Interview
"EVA Is Working"

Q. Mr Stern, it's a pleasure meeting you. Ever since we read about the concept pioneered by your firm, Stern Stewart & Co., in 1990, we've been seeking answers to one question: despite being termed the hottest financial idea, why is it that Economic Value Added--which you call EVA--has not really found corporate acceptance?

A. It is always embarrassing when I am asked that question. People say that if you are so good, how come you aren't more successful? How come you have only 375 corporate clients--not 25,000 companies? It is very difficult to get people to adopt a new idea. It will happen only gradually. So, in the beginning, we had to find those companies that were considered intellectual leaders in their community--and sell them the idea. Soon, we felt that the other members of the community would be willing to give it a shot as well. One interesting example: Coca-Cola began working with Stern Stewart & Co. on EVA way back in 1982, and implemented it the following year. We are now implementing EVA in Equifax, the Atlanta-based information processing and credit evaluation company. But how did that happen? Our friends at Coca-Cola introduced us to Equifax.

Obviously, embracing a new idea is not as easy as it seems. It has to begin at the top. After all, it is a difficult thing to convince people to abandon the existing accounting framework and move to an economic framework

Now, there are three different aspects to EVA-ing a company. One, convert accounting measures into economic measures. Two, design and calibrate the incentive system. And three, educate and train people. If you have a strong leader at the top, who wants EVA implemented, everybody will do it. After all, he is the boss. In order to get the attention of the entire organisation, we have put in place an employee-incentive design. It bridges the gap between what people are told to do and what they really do.

Unless we have a chance to address the senior management in an organisation, we do not implement EVA. We have to get a voluntary buy-in to the idea. The single most important thing behind the success of an EVA programme is the CEO, who has to champion the programme. Second, the executive committee has to be solidly behind him. The reason why we have had such a healthy success rate--we've had only four failures--is that the company sets up a steering committee which actually works with us to tailor the EVA programme to the company's requirement. No two programmes are the same. The calculation of EVA can be different in different programmes. More importantly, the designs of the incentive structures are often different. In these committees, we include the heads of human resources, planning and other such people, who would be important to the design and implementation of the programme.

But consensus at the top level may not be enough to make a programme successful. Isn't it vital for it to percolate to the bottom of the organisation?

Oh, yes. Incidentally, some board members may not like EVA because it is a cultural issue. I must say I'm impressed with the strong culture in this country. There is something about the commitment shown here that reminds me of other ethnic people. But there is a weakness too: if people in India and Japan are told to do something, they will do it because they believe it is the right thing to do. That is the way they are. It is part of their work ethic. I have a problem with that. I believe that there is latent entrepreneurism inside every worker. And it is not going to show unless you put an EVA-type programme in place.

For instance, my firm is on EVA. Pat, my assistant who's worked with me for years, wanted to be part of EVA too. And she wanted to prove it to me. One day, she called British Airways and told them: "I want my boss to fly the Concorde free of charge." Three days later, the airline called back: "You've got yourself a deal. But your boss must give us 70 per cent of his business on all routes that the airline flies. We want you to monitor that. If he fails, the deal is off." She was laughing as she entered my office to tell me the story. She said: "British Airways should have known better; we are already giving them over 70 per cent of our business. They, probably, are not on EVA. If they were, they would have done the calculation even before they spoke to me." That's my role: to convert everybody from an ordinary employee into a value-change agent. Whenever you are speaking in front of a group, there is always what psychologists call a group leader. Let me tell you, they are extremely crucial to the process of EVAing a company.

But larger enterprises like Siemens, where your firm is introducing an EVA programme, may throw up problems of their own

Large enterprises are accustomed to be managed in a complicated and overlapping manner. Every time you are dealing with a part of the organisation, you are not dealing with one person, but with a group of people. That is the preferred method of taking decisions. That consumes time. I have told Heinrich von Pierer, the CEO of Siemens, more than once that he has to be there and say he is the champion of the programme--and we will implement it. And he has to do it regularly.

Normally, it takes between 10 and 12 months to implement a programme. In one small single-product company, we have been able to do so in seven months. The longest programme will be the one at Siemens, one of the largest companies that we have interacted with so far. They have 3,30,000 employees in 17 different business categories, and they are all over the world. On top of that, it is complicated because instead of making presentations to employees--as we are doing at niit--at Siemens, we are going to train teachers who will then spread the programme throughout the company. It is a much longer process which will take at least 30 months.

Is calibrating the incentive structure really a tough challenge?

Yes, you have to calibrate the system carefully. For instance, if you are in the fastest-growing EVA part of the company, I would give a smaller percentage of the improvement in EVA there. If you are in the slow-growing part, I'll give a larger percentage. What is difficult to improve will definitely get a bigger reward. That makes it very interesting because the people who are very often the very best in the company find it the most challenging to be in that part of the company where it is difficult to improve EVA. The reward structure is there to compensate for the difficult task.

But doesn't EVA actually encourage a culture of short-termism by discouraging huge capital investments?

Some people have said--incorrectly, of course--that EVA encourages short-termism. Nothing can be more ridiculous than that. In fact, the EVA programme overcomes any temptation to look at short-term behaviour. Under our bonus scheme, an employee gets only a small percentage of the bonus. In some of our programmes, the employee gets only one-third of the bonus right away. The rest--the two-thirds--is held at risk, subject to loss, in a deferral account. Can you imagine how people will behave if you keep one-third of their bonus in their right pocket and two-thirds--zipped--in their left pocket. As they walk around, they will feel the bonus in the left pocket, but the left pocket is subject to loss unless they sustain the results that caused the bonus declaration in the first place.

The question of short term versus long term is really an empirical question. All you have to do is to go out to test what organisations really do. Instead of reducing R&D, they will increase it; instead of cutting the number of employees, they will have more; and, instead of cutting capital expenditure, they will increase it. Mathematically, EVA is equal to the amount of your total capital multiplied by the spread between the actual rate of return on your investments and a hurdle rate or a required rate of return. As long as the actual exceeds the required, the more you invest, the higher the EVA. And since your bonus is tied to improvements in EVA, the last thing you would want to do is contain investment.

Despite the fact that EVA is aimed at motivating the employee, it is primarily a financial tool which helps corporates utilise capital efficiently. Would we see an EVA-led strategic transformation?

Let me be totally honest about this. EVA is no substitute for good planning, good product development, or good strategy. We don't make successful companies out of unsuccessful companies. If you don't have good ideas, and you are not developing good products, there's no way EVA will save the day for you. EVA only makes an individual more productive and more conscious about balance-sheet management. It also enhances the decision-horizon of the individual, makes him more concerned about tomorrow's consequences of today's actions.

We are reducing the temptation of corporate waste. What we are trying to tell people is that if the minimum rate of return that people expect is 15 per cent, you should not be picking up projects where returns are 10, 11, or 14 per cent. The problem is that under the more established methodologies, almost everybody is interested only in size. Under EVA management, we snuff out, or discourage, projects that destroy value.

That's an interesting point. But can EVA really rejuvenate projects or a company's culture?

It surely can. For instance, we're now doing work for SmithKline Beecham in the UK. It all started when Jan Leschly, the CEO, asked me: "Can you Eli Lilly my company? It is killing us everywhere. We want our people to be energised to turn out high-quality results." About 30 months ago, Eli Lilly implemented our EVA programme. Now see the difference it made to them. Exactly four years ago, Merck was selling 25 times its earnings, Eli Lilly was selling only 12 times. Today Merck sells 28 times while Eli Lilly is at 37 times. And the price of the Eli Lilly share has gone up from $53 to the $220 today. Isn't that fascinating? Eli Lilly's shares have quadrupled in value in the last four years. Nobody in the pharma industry is anywhere close to that.

How did we--and Eli Lilly--do that? We found out that no new products were being introduced by the company. We spoke to the chief scientist. His people were too busy doing original research. I told them that if they do original research under EVA, they should do it at a medical school. If they were going to work for the company, they must introduce newer products.

But doesn't your programme seem to be directed more at the interests of the shareholders than towards the other stakeholders of the company?

That's not true. I believe in free markets and shareholder value, but there is no possible way that you can be a successful company and not be conscious of all the stakeholders in the company. We care about our suppliers, our customers. If you don't treat your customers well, will they come back and buy from you again? We are entrepreneuralising the company under an EVA banner. It means that those who could afford to be lackadaisical about other stakeholders now have a real interest in all the stakeholders. As owners of the EVA programme, they want the programme to be successful over a long term.

I don't think a shareholder-value focus has to be identified with a programme that says, `I don't care about other stakeholders.' The fact that the US Postal Service implemented EVA only proves my point. They have no shareholders. They said they wanted greater efficiency and productivity out of people. Their performance has been spectacular. In the past, they have had to raise the postal rates faster than the rate of inflation. They just said they wanted the increase to equal half the rate of inflation. And the reason they're able to do that is because they have put EVA in place.

My last question. Why is EVA then supposed to be the best governance system for corporations?

Between 1935 and 1975, something strange happened in the US. The Securities Exchange Commission tried to make members of the boards of directors behave independently. They were to be concerned about all kinds of constituencies--not just the shareholder. As a consequence, corporations began to behave in ways other than value maximisation. In the late 1970s and 1980s, a new force began to take hold, whose goal was to better focus managements on the creation of value. And they found a very simple way of doing so. They conducted leveraged buy-outs in which they said to the management that they could stay on on one condition: that they put in their money into the deal. And the performance of these companies improved tremendously.

Because they restructured. But if you want to restructure your company with massive write-offs, I've got bad news for you. Under my EVA programme, I'm going to keep those write-offs as investments that shareholders have made to improve the company's performance. Remember: it's not EVA that matters; it's improvements in EVA that matter. Often, the thing that helps companies is not making decisions that they were willing to make earlier. Under EVA, if they do one investment less that was going to be bad for them and, instead, take that cash and pay it out to shareholders as dividends, everybody will be better off at the end of the day. People are incentivised to make that choice.

Let's assume that a company has surplus cash. A typical company that's not on EVA will not distribute the cash to investors. It would try to find another way of using that money because it wants a larger organisation. There's more power, more authority, more importance, more of everything that a person wants in an organisation. Yet, under EVA, there's a cost to making that choice. That's where the magic of EVA lies.