Home » Economic Development » EVA and the Private Company

EVA and the Private Company

What can “economic value added,” increasingly considered the public company’s preferred performance metric, do for your company?

Every company seeks the perfect measurement quantifying its performance against strategy. Historically, the corporate world has relied on an alphabet soup of acronyms—EPS, ROE, ROI, EBITDA and TSR, to cite a handful—for this guidance, employing these metrics to make key decisions on resource allocation, expense management and incentive compensation. In recent years, public companies have increasingly turned to an alternative method—Economic Value Added (EVA), prized as a more accurate measure of how companies perform for shareholders than many of its peers in the metrics game. Now private companies, as well, are finding favor with this metric.

“EVA incents employees to think about investment and capital the same way an owner does because you pay a charge on any capital you use,” explains Tony Simmons, CEO of Mcllhenny Company, manufacturer of the iconic Tabasco brand pepper sauce. “With EVA, managers must look seriously at capital investments and question whether or not they are intelligent investments. Tying their bonus to EVA serves as the incentive.”

How Does EVA Work?

Mathematically speaking, EVA is sales, minus operating costs, minus the full cost of capital, multiplied by the money tied up in the company’s net business assets. The metric is essentially an estimate of the profit generated after setting aside a full cost of capital charge on each of a company’s business assets, as well as the returns for shareholders. Therefore, EVA is positive when the company earns a return on capital in excess of its cost of capital.

Bennett Stewart, CEO of consulting firm EVA Dimensions and co-inventor of the metric, says that in the past companies like Mcllhenny tended to overlook EVA, believing that the metric didn’t apply to them. However, private firms can use an adapted EVA model, adjusting accounting, tax and cost of capital with family preferences and goals. “The main one is for the cost of capital,” he explains. “Private companies, which tend to be smaller and have less access to liquid capital, need to be sure they can finance all growth internally and conservatively. To reflect that, we often set the cost of capital one or two percentage points higher (in the EVA) than for a similar public company.”

Another adjustment applies to companies filed as Subchapter S or LLCs. “These are not taxed, but their owners are,” says Stewart, “so we often have to impute a tax in the entity to account for the taxes the owners must pay (in establishing the EVA).”

Although EVA is still used predominantly by public companies concerned about their share price in the market every day, private companies are now also finding it useful as a compass in running their businesses. Family-owned private companies, in particular, have found great value incorporating the ratio. (See Sidebar: A Family Business EVA Approach)

Stewart argues that EVA improves an organization’s operating efficiency, asset management and profitable growth. When managers are held accountable for EVA, they are theoretically less likely to spend capital like drunken sailors. “They’ll be much more apt to continue to develop capabilities and brand value and not manipulate reported profits,” he says.

Valuing Value Creation

John Percival, an adjunct professor of finance at The Wharton School of Business of the University of Pennsylvania, agrees that EVA can provide a clearer measure of success. “We have this unfortunate document called an income statement, and at the bottom of it is this number we call ‘net income’ that shows if the company is in the red or in the black,” he says. “A little black means the company got a little profit, which everyone thinks is good. The ‘unfortunate’ part is that the interest expense is subtracted but not the return to the owners of the business. Just because the company is in the black doesn’t mean it accomplished anything.”

EVA, on the other hand, subtracts these returns to owners. “The objective is to earn more than the cost of capital and then measure this over time,” Percival says. “If EVA continues to rise, you’re in increasingly better shape.”

Certainly, this is the goal at Avery Island, Louisiana-based Mcllhenny. Established in 1868, the company is still family-owned and operated, and Simmons is the great-great-grandson of founder Edmund McIlhenny. As a board director in 1997, he urged the adoption of EVA, which he relied on at the time to manage Manitowoc Southeastern, an independent crane distributor, as its president and CEO. “I was young and they didn’t take it up right away; but then, another board member started investigating it and recommended that the board give it another shot,” he recalls. “My cousin Paul (McIlhenny) was CEO, and he decided to implement it in 2000.”

Key to the board’s approval was its anticipated impact on compensation. “We believed it took the subjective part out of the bonus potential,” Simmons explains. “The idea is [that] the better you do as a company, the more the bonus. It shouldn’t make any difference where you start, just that you’re moving in the right direction of creating value for shareholders.” His point is that the bonus should reflect true company performance, as opposed to just revenue or profit growth, which can be misleading.

Adopting EVA has proven fruitful. “Thanks to EVA, we’re using roughly the same amount of capital (in 2013) that we used in 2000, yet our revenues have doubled over this period,” Simmons says. “EVA has paid off in spades.”

EVA also keeps employees honest. “By relying on conventional metrics, CEOs run the risk of employees gaming the system,” Percival says. “Managers can do things in the short run like raise prices on a product to make the rate of return look better, or they might resist expenses that will be important to the organization in the long run like R&D—all to achieve the best metrics to ensure the highest bonus.”

By tying incentive compensation to EVA, employees “behave more like owners of the company, focused on the true cost of capital and not tempted by doing things that are good for them compensation-wise but may not [be] in the best interests of the business,” he says.

At McIlhenny, employee incentive compensation is hinged to continuous improvements in EVA (or EVA Momentum—see below). The higher people rank in the company, more of their bonuses are at risk to EVA. “More than 50 percent of my compensation, for instance, is directly related to how well this company does under EVA,” Simmons says. “And I’m not complaining.”

EVA Momentum takes yesterday’s EVA and transforms it into a ratio—the change in EVA divided by the prior period’s sales. This ratio is essentially the growth rate in EVA, scaled to sales. For example, if sales were $100 million in 2012, and if EVA increased from $4 million to $5 million from 2012 to 2013, the EVA Momentum would be 1 percent. “EVA Momentum is the only performance ratio where more is always better than less,” Stewart says. “It’s positive whenever you cut costs, streamline assets and deliver profitable growth over the cost of capital. But, if it’s negative, watch out. That means the business is turning for the worse and you’re squandering resources that can be better allocated elsewhere.”

Leveraging EVA Momentum, companies can grade the performance of distinct business lines for resource-allocation decisions. The ratio also offers the ability to benchmark against peers. For instance, if your company’s EVA Momentum is soaring; but so is the EVA Momentum of your peer groups, then you might just be riding an industry wave and merely holding the line against the crowd. While this circumstance alone might warrant paying managers a decent bonus, it does not argue for the huge rewards that would likely occur when pay is linked to earnings per share or revenues.

While EVA advocates can be downright evangelical, some experts caution against over reliance on it. Lynn Stout, professor of corporate and business law at Cornell University, and author of the popular book, The Shareholder Value Myth: How Putting Shareholders First Harms Investors, Corporations, and the Public, recognizes the value of EVA, but cautions that it is not the holy grail. “There is no single, perfect accounting technology guiding companies [on] how best to operate, despite the hot pursuit for one,” she asserts. “All metrics should be viewed with skepticism, as they are generally promoted by consultants. They should be severely deemphasized, used only as tools—not drivers. The idea that EVA is `the one and only’ is ridiculous. It merely gives CEOs breathing room not to consider the more important variables driving a company’s long-term success—like employee engagement and customer loyalty.”

Steve Denning, former program director of knowledge management at the World Bank, and author of the book, The Leader’s Guide to Radical Management, also thinks the notion of a single, guiding score is absurd. However, he still finds significant value in EVA. “What I like about EVA is that it measures profit in a way that takes into account the actual costs of producing this profit,” he explains. “In that sense, it marks an improvement over financial profits alone as a guiding metric.”

Asked for an example, Denning provides the following: “Say you’re growing the business, but you’re doing it by pursuing a difficult cluster of customers, in which case the costs of generating profit may be greater than the actual benefit. Assuming the use of EVA, the capital would be better allocated elsewhere than in pursuit of disagreeable customers, [as] in a new product or business.”

A Family Business EVA Approach

When Colin Brown took the reins as CEO of JM Family Enterprises in 1997, he inherited a sweeping organization with three distinctly different business models. To exert a firmer grasp governing the enterprise, he sought a single, uniform metric, finding it in EVA. “I had read about it and was looking for a way to simplify communications with the business units and ensure [that] we were all operating off the same page,” he explains. “I figured we’d give it a try and brought in EVA Dimensions to implement it in 1999.”

Given JM Family’s breadth and size (the private company’s revenue was $12.5 billion in 2013), one can empathize with Brown’s quest. The company then and now includes Southeast Toyota Distributors, an independent distributor of automotive vehicles; World Omni Financial, a diversified financial services company; and JM&A Group, comprising an insurance and extended-warranty business. Obviously, each of these enterprises is distinct—hence, the different operating models.

Why EVA though? “The whole underlying premise of EVA is ‘are you creating value or destroying value?’” explains Brown. “We needed to have our eyes open as to whether we were doing things that made financial sense for the long-term benefit of the organization. We wanted everyone to manage their part of the company as if they were its owners.”

It’s a common refrain: EVA incents employees to make decisions only in the best interests of the organization. “It’s a far better way of tying manager decisions to company performance,” Brown asserts. “They’re always trying to improve the economic value of their organization.”

As an example, he cited a cost-cutting decision recently made by the management in charge of Southeast Toyota Distributors. Customers had always been offered a wide selection of accessories, like a spoiler or fog lights, that could be added to the Toyota and Scion vehicles they were interested in purchasing (Brown equated the offers to “ornaments on a Christmas tree”). While these various add-ons added dollars to the final price, they slowed down the sales and delivery process, which actually ate up money.

“We decided there was too much effort and work put into certain products that didn’t really add economic value,” the CEO says. Only a few key accessories, like Internet radio, are offered customers today. Most importantly, by establishing EVA as the entire company’s guiding light, Brown says he is “no longer flying blind. We’re all on the same page now.”

EVA’s Dark Side

Does EVA encourage managers to take less risk in making the big decisions, such as making an acquisition, developing a new product or entering a new market? If the bonus depends on the efficient use of capital, is there the possibility that EVA might steer someone away from making such bets, given the decision’s impact on that person’s compensation? Percival thinks so. “A lot of operational people are engineers who know how to deal with metrics, particularly as they relate to their compensation,” he says. “This could encourage decisions not in the long-term best interests of the company.”

Denning shares this concern, noting that EVA may encourage innovations to save money, rather than encourage innovations that add value. “The chance of an innovation to be successful at saving money in the medium-term is probably 90 percent or higher, whereas the chance of an innovation to be successful at adding value over the same period is probably 20 percent or less,” he says. “These percentages tell you that if companies rely exclusively on EVA as the sole basis of decision-making, they will systematically end up cutting costs and ignoring new opportunities to grow the business.”

Simmons disagrees, commenting that strong EVA performance and increasing revenues go hand in hand. “I really don’t see how you can sustain strong EVA performance without increasing revenues,” he says. “[In] the first year or two, a lot of ideas bubble up on ways to save money and reduce capital; but once you harvest that low-hanging fruit, it becomes harder and harder to find significant cost savings. We have been an EVA company for 14 years and the bulk of our EVA performance comes from increasing revenue while controlling costs. Isn’t that what a good manager does?”

Stewart concurs. “Smart managers always run a portfolio of innovations—they put multiple irons in the fire, rather than just betting on a risky outcome. A good example is Amazon. They made bets in customer connection, same day delivery, cloud computing, the Kindle, acquisitions like Zappos and way more. And guess what? Amazon’s EVA is going up with the share price, as the other measures like EPS, ROI, margins, cash flow from operations are going down. Properly measured, EVA tells the real story about the value of innovation.”

That said, Stewart doesn’t know that Amazon.com actually uses EVA. “We have not worked with them and I cannot say they formally use EVA,” he says, “but their decision making is totally EVA-consistent. They get value, somehow, as measured by EVA, and the market is rewarding them for it. But no, they are not an official EVA company.”

Cornell’s Stout is not immune to the value of EVA, but she argues that it is just another elaborate way for companies to focus “on easily observable metrics at the expense of essential intangibles, such as the quality of human capital and employee and customer loyalty,” she says. “It is less than obvious to me how EVA addresses the current myopia on short-term performance.”

Denning also has reservations about EVA’s possible short-termism. “Whether using traditional measurements or EVA, there is the risk [that] the firm will be solely focused on near-term business results and not long-term benefits,” he says. “The best metric for profitably directing a company is ‘positively delighting customers.’ If your customers rate your products or services high, then it is going in the right direction.”

He adds, “The customer is the boss, not owners or managers.”

Russ Banham can be reached at www.russbanham.com

About Russ Banham

Russ Banham
Russ Banham (russ@russbanham.com) is a contributing writer to Chief Executive