Maximizing Shareholder Value: Understanding Economic Value Added

Economic Value Added, popularly known by its acronym EVA, has become an increasingly popular mantra for a large number of businesses.¹ Proponents of EVA, which include the bluest of the blue chip companies like Coca Cola, AT&T, Philip Morris, RJR Nabisco, Quaker Oats swear that EVA is the miracle that rejuvenates a company from top to bottom. EVA is said to be the panacea that improves corporate governance, makes managers think, act and get paid like owners and re-engineers the financial management system to measure and reward value-creating activities.

In this article, we will explain the concept behind EVA, explore its benefits and shortcomings and suggest ways to address these shortcomings.

EVA Explained

Financial statements measure earnings as the residual after all factors of production other than shareholders have been paid for their services. For example, cost of goods sold accounts for costs of labor, supervisors and managers, raw materials, utilities, buildings, machinery, etc. Similarly administrative and marketing expenses are accounted for and so are the interest payments, which represents the "rental charge" on debt capital employed in the business. Even taxes, which represent Uncle Sam’s share of the corporate economic pie, are accounted for before computation of net earnings. The residual is the net income that belongs to shareholders.²

Equity capital is a scarce economic resource with an opportunity cost, just as any other factor of production. Yet, financial statements do not explicitly account for the opportunity cost of equity capital. EVA is computed by subtracting from the net income the opportunity cost of equity capital as if it were leased from outside.³ What is left measures how much better or worse the business did after meeting the opportunity cost of all resources employed by the business. If the business’ net income equals the opportunity cost of equity capital employed, the business has not added any value, even if it appears to have a sizable net income. Shareholders could have earned an equal amount by investing in capital market opportunities of similar risks. If a business earns less than the opportunity cost of equity capital employed, it has destroyed value because it has made shareholders poorer than they would be if they had realized expected returns on opportunities of similar risk in capital markets. Only if net earnings are greater than the opportunity cost of equity capital employed has the business added any value.

The fair market value of equity for a going concern equals the replacement cost of its assets added to the net present value of the expected investment opportunities. The net present value computation accounts for the opportunity cost of all capital. By subtracting from the fair market value of equity the replacement cost of capital employed, we get a measure related to EVA called the Market Value Added ("MVA").⁴ Not surprisingly, MVA is much more highly correlated with EVA than earnings, earnings per share, return on assets or return on equity.

Why Is EVA Important?

A modern corporation can be viewed as a nexus of a variety of explicit and implicit contracts involving several stakeholders, including, employees, customers, suppliers, lenders, the community and shareholders. These stakeholders provide resources and services to the business enterprise and expect to get compensated. Shareholders provide the risk capital that guarantees the performance of the corporation’s explicit and enforceable contracts by subordinating their financial claim to that of other stakeholders. Shareholders willingly accept a residual claim and get paid only if there is anything left over after employees, suppliers, taxes and other claims have been satisfied. In return for providing the risk-bearing function, shareholders get unlimited upside potential by acquiring property rights to the residual income.

To efficiently perform their role as bearers of risk in a modern corporation, shareholders should diversify their investments across a large number of different enterprises. By diversifying their portfolios, they eliminate a large part of the risk they bear. In a competitive marketplace, the price of risk will be determined by those shareholders who are best able to bear risk, namely, diversified investors. Therefore, market price of risk will only reflect risk which does not disappear in a diversified portfolio. (It is called the systematic risk and arises from economy-wide risk factors.)

The fact that equity investors should, and routinely do diversify to efficiently perform their risk-bearing roles creates the dilemma that is the central concern of corporate finance. When shareholders are diversified and own small ownership stakes in several business entities, they are unable to meaningfully monitor their investments. It is in not in the interest of each shareholder to individually expend resources monitoring the operations of a company because doing so would cause each shareholder to incur full cost of such efforts while any benefit would be shared by all shareholders. The market will fail to provide for meaningful monitoring by shareholders even if it were in their collective best interest. Economists call this market failure due to the free rider problem.

The separation of ownership of equity capital from the control of such capital by professional managers creates a potential conflict of interest. Managers who run the business need not necessarily be guided by incentives to enhance shareholders’ wealth. Economists call this the agency problem. Management of corporations based on EVA will maximize shareholders’ wealth. To achieve this objective, shareholders should compensate management on the basis of incremental EVA they generate. EVA makes people accountable not just for the results but also for resources utilized in achieving the results. For example, without an EVA-based incentive system, marketing people generally want more resources to sell more and earn larger sales-based compensation even when the marginal benefit to the organization is less than the marginal cost of increased sale.

Most companies estimate the marginal profitability of their product without regard to opportunity cost of equity capital. Suppose a company finds that a certain operation is profitable by traditional measures and it decides to incur additional investment to increase production. The company may find its profits have increased but its stock price has dropped because the shareholders could have earned higher marginal profits by investing elsewhere. EVA-based analysis will always provide the answer that is consistent with shareholders’ interest. To motivate managers to act in shareholders’ interests, their compensation should depend on increases in EVA they produce. Managerial objectives based on increasing income or market share, increasing return on assets or equity or other traditional measures can provide incentives inconsistent with maximizing the shareholders’ wealth. Maximizing EVA will always produce incentives to maximize shareholders’ wealth.

Some Shortcomings of the EVA Measure and How to Address Them

EVA is usually computed on the basis of historical numbers. Sometimes this produces distortion in incentives. For example, Northern Telecom cut its research and development expenditure a few years ago. While it increased returns in the short run, its competitive edge was weakened as a result. Without forward-looking assessment of long-term investment decisions, EVA analysis can provide incorrect answers. It is important to understand the unique aspects of a business and to account for all the strategic and long-term benefits of investments in order to correctly perform EVA analysis. Sometimes, this makes the EVA analysis impractical. As a general rule, start-ups and true venture companies are not suitable for EVA analysis.

A critical requirement for EVA analysis is to recognize all of the resources being used in a particular business activity, a task which requires a good understanding of the business. Many of the assets deployed in business activities are intangible assets that are hard to recognize, assign a value to and assess a capital charge for.

Conclusion

Finally, implementation of EVA-based management is not just a technical matter. It is as much an attitude and a way of thinking as it is a development and implementation of financial measurements and controls. To implement a successful EVA program, it requires commitment and leadership of top management and co-opting of the entire organization toward this effort. Outside consultants can provide fresh insights and technical assistance but ultimate success requires work from within the organization.

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¹ EVA is a registered trademark of Stern Stewart and Company.

² We are ignoring the distortions of the economic reality in the accounting measure of net income for the following discussion.

³ The opportunity cost of equity capital equals the rate of return shareholders can expect to earn if they invest in other opportunities in capital markets involving similar levels of risk. Well-accepted techniques can be utilized to estimate the opportunity cost of equity capital.

⁴ MVA is a registered trademark of Stern Stewart and Company.

Materials for further reading:

Marc Hodak, "How EVA™ Can Help Turn Mid-Sized Firms into Large Firms", Journal of Applied Corporate Finance, Volume 7, Number 1, Spring 1994.

Michael C. Jensen and Kevin J. Murphy, "CEO Incentives — It’s Not How Much You Pay, But How", Journal of Applied Corporate Finance, Volume 3, Number 3, Fall 1990.

G. Bennett Stewart, III, "Simulating Ownership for Line Managers", Journal of Applied Corporate Finance, Volume 3, Number 3, Fall 1990.

June 1997