a positive EVA decision, its EVA goes up by the EVA of the decision, and the parent’s EVA goes up in exact like amount. EVA harmonizes perspectives so that managers at all levels reach the same conclusion about a given decision and how significant it is – but that is simply not true of ROI (or margin, growth, or any other ratio statistic).

ROI is a legacy metric. It’s burdened with an accumulation of the returns from all past investments and decisions, which dilutes the impact of current performance. The change in EVA, by contrast, brings the period’s performance into sharp relief.

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We’re already using NPV, so EVA is not needed Not so. Projecting and discounting EVA is actually far better than discounting

cash flow, because cash flow is not a reliable measure of performance.

A company’s cash flow could be negative if it is losing money or if it is pouring capital into positive NPV growth. It could be bad or good. What about a firm that’s generating positive cash flow? Is it a sure winner? No. Perhaps it’s just run out of attractive investment ideas. It’s impossible to tell whether more cash flow or less is a good or bad thing. While cash flow measures value (when forecast over the entire life of a plan or project), it never measures performance.

Analysis by EVA Dimensions confirms this – the correlation between Free Cash Flow and an expanding corporate NPV is actually quite weak, with the poster child being Amazon, a firm that has produced outstanding shareholder returns in the face of a consistently negative cash flows net of investment spending.

Most CFO’s know this, and so they reach for other measures. They turn to measures like EPS and ROE to set financial goals and communicate with investors, use sales growth, EBITDA, operating margins and ROI to review performance, and they take budgets as bogeys for measuring bonus awards.

The result: complexity—line teams must balance a dizzying array of financial metrics that are employed for different purposes. Worse, accountability for actually delivering NPV is lost in the shuffle, as is explained on the next slide.

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We’re already using NPV (continued) Even screening new investments with a rigorous DCF test doesn’t really help,

because line execs aren’t paid for it. They’re paid for other measures that they can negotiate. Despite surface appearances, their real agenda is to get their hands on as much capital as possible, to build their businesses, build their budgets and pad their bonuses, and look like heroes compared to their peers.

Knowing the bias, CFOs send storm troopers into the field to check assumptions, field teams retaliate by raising their projections, CFOs respond by raising the hurdle rates, and in the end capital budgeting is characterized by mutual deception and Kabuki theatre—everyone is wearing a mask.

What’s the solution? Forecast EVA to measure and improve the NPV of plans, projects, acquisitions and decisions. Back that up with periodic reviews of the EVA profits actually produced, and tie bonuses to increasing EVA over time.

Now, just one measure matters—it’s EVA for making decisions, checking results, getting paid. That’s clearly a lot simpler, and it paves the way for sharper, swifter, more valuable and accountable decisions. Division managers really do want to maximize NPV because they really want to get paid for increasing EVA.

Truth is, cash flow is not the answer—it’s the problem. Use cash flow in capital budgeting, and you invariably end up with a bloated and poorly functioning management model. It is unavoidable. To break out, you must use EVA instead.

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We’re already focused on all the ingredients The claim here is that management can just use an array of traditional metrics –

such as sales growth, operating margins, working capital turns, free cash flow, EPS, EBITDA and the like, to guide decisions, and just dispense with EVA.

Not so. That’s like watching a basketball game, and keeping track of blocked shots, shooting percentages, rebounds and assists, and forgetting to ask, who won the game?

The concern is not that companies lack detailed performance measures (though some do). What’s lacking is the big picture, a decisive overall score. Without that, it is very hard to allocate resources across competing divisions or strategies, or make decisions that involve tradeoffs, as all real decisions do.

How can managers judge whether it makes sense to end up with more EBITDA if that requires more capital, or lower margins but faster asset turns, or a lower ROI and cash flow but more growth? Or to decide if its more valuable to invest in one division or another or one strategy or another? Examining an array of contradictory metrics is complex, ambiguous, and highly error prone, to say the least; an overall metric is essential to guide managers to the right choices.

That’s EVA. Alone among all measures, it consolidates the pluses and minuses of business decisions into a decisive profit score that directly discounts to value. Without it, you’re flying blind no matter how many dials are on the dashboard.

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Is EVA too complicated? The assertion is hard to swallow, because EVA is just a simple three-line

calculation—it is sales, less operating costs, less an interest charge on net assets.

It’s as if the head office acts like as a bank that advances capital to the operating units via a line of credit that bears interest at the cost of capital rate. The managers’ mandate is to maximize the spread between the operating profit they earn and a charge they incur for tying up balance sheet capital.

Unlike ROI, where capital is a divisor in a ratio, or cash flow, where the change in capital is deducted as a period expense, with EVA the money tied up in business assets is just another operating cost, a P&L charge, like cost of goods sold.

As simple as it is, EVA shines a bright light on how to win and create value in anybusiness— by cutting wasteful costs, by speeding assets turns and releasing capital, and by investing capital in profit growth above the cost of the capital. No other measure, or combination, gets the message across so clearly, so succinctly.

True, EVA may not be as familiar as gross margin, ROI, EBITDA and the like. But with a modest amount of training, reinforced with practical examples, it’s actually quite easy for line teams to grasp and use it, in fact, typically far easier than with other metrics because EVA makes so much sense and reinforces the decisions and tradeoffs that smart business managers have understood all along. Other measures always tell them to do dumb things, but EVA, never.

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EVA is too complicated? (continued) A related concern is that EVA is typically measured after making modifications to

ordinary accounting rules that can make it appear more complex.

One example is to add back a restructuring charge to profit, as if the charge never happened, and to add the charge back to balance sheet capital, subject to the capital charge. The idea is to treat a restructuring not as an admission of failure, but as a pro-active opportunity to invest capital and increase EVA.

Granted, it does take a little explanation and a case illustration to get the point across, but it’s worth it. Managers all of a sudden become much more inclined to restructure promptly and with greater efficiency. Good money is no longer poured after bad to defer a day of reckoning on value-damaging investments, and resources are mobilized to better uses.

Another example is to write off R&D and ad spending over time, over 3-5 years typically, with a cost of capital charge placed on the unamortized balance. That stretches managers’ horizons. It curtails their incentive to slash the spending just to make a near term earnings goal and motivates them to step up the spending where they’re convinced it will pay off, but with accountability for doing so.

We help our clients to choose the 3-5 adjustments that make EVA a reliable measure of period-to-period added value, where more EVA is really better than less, while balancing that precision with the desire to keep it relatively simple.

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EVA is too complicated? (continued) Here’s a key insight: if EVA is carefully defined so that it really is a “continuous

improvement metric,” one where the adjustments help ensure that more EVA is truly better than less, at least to a very great extent as we strongly suggest, then a great simplification in setting targets and in structuring incentives is possible.

With EVA, the goal is simple and always the same. Increase it. Make it bigger. More is better than less. Bonuses can be reduced to a simple formula: a base bonus (to bring pay up to market) plus a percent of the change in EVA over time.

The point is, EVA incentive plans are not tied to budget or business plan targets. They’re tied to sharing the added value. Managers no longer want to negotiate weak goals. They stretch to find the best business plans, the ones that will truly produce as much EVA and value as possible, and not just next year, but long term. Managers think and act like owners, because they’re paid like owners.

It is impossible to do this with any other measure or any other combination of measures. They can all increase, while value really decreases. The only way to set targets for those is through a complex, adversarial, and often quite myopic give and take budgeting process. Even then, the goals can never really be value-based.

We encapsulate this difference in the slogan: “simple measures make for complex conversations.” The familiar metrics may be simple, but they lead to complex discussions about how to set targets and structure incentives. Sound familiar?

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EVA is too complicated? (continued) To take this conversation to a higher level, what really makes EVA simple and

effective is to use it for everything and focus on it. This is not well-understood.

For example, some companies make the mistake of using EVA alongside ROI and cash flow. They end up thinking EVA is complicated and unnecessary baggage. But they’ve made an error. It’s not right just to add EVA. It’s essential to subtract, to streamline decision-making by eliminating analysis of ROI and cash flow. They’re unnecessary distractions, once EVA is in place. The right answer is to:- Focus on increasing EVA as the company’s prime financial goal, across all lines of business

- Forecast, analyze and discount EVA – not cash flow – to measure and improve the NPV of plans, projects, acquisitions and decisions, and

- Use custom EVA Momentum and EVA Margin schedules as the prime performance analysis frameworks and heart of management reporting, and not the DuPont ROI formula

EVA calls for overhauling the overall management model. Planning, reporting and decision-making should be EVA-based. Compensation should be EVA-based. Communication with the board and investors should be based on EVA, too. Not out of religious fervor or theoretical purity, but as a practical technique to achieve a black-belt, six-sigma, totally simple, effective, parsimonious and value-aligned management model.

And for that to happen, the top management team must really understand EVA and believe in it, and express that conviction to their team and board.

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EVA® is a registered service mark of EVA Dimensions LLC (in the field of financial data, valuation modelling, and investment management and research)and of Stern Stewart & Co. (in the field of financial and incentive consulting) Copyright © 2014 by EVA Dimension LLC. All rights reserved


EVA’s Not Just a Measure – There Are 5 “M‘s” to EVA

Mission:

Measure:

Manage:

Motivate:

Mindset:

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Increasing EVA is the prime financial goal;Other metrics are purged or used to explain EVA

Management reporting and analysis is focused around understanding EVA and what’s driving EVA versus budget

Decisions and strategies aim at increasing EVA, technically, to maximize the PV stream of EVA, and not cash flow or IRR

Incentive awards are driven by increasing EVA over a formula target, or versus peer performance, but not against budget/plan

EVA is in the “culture.” Its well-understood and embraced throughout the company, at the board, and with investors

Best-Practice EVA is a comprehensive model for value-based financial management. To make it work, management needs to tackle all 5 M’s. It’s not just a measure, nor just a compensation plan. It is a totally integrated framework that becomes simpler and more effective the more management really focuses on EVA and uses it for all these purposes.



EVA is too complicated? (cont’d) A new advance has also made EVA more lot more practical.

EVA Dimensions has turned EVA into a set of headline ratio statistics and a technique to trace them in steps to all the underlying gears that are moving the EVA needle. Now line managers can clearly see how their plans, their decisions, and their performance drives EVA and drives value, by driving margins, turns, and growth, and specific operating metrics, which was not as easy when EVA was just a money measure of profit performance.

The most important new ratio is EVA Momentum, which measures the change in EVA over a period, divided by sales in the prior period. It measures EVA growth, scaled to sales. It ignores history, and is always forward looking. It’s the one ratio that managers in all business lines should aim to maximize over time.

Momentum unfolds to reveal underlying drivers, starting with two main levers:- The first is to increase EVA Margin—the ratio of EVA-to-sales—which covers improvements in operating efficiency (such as by

expanding gross margin and cutting overhead costs) and in asset management (such as by cutting working capital days, increasing plant turns, and generating a higher return on the investments in intangibles, such as R&D and brand-building advertising).

- A second thrust to add Momentum is through profitable sales growth, that is, to add even more sales at positive EVA Margins (or to excise sales with negative EVA Margins). The insight is, its multiplicative. Adding value depends on the product of the business’s sales growth rate and its EVA Margin. If the EVA Margin is not at least 2%, sales growth is not really a value driver.

EVA Momentum turns EVA into superior method for scrutinizing plans and benchmarking performance and improving value. It provides more ready, reliable, and actionable insights than ROI, which no longer has a role to play.

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ΔEVA MarginSales Growth x EVA Margin

In practice, company-specific measures and milestones are tied to EVA Momentum so it becomes a comprehensive and transparent scorecard for summarizing strategy, spotting pressure points and managing the business. The Coke example is just the tip of the iceberg.

Coca-Cola uses EVA Momentum as the Pinnacle Score of its Plan Vision and Traces It to Underlying Drivers

EVA Momentum is the Goal



CEO Andrew Liveris on why Dow uses the EVA Management Model No matter what size your enterprise, you really have

inefficiency embedded in your decision making. No matter how good you are, no matter how good you think you are, no matter what you know about your business, you have inefficiency. You are making poor decisions today, so you've got to minimize those, if not eliminate them, and you've got to use metrics to do it.

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You are what you inspect, not what you expect, so what you inspect, what you measure, has to have a versatility and a utility that enables you to take your decision making as close to the journey of perfection as you can get.

I would say to other CEOs, go look at EVA momentum and go look at EVA as a tool and technology in its current form.

The Dow experience would tell you that we are actually—as the market is starting to very much recognize—becoming seen as very efficient capital and resource allocators.Dow began to adopt EVA starting in March 2013 with a Pilot Program with EVA Dimensions. By August 2013, the leadership team decided to fully embrace the new EVA Momentum management model with continued assistance from EVA Dimensions.



EVA will motivate us to make short-term decisions It’s said, EVA is a short-term measure, and will motivate short-term decisions.

To the contrary, EVA is more pro-investment and pro-growth than all other financial measures. Unlike ROI or profit margins, EVA rewards managers who pursue all growth over the cost of capital and that will add to NPV and share price.

The aforementioned accounting adjustments also help. Managers, for example, are much more inclined to restructure and redeploy resources for long run value when one-time charges are treated as investments and not admissions of failure.

They also want to step up or at least not cut investments in innovation and brand building because the outlays are treated as strategic capital, not period expenses.

With EVA incentive plans, as noted, managers are rewarded for increasing EVA over time and not just in one period. They may be willing to forfeit some EVA in the near term for a greater payoff over time since they are guaranteed to participate in the fruits of their labors. Thus, what looks like an annual bonus plan actually functions as a long and short term incentive in one plan.

Managers’ long-term thinking is also reinforced when they analyze and discount long-run EVA projections as the technique to measure and improve the NPV of plans and decisions. The procedure helps managers to visualize, in fact to compute, how a long-term decision will play out through EVA and into their incentive pay over time. That linkage is critical to promoting strategic thinking.

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Ball Investor Overview Presentation – March 2012

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Drive for 10 Goal: Double EVA$

generated by the company over

the next decade

Ball Corporation, which has continuously employed a very pure EVA model for management and incentives since 1993, has thrived, invested, acquired, gone global, and grown markedly in size and value, compared to peers. The facts don’t back the myth.



Morningstar sees the Merit

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EVA isn’t recognized by Wall-Street Investors EVA certainly is not, yet, the universal language of investors – although that is

our goal. But it is certainly not unknown, and is a force in equity valuations.

Start with the fact that EVA is a required topic in the Chartered Financial Analyst (CFA) program. Almost all Wall Street investors and analysts are familiar with the concept of EVA.

Recall also that the present value of a forecast for EVA is mathematicallyidentical to the NPV of cash flow. To the extent stock prices are shaped by investors who care about net cash generation or the “free cash flow” generated over the life of the business, and that is by far the bulk of the market, then they effectively care about EVA, too, for they amount to the exact same thing.

Moreover, the evidence we’ve assembled from our data base shows that the best measure to explain TSR and wealth creation, using stock market data, is EVA Momentum, is the growth in EVA over time, as would be expected, and far more so than EPS or any of the other conventional metrics.

So no matter what investors or analysts may say, the fact is, the market does indeed value EVA and responds to EVA and not to EPS or EBITDA or any of the other conventional measures. The fact is, those measures matter only to the extent they proxy for EVA or signal a change in the outlook for EVA (such as when dividends are increased).

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EVA isn’t recognized by Wall-Street Investors (continued) Granted, sell-side analysts tend to couch expectations in terms of EPS. Under

the hood, though, many use discounted cash flow forecasts to measure value, which is the same as using EVA. And no matter what the sell-side says, the sell side is not the buy side, and the buy side buys value and not earnings.

Besides, the concern with EPS is misplaced. If a company is increasing its EVA, and covering its full cost of capital, then it is almost certainly increasing its EPS, too. The opposite is not the case. It’s relatively easy to manufacture growth in EPS without increasing EVA, because there’s no charge placed on the retained earnings – accountants consider it to be free capital.

The point is, EPS is a lesser profit standard, not a higher one. We say, focus on increasing EVA, and your firm’s EPS will come along anyway. You won’t miss the mark. But focus on EPS (or worse, EBITDA), and there’s no guarantee you’ll get EVA. That’s the real problem, and it’s the opposite of what most CFOs think it is.

Granted, EVA can go up as EPS goes down, such as with a restructuring charge or spending hike on R&D or brand building. But academic researchers studying events like those have concluded the market responds to the long-run economic value, to the EVA prospects, and NOT to the near-term accounting appearances. In those special cases, the share prices follow EVA up, not the EPS down, and the firm’s P/E multiple expands to reflect the improved quality of earnings.

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EVA isn’t recognized by Wall-Street Investors We furthermore maintain that those concerned about the role of EVA on Wall

Street are operating under a misconception of how the stock market works.

To increase stock price, it is not a question of convincing more investors to buy the stock – that only leads to more trading volume. If some investors are persuaded to buy, but the firm’s fundamental value remains the same, then other investors will sell the stock or even short it to create an artificial supply to meet the artificial demand. Volume will change, but not price.

To increase stock price, it is a question of convincing the right investors the company is worth more, not convincing more investors to buy the stock.

It is a question of convincing the smart money crowd – we call them the “Lead Steers” in the herd – to pay more for the stock, because they think it’s worth it. They must be convinced the company will be able to create more EVA profits over time. That’s the only way a firm’s fundamental value can improve.

And what better way to convince investors that EVA is going to go up than to make increasing EVA the company’s clear goal and to pay the management team for doing that, and then to tell the world that’s how you run the business?

Which leads to our suggestion to run an EVA Activist Campaign – communicate the commitment to EVA as the best way to drive value and fend off activist investors.

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For over three years, EVA Dimensions has been providing an EVA-based research service to institutional investors in the US and UK. - 8 of the top-20 US-based actively managed firms are already paying clients.

- We are providing service to virtually all of the top 20 firms.

- The funds that are either clients or active prospects manage over $1.3 trillion.

Our clients are split approximately 2/3 Growth and 1/3 Value investment styles. - In past, only “value” investors found “value-based” frameworks like EVA appealing.

- But by incorporating EVA Momentum as a measure of economic profit growth into our research ratings and toolkit, our service has garnered a much broader appeal.

While not every investor we meet signs up for our service, it is almost NEVER because they lack interest or understanding of EVA. - The work of Bennett Stewart, Stern Stewart & Co, Credit Suisse HOLT, Applied

Finance Group, and others have been able to establish the relevance of economic profits and returns on capital in the minds of most investors.

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Our Equity Research Client Profile



Our Equity Research team is regularly engaged in conversations with hundreds of institutional fund managers in America and in London.

The message they hear is that institutional investors are clamoring to buy stocks of companies whose management leaders “get it” – that understand and manage for real economic value, not near term profits and beating consensus.

While the sell-side analysts talk an accounting language, and focus on meeting near term expectations, our team finds most buy-side investors are strategic thinkers who look well beyond the conventional street research.

When asked, our investor clients typically call the opportunity to engage in an EVA-centric discussion with corporate leaders a “breath of fresh air.”

The market for such a message has exploded in recent years. EVA or value-based techniques in general are no longer a fringe academic area of investing. They are core disciplines represented in virtually every buy side shop.

When asked about the possibility of meeting with a management team that is adopting Best–Practice EVA, the response from an informal survey among our client base has been quite positive.

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We Hear a Very Positive Reaction to Bringing a “Different” Message from Corporate Leaders



We Sent this Note to a Sample of Fund Managers Our firm has two sides -- the Equity Research division for institutional investors and the

Corporate division, which helps CEOs and CFOs to implement Best-Practice EVA into their management discipline, financial systems, and incentive plans. That business is run by Bennett Stewart, the principal architect and thought leader of EVA.

The corporate team has gained so much momentum in the past couple years we are now assessing opportunities to bring our corporate clients out to investors to tell their EVA story. We have identified two Fortune 50 client firms that are potentially interested in having meetings with investment managers like you.

In both cases, the companies at the cutting edge of adopting the latest version of EVA and are keen to share their strategy for using it and how they think it will help them to make even better decisions and add even more value – something they’ve always done – but which EVA will help make easier and more predictable.

This is a new type of message from corporate managements than the typical non-deal roadshow sponsored by investment banks, but one which we think could be of real value to help investors understand the motivations and goals of managers as they set strategies and make decisions.

Bottom line, what’s your interest in hosting such a meeting at your firm, with the understanding that it will be limited to a discussion of the practical applications of EVA as a management and incentive technique. The agenda is not to discuss earnings outlooks or even business strategy, but rather, the process of how the firm expects to systematically manage its business for the creation of long run value.

Please let me know what you think! Regards, Craig

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Typical Responses

PM# 1. Definitely interested. If they want potentially

long-duration equity capital, we are a good place to visit. Thanks Craig

PM# 2. Would love to see them. We have found that there is a potential mispricing as the background story of

how managers manage, and their real incentives, is

often not told very well.

PM# 3. I would be interested particularly if one we are interested in from our methodology

PM# 4. Hi Craig, Would be very useful and interesting for

us too. Would love to host a meeting like that.25

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