Implementing Eva

EVA(TM) (economic value added) is a measure of financial performance that combines the old concept of residual income with principles of modern corporate finance--specifically, that all capital has a cost and that earning more than the cost of capital creates value for shareholders.

Companies that generate high EVA are top performers that are highly valued by shareholders.

To make EVA work for your company, take three steps and follow four rules that have worked for a wide range of companies during the past 10 years.

STEP 1: Understand EVA.

EVA is the dollar value created for investors over a set period of time, like a quarter or a year. The value added is any excess of after-tax operating profit minus all the costs of doing business, including the interest cost of debt and the opportunity cost of equity. in other words, EVA is after-tax operating profits, less a capital charge equal to the amount of profit needed to cover interest expense and provide an adequate return for equity investors.

What EVA is

First, EVA is the best way to integrate the often competing goals of growth and operating efficiency. As such, it is a better measure than earnings or return on net assets (RONA). Earnings growth creates size but does not always equate to share value growth because it may be achieved at excessive capital cost. RONA measures efficiency but not the magnitude of profits, as earnings does.

Low returning businesses may invest in projects that increase the average return on capital but earn less than the cost of capital. Likewise, high returning businesses may be incented to forego value-adding investments because they lower the average return. EVA combines the magnitude of an earnings measure with RONA's focus on efficiency.

Second, EVA measures the value created during a defined period through increased margins, improved working capital management, profitable investment or redeployment of underutilized assets.

EVA holds management accountable for all economic outlays, whether they are recorded on the income statement, balance sheet or in the footnotes of the financial statements.

Third, EVA creates a common language for making capital budgeting decisions, evaluating performance and measuring the value-creating potential of strategic and tactical options.

What EVA is not

EVA is not a holy grail. EVA is a good instrument to have on the dashboard because it is an internal measure closely linked to share price performance. However, EVA does not solve business problems; managers do.

Even though Scott Paper adopted EVA-based measurement and reward systems in 1993, management's actions did not significantly enhance shareholders' returns. The company's value was dramatically increased through a restructuring effected by a new chief executive whose compensation was tied to his significant equity ownership and stock options.

Furthermore, EVA can be just as distorted by historical cost accounting as EPS, ROE or CFROI. EVA is computed from historical accounting information, or sunk costs. From a share value viewpoint, sunk costs are irrelevant to the generation of future free cash flow. Without adjustment, an old factory will report higher EVA than a new one, even though both promise the same free cash flow.

By the same token, adjusting historical costs to economic reality is not a perfect science and can add layers of administrative complexity and confusion. To minimize distortions caused by historical cost accounting, management should at least focus on the change in EVA--not its absolute level.

Finally, EVA does not direct management. Because it is a single-period measure, it provides little guidance for the future. For example, negative EVA alone does not mean a business should be sold. The sunk capital may be worth little, but it may be worth even less on the scrap heap or in someone else's business. Moreover, relatively small capital investments may generate positive EVA. Conversely, a positive EVA business shouldn't always be kept. Selling the business to a bidder who could deploy the assets even more effectively may be in the best interests of shareholders.

STEP 2: Commit to EVA.

Successful EVA companies embrace the concept throughout the organization. Their shared traits:

* They recognize that the current financial measure, whether it's earnings growth or return on assets, distorts the allocation of capital and does not reflect the value created for shareholders. The company thus views EVA as both relevant and timely.

* A high-ranking EVA champion emerges who views EVA as a critical agent for changing the way operating policies are set, capital investments are evaluated, business strategies are developed and managers are evaluated and paid.

* They spend the time and resources required to help managers understand EVA and its usage.

STEP 3: Implement well.

A coherent implementation plan is the single most important prerequisite to becoming a successful EVA company. Anyone charged with capital investment or operating decisions should be able to answer three questions about their financial management system:

* What comprises the three main components of EVA, namely, operating profit, capital and the cost of capital?

* What are the key drivers of EVA (i.e., margin, inventory turns, etc.) and how can management affect them?

* What are the tradeoffs between current EVA and future EVA, vis a vis investment in quality, customer satisfaction, market share growth and other non-financial measures of performance?

EVA creates one financial statement that includes all the costs of being in business, including the carrying cost of capital. Hence it makes managers conscious of the operating costs as well as the carrying cost of working capital and fixed assets.

The EVA financial statement can give managers a complete picture of the connections among capital, margin and EVA. It also makes managers conscious of every dollar they spend, whether that dollar is spent on or off the income statement. Properly implemented, EVA can help managers resolve nagging business tradeoffs like the one that pits current EVA against future EVA. For example, an emerging cable company used EVA to evaluate a major system upgrade that would enhance service quality. Two crucial questions were:

* If the company spent $20 million today, would the incremental profit offset the increased capital charge?

* If