Economic Value Added: Finance 101 on Steroids

A management project submitted in partial fulfillment of the requirements for the degree of Executive MBA at the University of Connecticut - April 1998 INTRODUCTION Creating Shareholder Value seems to be the mantra for public companies in the 1990s. Top management is increasingly focused on the fact that investors will cease to provide capital to companies that destroy value. While everyone's talking about it, not everyone is truly generating value. The stakes today are high. Part of the problem is a common misconception that investors only care about short-term earnings. The smart investors will be patient, to a point, if they believe a company is investing in projects that will create fundamental value. Unfortunately, many companies scramble to hit current quarter earnings estimates published by Wall Street and sometimes forego taking certain actions that are in the best long-term interests of their shareholders. In addition to this focus on short-term earnings, many companies simply do not have the systems in place to appropriately define the creation of shareholder value, let alone measure it. As Peter Drucker said, we generally call profits, the money left to service equity, is usually not profits at all. Until a business returns a profit that is greater than the cost of capital, it operates at a loss.1 In response, there has been a proliferation of consulting firms pitching their solution to this problem. These metric wars have been intense, with the various firms debating the pros and cons of their competitors' solutions. What matters most is that companies are focusing on creating shareholder value by rationalizing their businesses and setting financial hurdles to ensure that only value-creating projects are invested in. EVA is the measure developed by Stern Stewart and Co. The basic concept is the application of net present value and capital budgeting techniques, learned in Finance 101, to entire businesses. EVA recognizes that capital is not free and charges every business unit for use of this capital, based on the riskiness of the individual business unit and the weighted average cost of capital for the overall company. Earnings are then adjusted for accounting distortions and unusual transactions to derive a pure measurement of the operating results for the company. If these adjusted earnings are greater than the cost of capital, the company has created value (less than the cost of capital and the company has destroyed value). This analysis on a business unit by business unit basis should lead to one of the following actions: Find a way to grow operating profits without tying up any more capital (i.e., become more efficient) Invest new capital in any and all projects that earn more than the full cost of capital Divert capital from business activities that do not cover their cost of capital. The key to the EVA solution is the development of a reward system tied to the creation of shareholder value. Many companies may find that they are incenting employees to destroy value due to the complexity of existing reward systems. EVA can serve as a link that brings all employees together with a common language that appropriately aligns their interests with shareholders. In order to implement an EVA-based reward system effectively, the company needs to develop a comprehensive change-management strategy in light of the current culture of the organization. Without considering strategy, organizational structure, processes, people and rewards, and linking mechanisms to tie it all together, any major initiative is doomed to fail. CHAPTER 1 EVA - WHAT'S IT ALL ABOUT??? Creating Shareholder Value seems to be the major topic for public companies in the 1990s. Everyone's talking about it, but not everyone is truly generating it. While it's good that companies are focusing on generating value for their shareholders, the results can vary significantly from company to company. …