Switzerland: "Economic Value Added" is in Vogue

Economic Value Added, sometimes referred to as "EVA", continues to gain acceptance among many large companies and some not so large companies as a performance measure that is likely to create additional value for shareholders. Fortune Magazine reports that companies such as AT&T, CSX, Coca Cola, Briggs and Stratton, Quaker Oats and others have adopted Economic Value Added as a measure of internal performance because they believe that Economic Value Added provides a better basis on which to make decisions. After adopting Economic Value Added as a performance measure, these companies report such benefits as:

• a clearer focus on profitable markets and customers,
• managers who are asset conscious
• objective priorities for investments
• incentive compensation aligned with shareholder expectations.

Economic Value Added is a relatively simple performance measurement which takes account of profitability, the total cost of capital and the amount of assets under a managers' control. Traditional indicators of profitability measure managers of a business unit on the net profit or net margin produced from their business activities. These measures include return on capital employed calculated as net operating profit divided by the average amount of assets that they manage in their business activity.

However, there is growing recognition that existing measures of profitability do not include the full cost of capital needed to do business. Put simply, shareholders require a return on the equity that they invest in a particular company, whether through dividends or capital gains or a combination of both. While this return to shareholders rarely shows up as a charge to a manager's operating statement, it is indeed an opportunity cost to the shareholders. They sacrifice the opportunity to earn a return on another equity investment of comparable risk and investment characteristics by investing in a particular company. Should shareholders fail to earn the minimum return that they require on investing the equity of a company, they will frequently sell the stock and in some cases, larger shareholders will seek change.

Economic Value Added addresses this dilemma by measuring economic return after deducting the average cost of capital. The weighted average cost of capital (WACC) is the weighted average of a company's after tax cost of debt and the minimum return required by shareholders to maintain the value of their equity investment. This average cost of capital in percentage terms is then multiplied times the average capital employed in a particular business activity to estimate the "expense" of using this capital. For example, if a business unit's net working capital is $10 million and its long term assets are $50 million, it would then have capital employed of $60 million. If its management had determined that the company's minimum average cost of capital including debt and equity is 10 percent, then no Economic Value would be added to shareholders unless the manager of that business unit earned at least $6 million ($60 million average capital utilized x 10% WACC) in after tax operating profits (excluding the cost of interest).

Economic Value Added measures managers in much the same way that investment fund managers are measured. If the investors in a fund believe that they could otherwise earn a return of 10 percent and the fund manager earns a 12 percent return on it, the fund manager has created Economic Value Added of 2 percent times the amount of funds under management. If this spread of earned return over opportunity cost of funds holds, then investors always gain by adding more money to the fund. In the same way, operating managers give their shareholders added value by investing more as long as the incremental return on that investment is greater than the cost of raising money - in other words invest in projects that add Economic Value.

As the following chart shows, shareholders have explicit expectations for their equity investments and widely available benchmarks for determining whether their companies have met them. Long-term returns by investment class from 1926 to 1995, show that large company stocks have consistently earned a return approximately 7 percent higher than investing in risk free investments. More recently, the top 10 percent of the Fortune 500 listed companies have provided total annual average returns to shareholders of 27 percent per year, more than double the average annual total return to shareholders earned by the Fortune 500 median company.

When these expectations have not been met, shareholder disappointments have lead to significant changes in a company in many cases or, at a minimum, a restructuring of operations and finances. Since higher Economic Value Added rewards investors relative to their original investment, getting higher Economic Value Added rewards a company's shareholders and at the same time provides a better basis for managers to make the strategic investments they need to grow their businesses and maintain competitive position.

Companies who use Economic Value Added as a measurement tool make it clear to their managers that they seek to reward their shareholders with increased value by investing in assets whose incremental return is greater than the cost of financing those assets. All too frequently, companies that measure their managers on a percentage return on capital employed incent those managers to diminish their asset base relative to operating earnings in the hope of maintaining an already high return on capital. This may deprive the company's shareholders of opportunities that they would otherwise have if managers invested in new assets that earn a return greater than the cost of financing them. These investments may also create strategic advantage and fund future growth opportunities for a company.

Companies that have adopted Economic Value Added as a measure of performance are using it in several different but related ways. At the corporate level it is being used for management decision making regarding the proper capital structure of the company, the optimal portfolio of business units and product lines, and how to allocate the cash generated by the entire corporation to business units that create the greatest value for shareholders.

At the business unit level, Economic Value Added is being used as a measure to set goals for performance, to formulate strategy and to hold managers responsible for those elements of Economic Value Added that are under their control.

Within individual product lines and distribution channels, it is being used as a basis for evaluating returns on marketing strategies and more broadly to measure the return on investment and improved business processes. When incorporated properly in management bonus schemes and other incentive compensation, Economic Value Added leads managers to invest and grow their businesses by creating returns on assets that are greater than shareholders could earn on their own.

As the following diagram shows, performance targets based on Economic Value Added can be established for each operating unit of a company. These targets then become new goals for each operating business unit based upon the minimum operating profit needed to earn a return on the assets employed in that business that is greater than its cost of capital, reflecting both the actual charges to the company for servicing debt as well as the opportunity cost to shareholders.

These new performance targets can be developed using three perspectives:

1. Analyze the current business plan to determine which businesses are creating, maintaining or reducing value, which elements of Economic Value Added affecting value are the most important and whether they are reflected as business goals.
2. Analyze the sources of Economic Value Added created by the "best in class" performers in the same industry. More specifically, what are the realistic ranges of possible performance in operating profitability, asset turnover and cost of capital that can be achieved to create Economic Value Added and how does strategic position, i.e. size, market share, product quality affect this range of possible performance.
3. Consider the philosophies and operating targets that an alternative owner would employ in running your business were they hypothetically to manage it. Would they accept current assumptions regarding the limits on operating profitability, ability to eliminate overhead, potential savings in capital budgets and management of working capital? Managers who understand what value an alternative owner might see in the business and attempt to capture as much of that value as possible for the current shareholders preserve continuity.

The current business plan of a company we shall call "Catch Up" as the following diagram shows, started with a lower operating margin than the industry best in class, and an asset turnover significantly below the performance achieved by the best in class competitor. A series of internal analyses indicated that an improvement in operating margins to best in class levels, coupled with a major program to improve net asset turns, would put actual return on assets, well above the company's average cost of capital.

The market value of these changes in performance can be dramatic. As the following diagram shows, the initial position of Catch Up was well below the multiple of market value over book value of the best in class competitor. By achieving comparable performance, Catch Up believes that it can significantly its multiple of market value to book value, and consequently its value to shareholders.

The next step towards creating Economic Value Added is to align business strategy with the new goals based on the key measures that affect Economic Valued Added. There are several reasons for doing this:

• The firm may be investing too much in businesses that are not creating significant levels of value and not enough in businesses that are
• Business unit managers with new targets may initially find them aggressive and difficult to achieve with existing strategies and will need to reassess the growth, margin and investment characteristics of their product lines
• Some businesses may have a strong enough market position to provide additional cash flow to support transition strategies in other businesses provided a positive Economic Value Added results from these actions. In these cases the impact of these actions need to be assessed in light of the strategic position of each business, i.e. market attractiveness and share, strength of customer relationships and importance of research and development activities.

A corporate strategy that creates additional Economic Value Added usually builds on a strong core business focus that contributes to each element of Economic Value Added as shown in the following diagram:

Reassessing business unit strategies once new goals for achieving Economic Value Added are in place takes several months, but the rewards can be significant in terms of closer attention to asset management, simpler, more easily understood goals and greater investment in business expansion projects previously restrained by an earnings per share or return on capital focus.

Allocating specific responsibility for achieving the performance targets suggested by Economic Value Added is the key to successful implementation of this new measure of performance. This, however, has been found by many companies to be the most challenging aspect of adopting Economic Value Added as a management tool. While the concept of Economic Value Added is easily understood, operating managers may not understand how their performance directly affects Economic Value Added. The responsibility for achieving these elements of performance must be understood and assigned to specific levels within the organization. Senior management, for example, usually retains overall responsibility for corporate expense, fixed assets and the capital structure of the company. Responsibility for controllable costs such as payroll, supplies, advertising, etc. on the other hand, generally belong to managers of the product line level.

As the following diagram shows, allocating responsibility for achieving these targets as part of a formula for achieving higher Economic Value Added puts responsibility for those measures at the level where they can be controlled consistent with a formula for increasing shareholder value.

Opportunities to increase Economic Value Added in line with strategy can exist in many areas.

• Reposition business segments into larger, higher growth markets
• Improve coverage of all strategic geographic areas in each business
• Reduce discounts, allowances and inventory shrinkage
• Exploit quantity discounts for materials and services
• Lower facilities costs i.e., energy conservation, review insurance policies against actual value, consolidate space
• Review all reporting and information processes and eliminate unnecessary reports and associated activities

• Lower investments in accounts receivable by improving (lowering) DSO, terms and conditions and cash flows
• Lower inventory levels, related provisions and carrying costs with a product design methodology based on build for manufacturability, common design architecture and parts, and reliability of servicing
• Negotiate reduced delivery times with suppliers to cut inventory Consider consolidation of warehouses/plants to reduce pipeline inventory
• Identify and prioritize supplies and lengthen payment terms for lower priority suppliers
• Use buying power with large suppliers to negotiate favorable payment terms
• Sell off excess real estate
• Sell and leaseback selected assets at lower effective financial costs
• Close underutilized facilities

• Increase competition for loan business
• Negotiate financing fees
• Exploit lower interest rate alternative loan sources
• Strengthen and broaden investor communications program

Economic Value Added is a practical, valid concept that aligns management performance goals with the expectations of shareholders and their opportunity cost of capital. While easily understood, Economic Value Added can be a challenging concept to implement. By taking the four steps outlined above, corporate management and their business unit managers can be effective in realigning their performance with shareholder expectations and achieving many operating and competitive improvements at the same time.

The content of this article is intended to provide a general guideline to the subject matter. Specialist advice should be sought about your specific circumstances.