Joel Stern

graphics/joelstern.gif

Joel Stern is managing partner of Stern Stewart & Co., the New York corporate finance firm which devised the concept of EVA. He has advised companies of all sizes and on all continents on the implementation of EVA processes, and has lectured widely at business schools in the USA and Europe.

Books

The EVA Challenge , John Wiley, 2001

Revolution in Corporate Finance , Blackwell, 1998

EVA as an enhancer of shareholder value

Introduction

Each day, millions of managers systematically destroy shareholder value. Why? It is not because they are incompetent, nor is it because they are dishonest and are diverting corporate assets to their own use. No, it is because they are responding rationally to the compensation systems used by the vast majority of corporations which actually reward them for over-investing in mature industries, over-spending on labor-saving automation, and over-paying for acquisitions.

EVA is the system developed by Stern Stewart to bring the interests of managers back into line with the interests of shareholders. The rules below explain why their interests are often misaligned , and how the implementation of an EVA system encourages management to make decisions that enhance rather than destroy shareholder value.

Rewards based on growth in EPS lead to over-investment.

In most companies, the measure of success is accounting earnings (or earnings per share). This measure includes a deduction for interest paid on debt, but no charge for the cost of equity capital. The result is that earnings often go up even though economic performance declines, a fact that can propel over-investment. Consider a company that borrows at 8% interest and pays a tax rate of 40%. The company's after-tax borrowing cost is 4.8%. But if it finances new investments with a target ratio of 70% equity and 30% debt, its after-tax interest cost on added capacity is only 1.44% (30% of 4.8%). Any investment that returns more than 1.44%, even if it is far below the company's weighted average cost of capital, will cause earnings and EPS to rise. Managers who are rewarded for growing earnings are sure to over-invest in expansion that causes earnings to rise but returns less than the full cost of capital. They also will over-invest in labor-saving automation even when the full cost of capital on the new equipment exceeds the savings in labor costs, because the reduction in labor costs boosts earnings, while the greater cost of capital on additional equity goes uncounted.
Rewards based on size encourage empire-building.

A second reason that conventional compensation systems encourage managers to destroy wealth is that most of them are based in one way or another on size. Under the Hay system that has become virtually universal, an executive's fixed compensation is a function of the number of people reporting to him or her, the size of the budget or the amount of revenues . This carries down from the chief executive to virtually every manager in the company, so every manager profits by empire building and pursuing growth for its own sake, regardless of whether the new business earns enough to cover the cost of additional capital.
Capped incentive compensation plans backfire on shareholders.

Most managers have incentive compensation plans that are capped, often at 150% or so of the target bonus level. No matter how much wealth they create for shareholders, their compensation tops out at the bonus cap. Yet managers do have a way of working around the cap. If they can make the business bigger, their Hay points go up, and since the target bonus is a percentage of fixed pay, their potential bonuses go up as well. It's a formula for growth at any cost, no matter how much it hurts the shareholders. It's not that these managers want to diminish shareholder wealth. Quite the contrary. All things being equal, they would much rather increase shareholder wealth. But all things are not equal. Because non-EVA systems use the wrong performance measure and poorly designed incentive structures, they make it perfectly rational for managers to do things that owners never would do. The managers, like the shareholders, are victims of perverse rewards.
The present value of expected future free cash flows is mathematically identical to a firm's economic book value plus the present value of expected future EVA.

The theory of modern finance and the associated empirical evidence tie changes in value to changes in the expected growth in EVA. Modern finance says that a firm's value is the present value of the free cash flows it will generate in the future. While it is not obvious to everyone at first glance, the present value of expected future free cash flows is mathematically identical to a firm's economic book value plus the present value of expected future EVA. Thus, if management drives the firm to increase EVA, this is consistent with increasing shareholder value.
To provide a superior return, management must bring about increases in EVA which exceed market expectations.

Since the current share price of a stock already incorporates current expectations about future EVA, increasing EVA at the rate already expected will simply earn shareholders a rate of return equal to the cost of equity capital, which is the required return for equity risk. To provide a superior return, management must bring about increases in EVA greater than the figure expected by the market.

To do this, management should focus on measuring economic book value and the components of EVA very carefully , and then use supportive management tools that are reinforced by an incentive system based on sustainable improvements in EVA. If CEOs and their management teams are paid significant rewards for achieving sustainable improvements in EVA, that is what they will strive to do. And those who succeed will produce significant improvements in shareholder value.
EVA makes a charge for equity capital.

In the accountant 's version of residual income, management gets to use ordinary equity free of charge. This encourages the use of too much capital in the business because not enough is charged for the use of capital. EVA is Stern Stewart's special version of residual income

First, we levy a charge for equity capital at the minimum rate of return that shareholders demand.

Second, we make modest adjustments to both income and capital in measuring the return on capital employed. As an example, we capitalize investments in intangible assets such as research and development and brand value. This removes the charges for those investments from the income statement and puts them on the balance sheet. The reason accountants expense these items is that accounting originally evolved as a framework to help lenders determine if borrowers could repay indebtedness. If a firm fails, intangible assets clearly will have little or no value. EVA, in contrast, focuses on going-concern value - the measure that matters most to shareholders - instead of the lender's liquidation value.
EVA discourages excessive off-balance sheet borrowing.

When management borrows off the balance sheet, the borrowings are not recorded as capital employed under the normal accounting framework. The effect is to overstate the return on capital employed. EVA requires adjustments for off-balance-sheet borrowing - for instance, for operating leases - so that the borrowings are capitalized and the return on capital accurately reflected. If managers know that they cannot inflate ROCE through off-balance-sheet borrowing, they will be less inclined to do it.
EVA discourages expensive acquisitions.

EVA requires that goodwill on acquisitions remain on the balance sheet as part of the price paid. Only by including the full price paid as part of capital employed - and charging for the use of capital - will management be discouraged from overpaying. At the same time, we do not want to discourage genuinely profitable acquisitions or other investments simply because they do not have an immediate payoff. So we record strategic investments with delayed payoffs in off-balance-sheet 'suspense accounts', and move them onto the balance sheet (and into the calculation of EVA) when the investments are expected to produce income. In the interim, however, the suspense account grows by the cost of capital it has yet to produce. Some adjustments to accounting are industry specific. In natural-resource companies, for example, each year's gains or losses on reserves in the ground should be included in EVA.
EVA works best when it is used at all levels of an organization.

Once management decides to use EVA, it must ensure that EVA tools for decision-making are carried down through the organization. With the reinforcement of a strong incentive plan tied to changes in EVA, companies will not consider capital outlays that are value destroying. Investments earning less than the cost of capital will be rejected, both because they destroy shareholder value and because they reduce bonus payments. At the same time, managers will rush to make investments that increase shareholder value and bonuses. Most firms implement incentives down through middle management, but the very best performers carry it right down to the shop floor, so that all employees can earn significant variable pay and more closely align their own interests with those of shareholders.