Cover Story: Winning with EVA!!!

You can't go wrong with EVA. The 160-odd adjustments that Stern Stewart & Co. recommends be made to the financial statements of a company before calculating its EVA may turn CEOs away. Still others may interpret the fact that EVA is an annual measure to mean that it encourages short-term thinking among managers. In an article explaining how EVA should, ideally, be implemented, the head of Stern Stewart's India operations explains how it is really the one true metric of growth and shareholder value.

The last few years have seen Economic Value Added (EVA) become the most accurate measure of shareholder value-creation around the world. In December, 1995, Fortune magazine published a survey of companies that had implemented EVA, like the Coca-Cola Co. and Eli Lily, and found that, over a 5-year period, they outperformed their peers by delivering a shareholder return that was 51 per cent higher. Consider the implications: a company with a market capitalisation of Rs 500 crore would, annually, create about Rs 45 crore more in shareholder wealth than its peers.

Given this track-record, the natural reaction is to wonder how these companies are able to post superior performances and to ask if EVA is, indeed, the singular measure of value-creation? To understand why implementing EVA is critical to a company's success, one needs to first understand why creating shareholder value is important. All corporations have a fundamental duty to meet the expectations of all of their investors (both creditors and equity-holders). Equity-holders as a rule get paid last (after creditors and employees) since their returns come out of after-tax earnings; moreover, the other claim-holders to the corporate pie, like creditors and employees, have stronger legal covenants to enforce their contracts with the corporation.

The obligation to meet shareholder expectations would arise only after the organisation has satisfied every other claimant. The corporate goal of meeting shareholder expectations , then, is the same as fulfilling the obligations of every stakeholder in the corporation. Therefore, a company's management should adopt and pursue only those strategies that will deliver the most value to the shareholders. This objective is the philosophy that will ensure that the organisation's scarce resources are allocated, managed, and redeployed as efficiently as possible. This, in turn, maximises the wealth of society at large.

Because creating shareholder value is the fundamental goal of every corporation, measuring companies-and their management-on the basis of value created is an objective measure of their performance. But how does one measure the creation of wealth? The best measure for this is Market Value Added (MVA). MVA is an absolute measure of wealth-creation, and is obtained by subtracting the economic capital of a corporation (book capital after adjusting for accounting anomalies) from its total Market Value (MVA = Market Value - Capital). Because MVA represents the value added by the management to the resources provided by all investors of the firm, it is the perfect summary assessment of corporate performance. MVA shows how successful a company has been in allocating and managing resources to maximise the value of the enterprise and the wealth of its shareholders.

While MVA is the best measure of corporate performance, it is not very useful as a management tool. It does not exist for divisions within an organisation. And since MVA is prone to fluctuations in a company's scrip-price; it changes every (trading) minute, and, therefore, is not a consistent management tool. Enter EVA. EVA is the one parameter that best explains changes in the MVA of an organisation. Single-industry studies have revealed a remarkable 70-80 per cent correlation between the MVA and the EVA of a corporation. This is because EVA is the one true measure of economic performance of a company. Simply put, EVA is the Net Operating Profits After Tax (NOPAT) of a business, minus a charge for the capital employed (EVA = NOPAT - COC*Capital Employed). COC, the cost of capital, is the weighted average of the after-tax costs of debt and equity.

It is true that EVA, similar to residual income, integrates operating efficiency with balance-sheet management. It achieves this by converting the balance-sheet into an expense: the capital charge. Under EVA, the capital is charged at a rate that compensates investors for bearing the firm's explicit business risk. By subtracting the cost of capital, EVA automatically sets aside a return, which is sufficient to recover the value of the capital that has been, or will be, invested. For this reason, it automatically accounts for any premium over, or discount under, the capital invested. Over a specified period of time, this spread is exactly the value of a project, or, in the case of a company, the MVA. Maximising MVA is the fundamental objective of any enterprise. And maximising the period of EVA performance is the route through which a company can achieve that objective.

Most people assume that EVA is simply an accounting number. Nothing could be further from the truth. To calculate EVA, one needs to begin by making adjustments to accounting statements. This is because standard accounting practices introduce distortions in measuring the true performance of a company; for example, why do accounting rules insist on converting R&D-spend into a balance-sheet expense, when the benefits of R&D are not evident in 1 year? Shouldn't the expenses related to R&D be spread out over the period during which the benefits would appear? A proper calculation of EVA would entail adjusting the NOPAT and Capital for accounting anomalies such as this . Stern Stewart & Co. has identified about 160 such accounting anomalies across different industries that mask the true performance of a business.

It troubles some that EVA is measured after subtracting depreciation. The basis for this confusion is the notion that depreciation cannot be an economic charge since it is a non-cash charge. But the depreciation suffered by assets must be recovered from a company's cash-flow over time so that investors can obtain a return of their capital before they can earn a return on it.

The easiest way to appreciate this is to think about it as similar to the lease payment if an asset was leased instead of being bought. The lease payment would implicitly include depreciation because the lessor would charge the lessee for a recovery of the asset's cost. Depreciation is an economic charge: one would pay for depreciation in cash if the asset were leased instead of being owned. Incidentally, advocates of internal rate of return measures, like CFROI (Cash Flow Return On Investment) feel that depreciation is a non-cash charge, and claim that by excluding it from calculations, distortions introduced by it can be avoided.

What is ironic is that depreciation is implicit in CFROI. Hidden in the mathematics for arriving at the rate of return is the fact that the shortfall between the money spent on purchasing an asset and the money to be recovered from its residual value must be, somehow, retrieved from intervening operating cash-flows before investors begin to earn a positive return on their investment. If this sounds like depreciation, that's because it is!

What is true is that there is a problem in calculating EVA or any other financial measure on straight-line depreciation. Any rate-of-return measure based on straight-line depreciation will understate the true return in the early years and overstate it in the later years. This is because taking a steady depreciation charge against steady cash-flows leaves steady earnings against an asset-base that declines with depreciation. This bias in returns can make managers reluctant to acquire new assets when they should (because the calculated returns would then be low) or drop old assets beyond the point of economic return (since the calculated returns would be high). The problem is real, but the blame does not lie with EVA. It arises from basing depreciation on accounting instead of economics.

A better way to calculate depreciation is to introduce economic depreciation. In this method, depreciation is calculated as an annuity payment, where, in the early years, most of the cash generated by the asset is used to provide for the return on the capital, and only a small portion amortises the capital balance. In the latter years, only a little cash is needed to provide for a return, and the bulk is used to amortise the remaining principal. Economic depreciation is one of the 160 accounting adjustments that may require to be made to arrive at the true definition of EVA.

A properly-calculated EVA presents a true picture of the economic performance of a business; in fact, an EVA analysis and a free cash-flow analysis would yield the same mathematical answer for any project or business. This proves that the concept of EVA is tied to the fundamental economic tenet that the value of a business arises out of its future cash-flows. An analysis of free cash-flows gives us a point-of-time measure of value while EVA yields a periodic measure of performance. And EVA is a much more powerful tool than free cash-flow because it can be used to measure performance, evaluate strategies, allocate capital, price a company's acquisitions or divestitures, restructure balance-sheets, and serve as the basis for a variable-compensation system.

EVA is more than just a financial-performance measure. Metrics like customer satisfaction, employee morale, quality, and productivity are important value-drivers for an organisation. Only by addressing these issues can a company maximise its EVA. The real power of EVA comes about when the other line-of-sight operating metrics, at various levels of a company, are aligned to value-creation and EVA. Successful EVA companies across the world have been able to identify the value-drivers in their business, and link them back to the overall corporate EVA. These links ensure that local metrics do not strive for local optima that will compromise the overall pursuit of wealth-creation. For example, a single-minded drive to improve productivity could lead to unwarranted capital-spending. EVA helps a company make the right trade-offs between economic returns and the expenditure involved in any corporate initiative. For, at the end of the day, companies and managements should be held accountable for delivering value, not simply for improving metrics.

The real purpose of EVA is to serve as the centrepiece of an integrated management and compensation system. Most organisations follow different (and, often, conflicting) metrics for different purposes. They use a variety of seemingly-simple measures like discounted cash-flows for capital budgeting, earnings for goal-setting, and budgets for performance appraisals and compensation.

The result is a corporate system that is complicated and disjointed, resulting in a loss of comparability and accountability. And in cases where the measures conflict, the system becomes confusing and divisive. Think of a manager whose performance measure is variance in the budget while the overall corporate goal is to increase earnings. Would any rational manager want to control costs, knowing fully well that his or her budget will then be affected?

In contrast, under the EVA Management System, all corporate processes, like capital budgeting, planning, goal-setting, strategy reviews, and incentive compensation, are linked to one measure: improving EVA. This makes the system much easier to comprehend and administer. Improving EVA becomes the focal point of a simpler, integrated management system; one that serves to unite the various fiefdoms and functions within a corporation. And it makes them all accountable to the mission of creating value.

Critics of EVA often contend that because of the explicit capital charge under this system, CEOs will refrain from spending or investing for growth. This is only partially true: EVA puts a crimp on investment or expenditure decisions that do not add value. Advocates of growth should note that the only desirable growth is the one that creates economic value. Most of the adjustments that EVA organisations adopt actually encourage spending on value-adding projects. The reason for capitalising R&D expenditure is to encourage managers to give proper consideration to the short-term costs and benefits as well as the long-term benefits of R&D.

Capitalising a hitherto-expensed item would make it less tempting for managers to cut down on R&D in lean times. In the case of other strategic investments with longer pay-off periods, a properly-designed EVA system will keep such capital off the books (for internal performance evaluation) and gradually re-admit it into the manager's capital account to reflect expected pay-offs over time.

EVA actually encourages a far-sighted corporate investment policy than traditional accounting measures. One example of this is Federal Mogul, an auto-parts manufacturer based in Detroit. Soon after adopting EVA in 1997, the corporation publicly announced its intention of quintupling its size from $2 billion to $10 billion over 5 years. With revenues close to $7 billion in 1999, Federal Mogul is well on its way.

The EVA bonus-programme helps employees acquire a long-term vision. An EVA-based incentive plan rewards employees for both the current and the cumulative increase in EVA, over time with an at-risk, bonus-bank system. This system serves to keep everyone focused on longer-term value-building rather trying to game the system through short-term efforts. The targets for achieving bonuses are objectively set, based on investor or market expectations, and are communicated well in advance within the organisation. This is a change from the usual practice of negotiated budgets and targets that change annually.

EVA is a powerful management tool that has gained international acceptance as the standard of corporate governance. It is a way both to legitimise and to institutionalise the running of a business in accordance with the fundamental principles of microeconomics and corporate finance.

EVA is most effective when it is used more than as a performance measure; instead, it serves as the centrepiece of a completely integrated management and incentive-compensation system. Successful companies make 'managing for EVA' the singular mindset of their organisations. The experience of a lengthening list of companies throughout the world strongly supports the notion that an EVA-system can refocus energies and redirect resources to create sustainable value: for companies, customers, employees, shareholders, and the management.

S. Chaith Kondragunta is the Vice-President & Country Manager (India) of Stern Stewart & Co., the corporate finance advisory and consulting firm. EVA is the registered trademark of Stern Stewart & Co.. Website: http://www.EVA.com

EVA: THE METHODOLOGY
The Methodology
How We Calculated This Listing Of The EVA Of India's Companies.

Our Economic Value Added (EVA) analysis began in June, 1999, with a universe of India's 1,300 largest companies, as identified by the Mumbai-based Centre for Monitoring Indian Economy (CMIE) by their average market capitalisation between April 1, 1998, and March 31, 1999. After arranging them in descending order, banks, financial institutions, and non-banking finance companies were excluded from the list to prevent distortions in the comparison. Companies for which complete financial information was not available for at least 2 out of the past 3 years were also excluded. The top 500 companies by their average market capitalisation during 1998-99 were then chosen for the study.

BT provided the financial information required for the study to the Mumbai-based Stern Stewart & Co. All the financial information required for the study was sourced from the CMIE's Prowess database. While information on credit-rating spreads was obtained from CRISIL, the risk-free rates were obtained from the RBI's annual reports. The following adjustments were made by Stern Stewart to the financial statements to convert the book profits and book capital to operating profits and economic capital:

NON-RECURRING INCOME AND EXPENDITURE. Non-recurring items were excluded from NOPAT, and capitalised after tax. Non-recurring losses or expenditure were taken as additions to capital while non-recurring incomes or gains were deemed to be reductions to it.

RESEARCH & DEVELOPMENT. For accounting purposes, revenue expenditure on R&D was charged to the profits in the year in which it was spent. However, R&D is a strategic investment . So, the after-tax R&D expenditure was included in the capital and added back to NOPAT. The amount included in the capital was amortised over 5 years.

GOODWILL. Goodwill is a permanent investment in the business on which the shareholders expect returns, and should not be amortised. Thus, goodwill amortisation was excluded from the calculation of NOPAT, and gross goodwill was included in capital. Indian standards recommend accounting for M&A using the Pooling Of Interests method. Goodwill is not recognised in the books when this method is used. In such cases, unrecognised goodwill should be computed and added to the capital. However, this was not done in the case of this ranking because of the lack of data.

INTEREST. All interest expenses were added back to profits. The tax-benefits of interest were also removed, and the cash operating taxes for the company were adjusted accordingly. This was done as the tax-benefits of interest were considered in the Cost of Capital. This adjustment separates the financing and investing activities of the business.

NON-INTEREST BEARING CURRENT LIABILITIES (NIBCLS). NIBCLs are part of the on-going operations of the business, and are a source of finance. All NIBCLs were excluded from the calculation of capital.

INVESTMENTS IN MARKETABLE SECURITIES. These were included in capital, and the income from these securities as shown in the books of accounts was included in the NOPAT.

INVESTMENTS IN SUBSIDIARY COMPANIES. Due to lack of adequate information, the financial statements of the subsidiary companies have not been consolidated. The investments in, and the income from the subsidiary companies as shown by the companies in their financial statements were retained.

CASH OPERATING TAXES. The tax-adjustment starts with the provision for taxes, which was restated to reflect taxes paid on operations. The tax-effects of financing and non-recurring items were eliminated. The marginal tax-rates for the respective years were used for all the adjustments.

REVALUATION RESERVE. Revaluation reserves was considered for all companies, and excluded from capital.

CONSTRUCTION IN PROGRESS. Construction In Progress was included in capital.

ECONOMIC VALUE ADDED (EVA(r)). EVA(r) is the difference between NOPAT and the shareholder's expectation, which is the capital charge. EVA = NOPAT - (Cost of Capital � Economic Capital).

However, since the Cost of Capital is determined by the prevailing interest rates in the country, the ranking of each company on Cost of Capital and its percentage growth is a purely mathematical exercise and not an indicator of their efficiency.

The Calculations

NOPAT = (Profits After Tax + Non-Recurring Expenses + Revenue Expenditure On R&D + Interest Expense + Good-will Written Off + Provision For Taxes) - Non-Recurring Income - R&D Amortisation - Cash Operating Taxes.

Cash Operating Taxes = (Provision For Taxes + Tax Benefit Of Non-Recurring Expenses + Tax Benefit Of Interest - Tax On Non-Recurring Income).

Economic Capital = Net Fixed Assets + Investments + Current Assets - (NIBCLs + Miscellaneous Expenditure Not Written Off + Intangible Assets) - (Cumulative Non-Recurring Losses + Capitalised Expenditure On R&D + Gross Goodwill) - Revaluation Reserve - Cumulative Non-Recurring Gains.

MARKET VALUE ADDED. MVA measures the value added by the management over and above the capital invested in the company by the investors. MVA = Market Value Of The Firm - Economic Capital. The market value of the firm is the sum of market values of equity, debt, and preference shares. The master-ranking of the companies was done on the basis of MVA, and not EVA. While the EVA of a company is a historical figure based on the efficiency with which it used the resources at its disposal in a particular year, its MVA is the market's assessment of its ability to create wealth in the future.

The number-crunching was done by a Stern Stewart team headed by Country Manager (India) S. Chaith Kondragunta, and comprising Rajeev Rao and Sanjay Kulkarni. At BT, the project was co-ordinated -
by Rajeev Dubey.