The EVA Challenge: Implementing Value-Added Change in an Organization
Joel M. Stern, John S. Shiely, Irwin RossBooks.org participates in affiliate programs including Bookshop.org and the Amazon Services LLC Associates Program. We may earn a commission from qualifying purchases made through links on this page, at no additional cost to you.
Overview
"EVA - Economic Value Added - is a measure of the true economic performance of a company and a strategy for creating shareholder wealth. It is also a method of changing corporate priorities and behavior throughout a company, right down to the shop floor. Properly implemented, EVA frees the measurement of corporate performance from the vagaries of accounting conventions and aligns the interests of managers with those of shareholders, ending a decades-long conflict of interest." "In The EVA Challenge, authors Stern, Shiely, and Ross outline how to implement EVA at all stages - including strategy development, organizational design, training, and incentive compensation."--BOOK JACKET.Synopsis
–Economic Value Added–is a measure of the true economic performance of a company and a strategy for creating shareholder wealth. It is also a method of changing corporate priorities and behavior throughout a company, right down to the shop floor. Properly implemented, EVA frees the mea-surement of corporate performance from the vagaries of accounting conventions and aligns the interests of managers with those of shareholders, ending a decades-long conflict of interest.
In The EVA Challenge, authors Stern, Shiely, and Ross outline how to implement EVA at all stages–including strategy development, organizational design, training, and incentive compensation.
Essentially, an EVA program encompasses three things: a measurement system, an incentive system, and a system of financial management. In measuring performance, for example, EVA’s key ingredient is the recognition of a capital charge——the cost of the capital in a company, in a division, in a branch store, or in a product. This detailed how-to guide shows executives around the world how to customize EVA for their organizations and improve the economic value they deliver. Here, EVA converts learn how to work some "EVA magic" through company-specific initiatives and case study examples. Coverage includes insightful new material on matters such as real options and new economy valuations, showing why new economy firms need EVA as much as old economy firms.
Executives around the globe now have a book that shows them how best to utilize EVA at their companies–reorienting the corporate ship in the direction of true economic profit. Research shows that companies using EVA outperformed competitors of comparable market capitalization by an average of 49% over a five-year period, as measured by total returns to shareholders.
Financial Times
The authors develop a number of powerful ideas in the book. The core of The EVA Challenge is a clear, accessible and often quite readable account of what exactly EVA is; how to calculate it; what information it can give shareholders; and how to devise ways of linking remuneration to EVA. ...It is an excellent, practical guide for busy chief executives. Buy it, read it on the plane and then start asking your top team some hard questions - before your shareholders do.
Editorials
Financial Times
The authors develop a number of powerful ideas in the book. The core of The EVA Challenge is a clear, accessible and often quite readable account of what exactly EVA is; how to calculate it; what information it can give shareholders; and how to devise ways of linking remuneration to EVA. ...It is an excellent, practical guide for busy chief executives. Buy it, read it on the plane and then start asking your top team some hard questions - before your shareholders do.Soundview Executive Book Summaries
Economic Value Added (EVA) is a measure of the true economic performance of a company - as well as a strategy for creating shareholder wealth. It is also a method of changing corporate priorities and behavior. The authors write that a properly implemented EVA plan frees the measurement of corporate performance from the vagaries of accounting principles and aligns the interests of managers with those of shareholders.Today's corporations are professionally managed, and the authors point out that the true owners of the corporation - the shareholders - are divorced from the actual operations and control of the enterprise. In an attempt to monitor their companies' performance, shareholders use presumably objective criteria - the ones accountants use. Specifically, they look at the company's net earnings as reflected in earnings per share (EPS). As the EPS grows, a company's share price is supposed to rise, on the assumption that its price/earnings ratio will remain relatively constant.
Misleading Assumptions
The problem, the authors write, is that as accountants work their way to the bottom line, they make several calculations on a company's profit-and-loss statement that distort economic reality. Specifically, the authors write, as accountants prepare profit-and-loss statements, they make assumptions that undervalue the company's true economic value.
First, there is the expense (deducted from revenue in the year that costs are incurred) of research and development (R&D) outlays. This has the effect of lowering profitability in the year the costs are "expensed" even though the benefits of R&D activities will impact the company's profits for years to come.
Accountants also "expense" advertising and marketing costs in the year they are incurred, even though the effect of those ads may be to build a brand that will pay dividends for years to come.
Finally, accountants list assets at the lower end of original cost minus depreciation, or market value. For example, a building that cost $10 million might now be worth $20 million, but will be listed on the balance sheet as $9 million (purchase price minus depreciation.)
In addition to accounting practices that distort reality, the authors write that EPS can be easily manipulated, especially by senior executives whose bonuses might be tied to earnings improvements. As a result of standard accounting practices or even outright manipulation of the numbers, the authors write that earnings per share don't really present the whole picture for the investor who simply wants to compare the cash he or she can take out of the company with the cash he or she invested.
The authors explain that properly implemented Economic Value Added (EVA) aligns the interests of the shareholders with those of the managers, ending the inherent conflict of interest that has long plagued corporations. EVA lets this happen because the measurement of corporate performance is no longer affected by the caprice of accounting conventions or the manipulation of managers looking for a larger bonus. The authors write that real economic profit is now the measure of corporate performance, and point out that over 300 companies worldwide have already adopted EVA, including Coca-Cola, J.C. Penney, and the U.S. Postal Service.
The EVA Formula
EVA is simply the profit that remains after deducting the cost of the capital invested to generate that profit. Thus, the exact formula for calculating EVA is net operating profit after tax (NOPAT) minus capital charge.
To calculate the capital charge part of the EVA equation, the authors write that managers must first determine the company's cost of capital, often referred to as the required rate of return. This is the rate that compensates investors for their perceived risk, and varies from industry to industry. If the company's profits equal the required rate of return, the investor hasn't made money.
To calculate a company's cost of capital, managers have to take into account both the cost of debt capital and the cost of equity capital. The cost of debt capital is simply the interest on the company's borrowing. Since interest is tax-deductible, the after-tax rate is used. Equity capital starts with the interest an investor could earn on a safe investment, such as a long-term government bond. Managers must then add the equity risk premium - the percent of risk associated with investment in the company or industry.
After the cost of equity capital and the cost of debt capital have been calculated, managers can calculate a company's blended cost of capital. This is achieved by determining the proportion of debt and equity capital in its capital structure. Once the blended cost of capital has been determined, managers can calculate the capital charge that is to be deducted from the company's profit. The capital charge is the company's total capital multiplied by its cost.
Now managers must calculate NOPAT. They will have to make adjustments for those accounting anomalies discussed earlier. There are more than 120 possible adjustments, but most companies will only adjust R&D costs, advertising and promotion costs, staff training and development, and depreciation costs.
The authors write that EVA is far more than just a measurement tool. They explain that EVA should become the basis of an incentive plan that rewards managers for actions that increase shareholder returns - and penalize them for failure.
Why Soundview Likes This Book
The EVA Challenge presents a thorough and eye-opening explanation of a better way to help managers create shareholder value. The wealth of information presented by the authors provides useful tools for organizations that are looking to align the goals of all organizational levels and motivate managers by connecting compensation to EVA performance. Copyright (c) 2002 Soundview Executive Book Summaries