I think it was the early 1990's when I first heard about the term Economic Value Added or "EVA." I was working with Hay Management Consultants at the time and seemingly out of nowhere clients started asking about it. Developed by the management consulting firm Stern Stewart, EVA caught fire when several high-profile corporations, including Coca-Cola, GE and AT&T started to use it internally to measure wealth creation on behalf of shareholders.
For a while there, it was all the rage, and consultants across the nation were scrambling to learn more about it. What they found was a complex series of formulas that seemed more at home in classrooms than a meeting rooms. Those who took the time to master it (I made a run at it back then), soon learned that the only thing more difficult than learning EVA was explaining it to others. Thankfully, it soon died out and became a compensation footnote like Ganisharing and Broad-Banding.
But last week it popped up again when I received a call from a compensation manager who had been asked to look into it by his executive team. He was interested in learning more about EVA as a possible incentive plan measure. We agreed to talk later after I updated my information (and memory).
To prepare for the call, I pulled up some old files and did an extensive internet search. Here is what I learned:
- EVA still has a loyal following, but it appears to be mostly with consulting firms and finance experts as opposed to executives and line managers.
- The concepts have continued to expand turning a once complex measure into a nearly unintelligible one.
- To counter this perception, those actively involved in promoting this measure have adopted the strategy of proclaiming the measure to be simple in hopes that this will make it so. Stern Stuart, the leading consulting firm involved in this type of work and the company that trademarked the term EVA declares on its website that "EVA® is a simple and clear indicator of when a unit is creating value." They offer the visual aide below as evidence. Hardly a ringing endorsement for simplicity!
- Investopedia remarks that the "EVA metric basks in a mystique of complexity, but . . .this complexity is only an illusion." It then goes into a 7 chapter explanation effectively undermining this assertion. See http://www.investopedia.com/university/EVA/default.asp
- There are many ways to comute EVA. A quick search revealed these little gems:
(Net Sales - Operating Expenses - Taxes - Invested Capital) x (Cost of Capital)
(Return on Capital - Cost of Capital) / (Capital Invested in Project)
(Invested Capital) + (Present Value of Future Economic Profits)
All right, so what's the bottom line?
Economic Value Added (EVA) is a financial performance metric used to calculate the true economic profit of a business. Unlike EBIT which is an accounting measure, EVA is an economic measure that is based on the idea that a company must cover both its operating costs and its cost of capital. EVA indicates the amount of wealth created or destroyed over a specific period.
As an operational metric, EVA helps managers clarify how they create value. Generally, they do this either by 1) Investing additional capital that produces returns above the cost of capital, 2) Reducing capital employed in a business, 3) Improving returns by growing revenues, 4) Reducing expenses or by reducing the cost of capital.
Because it relies on invested capital, it is more suitable for analyzing asset-intensive firms (those whose value comes largely from tangible assets on the balance sheet) that exhibit somewhat predictable growth trends. The best use of economic profit tends to be in traditional and mature industries. It therefore has less relevance for firms whose value is based largely on intangible, off-balance-sheet assets. That is why EVA has shown limited success in high-tech and service-oriented companies.
EVA pulls together into one measure several more common (and generally understood) measures (such as EBIT, ROIC, ROE, and free cash flow). Because of its complexity, and because most employees are going to have impact over one or more of the components of EVA (as opposed to the entire measure), in most cases it is preferable to reference in an incentive plan the component that is most relevant to the particular employee.