Not sales. Not profits. Not even the Return On Capital Employed. The true measure of corporate performance is Economic Value Added. Which is not just a measure but an integrated management philosophy. BT presents the user's guide to the measure, and the management-metric of the millennium: EVA.

By Rajeev Dubey

It spent the first 12 years of its existence in limbo, known and used only by the most fanatical finance-jocks. Then, in 1995, the then-CEO of Coca-Cola, Robert Goizueta, announced to the world that it was the use of this metric that had enabled his company add $59 billion in market value. Suddenly, Economic Value Added (EVA), a measure created by the New York-based financial advisory Stern Stewart and Co., was the fad-of-the-month.

Only, it didn't fade away like other fads do. Circa 2000, this pure-bred measure of corporate performance can boast of an impressive curriculum vitae. It played a leading role in pharma major Eli Lilly's resurrection, transformed the US Postal Service from just another public department into the world's most profitable postal service, and moulded Federal Mogul and Monsanto into lean, cost-efficient entities. A sampling of the transnationals implementing EVA-Siemens, Sony, Telstra, Johnson Worldwide, and Akzo Nobel-indicates that this could well be this millennium's most relevant management technique.

And why not? One study by Stern Stewart testifies that companies that adopt EVA outperform their EVA-shunning competitors by an average of 8.60 per cent a year: over a 5-year period, their return on investment is 51 per cent higher than that of the competition. Another study discovered that, in the 5-year period between 1990 and 1995, the use of EVA created an amount of $79.60 billion in market value for the Coca-Cola Co..

Given the tendency of the bourses to amplify cause-effect relationships, today even an announcement by a company that it proposes to adopt EVA results in a 25 to 30 per cent increase in its share price. Thus, Omnicare's announcement that it proposed to implement the EVA concept, in February, 1999, resulted in its share price shooting up from $28 to $39. To introduce India Inc. to the wonder that EVA is made out to be, BT presents the 5 FAQs on EVA:

Q1.What is EVA? Literally, EVA is the quantum of economic value (or profits) generated by a company in excess of its Cost Of Capital (COC). Mathematically, it is the difference between the Net Operating Profits After Taxes (NOPAT) and the capital charge; or, the product of the capital employed and the difference between the Return On Capital Employed (ROCE) and the COC. In principle, it is a comprehensive financial management system that encompasses a range of functions like capital budgeting, acquisition pricing, goal-setting, and strategic planning.

In accounting terms, the concept of EVA is based on the principle of residual income, which states that the real income generated by a company is the residue that remains after a company's shareholders and debtors have been paid their annual required return. However, even traditional accounting is based on the residual income principle: the Profits After Tax (pat) is the residual income after the payment of interest and dividend.

Where the technique of EVA scores over the plain-vanilla residual income method is in its ability to identify the contribution of every unit of a company's output to, and its impact on, the total economic value of the company.

The logical extension? EVA can be used to evaluate the contribution of individual products, employees, and departments. No longer will managers and workers be forced to focus on tracking unidimensional local optima for want of a better measure. The Coca-Cola Co., for instance, measures EVA at the level of each bottle (or can) of beverage it sells. Explains Anil Sachdev, 45, Managing Director, Eicher Consultancy Services: ''The concept of residual income has been around for years, but EVA is a significant improvement over it. It has taken the best of the residual income concept, and eliminated the worst of accounting practices.'' And emerged as a reliable performance metric.

Q2.How does EVA deal with accounting anomalies? A measure is only as reliable as the components on which it is based. Garbage in; garbage out. The EVA methodology sanitises the financial information it uses. Stern Stewart lists 168 accounting adjustments-including the amortisation of goodwill, R&D expenditure, interest payments, and non-interest bearing current liabilities-which are an integral part of this sanitisation process. The objective is to ensure that the accounting numbers used by a company in the EVA process are real, or economic figures, and not notional ones.

A company needs to fix these anomalies if it wishes its implementation of EVA to be effective. Avers Chaith Kondragunta, 29, Vice-President and India Head, Stern Stewart & Co.: ''These adjustments segregate the financial information and convert the accounting framework into the EVA framework so as to reflect the right value creation, motivate the right behaviour, and produce consistent and definitive results.'' However, the number of adjustments that a company will have to make is not as high as 168: the typical company will need to make only between 6 and 11 adjustments.

Q3.How is EVA superior to other measures of financial and corporate performance? Traditional measures of corporate performance assume that there is no charge on equity. The logic? Dividends come out of profits, and if a company does not make a profit, it can skip paying out dividends. Thus, shareholder-funds are available for free. Assumptions like these constitute a recipe for disaster. Shareholders expect at least a market rate of return when they buy a company's shares.

Second, traditional measures of corporate performance argue that since a company's pat is, in some way, meant for its shareholders (part of it is doled out as dividend, and the rest is retained to fund future growth), they are comprehensive measures of corporate performance. However, these measures encourage the company's managers to take decisions that will boost the bottomline. The first liabilities are likely to be costs related to R&D and market development, which do not result in an immediate increase in pat. This approach will inhibit growth and, eventually, destroy shareholder value.

In contrast, the EVA process requires that expenses like R&D and market development be capitalised over a 5-year period. Points out Mangesh G. Korgaonker, 53, ICICI Chair Professor and Head, School of Management, Indian Institute of Technology, Mumbai: ''EVA has standardised the financial accounting process independent of the balance-sheet approach. It is a potent financial tool for the continued economic growth of an organisation and all its constituents.'' This approach ensures that growth isn't sacrificed at the altar of short-term results.

Indeed, EVA was created by Joel Stern and Bennet Stewart in the wake of the reckless spree of diversification that most large companies in the US and Europe embarked on in the late 1970s and early 1980s. The basis of diversification is a company's , often mistaken, belief that it can invest funds far more efficiently than the market. Its very architecture ensured that EVA promoted the creation of shareholder value, and not growth that came at the expense of shareholder funds.

To align managerial initiative with shareholder expectations, Stern Stewart linked EVA to managerial incentives. Even today, the company believes that the very essence of getting managers to do what is best for the shareholders is to not just offer stock-options, but to create a deferred incentives-account. The amount in the account increases if the company manages to add incremental EVA, and decreases if it doesn't. And the incentives themselves are disbursed at the end of a pre-ordained time-period.

But is EVA a superior measure of corporate performance than higher-order balance-sheet-oriented tools like Return On Net Worth (RONW), Return On Equity (roe), or Return On Total Assets (ROTA)? Actually, yes. A company's RONW is a function of the returns its products and projects manage to generate. The catch? Whether this rate is lower or higher than the company's cost of capital is irrelevant. A company's EVA, however, will increase only if its products and projects generate a rate of return higher than its cost of capital.

Even ROTA isn't as refined as EVA, since it encourages companies to enter product-markets that can boost their sales, and, consequently, profits. Concurs Ralph Heuwing, 33, Vice-President and Director, The Boston Consulting Group: ''EVA is like a corporate nervous system. It enables the organisation to evaluate its decisions through a strategic lens.'' It is, perhaps, its ability to serve as a critical part of the strategy-process that makes EVA a thoroughbred metric. The pivotal goal of an organisation is to add shareholder value; and EVA is an accurate measure of the incremental annual shareholder value generated by a company.

By using EVA to evaluate options, a company will choose the strategy that results in the maximum addition of shareholder value. For instance, logistics-major Ryder Systems bases its pricing decisions on EVA. Lafarge, the French cement transnational, uses EVA as part of the due-diligence process while acquiring other companies.

All this makes EVA an ideal tool for equity analysis: the HSBC Group, for instance, bases its analysis of companies on EVA. Explains Vasudeo Joshi, 35, Director and Head of Research, HSBC India Securities: ''Since EVA standardises financial information, it provides a common platform for us to compare various companies across the globe.'' Goldman Sachs and Credit Suisse First Boston have instructed their analysts to use EVA while analysing a company. And the US-based Oppenheimer Capital only invests in those companies that use EVA.

Q4.What does it take to implement EVA? A lot, as indicated by the fact that companies don't use EVA; they implement it. An EVA-company, therefore, is a company that is managed the EVA way. What does this involve? One, the primary objective of the company is the enhancement of EVA. Not sales; not profits; but EVA. The mathematical construct of EVA ensures that those companies trying to optimise it end up optimising sales revenues, COC, ROCE, and Net Operating Profits.

Two, the entire financial reporting of the company is based on the EVA methodology. This bestows the financial statements of the company with a dash of reality. Three, EVA is the moving force behind the company's existing and new projects. Put simply, to justify their acts, every individual and department in the company should look, not at its impact on EPS, the p-e ratio, or RONW, but on its impact on EVA. Thus, EVA-companies pursue a course of action only if it results in an incremental EVA. And their managers focus on optimising the COC, inventory, and accounts receivable. Implementing EVA is a 4-step process. Stern-Stewart calls this the 4m process. The 4 ms are: Measurement, Management System, Motivation, and Mindset.

MEASUREMENT. Any company that wishes to implement EVA should institutionalise the process of measuring the metric, regularly. This measurement should be carried out after carrying out the prescribed accounting adjustments, using the formula EVA = (ROCE - COC) x Capital Employed.

MANAGEMENT SYSTEM. The company should be willing to align its management system to the EVA process. The EVA-based management system is the basis on which the company should take decisions related to the choice of strategy, capital allocation, M&As, divesting businesses, and goal-setting. In effect, each one of a company's activities should be aligned to, and derived from the company's EVA process.

MOTIVATION. Companies should decide to implement EVA only if they are prepared to implement the incentive-plan that goes with it. This plan ensures that the only way in which managers can earn a higher bonus is by creating more value for shareholders. Sales-based incentives reward managers for incremental sales without considering the costs involved, and profits-based reward systems can be the source of resentment, at least among those managers who believe their rewards are based on variables beyond their control. An EVA-based incentive system, however, encourages managers to operate in such a way as to maximise the EVA, not just of the operation they oversee, but of the company as a whole. Thus, it aims to make every employee of an organisation an entrepreneur who seeks not just to perform his of her function well, but to do so in a way that will enhance the EVA of the company.

MINDSET. Like other transformation techniques, the effective implementation of EVA necessitates a change in the culture and mindset of the company. All constituents of the organisation need to be taught to focus on one objective: maximising EVA. Any company that manages to do this will find all its employees speaking the same language. Indeed, EVA is an ideal tool to bring about a transformation in a company's culture. Its singular focus leaves no room for ambiguity: it isn't difficult for employees to know just what actions of theirs will create EVA, and what will destroy it.

It does not take long to implement EVA. A typical company can do it in between 3 and 8 months. But companies like Sony and Siemens, which propose to implement EVA across locations, will find that the process takes 18 to 30 months. However, EVA offers the flexibility of starting small to the large, multi-divisional, and multi-location corporation: it can be implemented in one division as a precursor to a company-wide rollout.

The key to the successful implementation of EVA lies in integrating it into the company's incentive-plan. Agrees Milind Sarwate, 39, CFO, Marico Industries, which has been measuring its EVA for the last 3-4 years, but now plans to take the logical next-step by setting up a EVA-based performance-measurement system: ''Institutionalising EVA is not easy. But it can best be achieved by using EVA as the variable in the company's performance-appraisal or the flexi-pay process.'' EVA lends itself to this: it can be measured at the level of each of a company's activities.

This also removes the fundamental flaw in most traditional compensation models. The compensation of the majority of a company's employees is fixed. The quantum of this compensation is a function of the employee's ability to perform his or her assigned role. All too often, this translates into doing what one does better, or doing more of what one does irrespective of whether that adds value to the company as a whole. An EVA-linked variable-compensation model ensures that employees focus their efforts on activities that enhance the company's economic value.

From these principles emerges a simple 4-step process that companies can use to implement EVA. The first requires the company implementing EVA to train as many managers as it deems necessary-this depends on whether the company wishes to implement EVA in one of its divisions or across the organisation-in the theory of EVA. Second, the company should put in place a system-this could be part of either the organisation's MIS or its ERP-that makes it easy for managers to derive the information they need to calculate EVA, from the company's financial reporting system.

Three, companies adopting EVA should develop the culture of entrepreneurship among their employees. In most companies, managers focus on performing the tasks earmarked for them well; in EVA-companies, they have the responsibility of ensuring that their performance translates into an increase in the organisation's ability to add shareholder value. The fourth step is to align the organisation's internal processes-its management, performance-appraisal, and compensation systems-to its ultimate objective of increasing shareholder value. This is the most important stage in the EVA-implementation process: in its absence, managers will not have the requisite motivation to look beyond the comfort of local, and short-term optima.

Q5.Since EVA is an annual measure, does it not encourage an emphasis on the short term? A standard allegation against EVA is that the excessive focus on ROCE and COC constrains capital growth and promotes short-termism. True, EVA is an annual measure: it is the difference between the company's NOPAT and its capital charge, in one financial year. Thus, argue some of EVA's staunchest critics, it encourages managers to postpone or ignore capital investments that do not generate immediate returns. This, they posit, helps boost the company's ROCE in the short-term.

Counters Joel Stern, 58, Managing Partner, Stern Stewart & Co.: ''The EVA system puts the brakes on growth only when it is a non-profitable. Experience shows that our clients grow faster than their peers. In fact, EVA promotes growth in 2 ways. First, it holds managers accountable for the long term by putting a portion of their bonuses at risk if there is a subsequent decrease in the company's EVA. Equally important, because bonuses are based on changes in EVA, the only way that managers can continually earn large bonuses is by finding ways to profitably grow the business. This is better for shareholders than rewarding managers for any growth regardless of whether it provides returns vis-à-vis the COC.'' In effect, EVA encourages managers to invest in growth, but only if it is growth that can generate returns in the long term.

The financial advisory also argues that the real measure of a company's long-term ability to add shareholder value is Market Value Added (MVA). In technical terms, MVA is the value added by the management to the equity capital and debt entrusted to it by the company's shareholders. Mathematically, the MVA of a company is the Net Present Value (NPV) of all its future EVAs. Thus, any management system that encourages the continuous measurement of EVA and rewards sustained improvement encourages the employees to add shareholder value.

If EVA has been around for 18 years, and is everything described here, why have a mere 300 companies across the world, and only NIIT in India, adopted it? One reason could be the accounting-rigour the implementation of EVA demands. Most Indian companies are reluctant to change accounting systems. Notional profits could well disappear when adjustments for accounting anomalies are made. Another, the fact that Stern Stewart insists that the companies it helps implement EVA also implement the EVA-based incentive-compensation or variable-compensation model.

Managers are loath to set in motion something that could affect their own earnings. But a company that manages to implement EVA will find that its employees acquire an unrelenting focus on shareholder value. Aligning shareholder-, and employee-interests could well be this wonder-tool's greatest achievement.

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