Over the past 20 years, numerous investment techniques have been devised to aid fund managers of all types to determine the most appropriate method of deploying investment assets.
Applying a school of practice (rather than a theoretical school of thought) is certainly a differentiating way to move from debate to provable result.
A school of practice has been developed in the corporate financial world named EVA, or Economic Value Added. It is the financial performance measure that comes closer than any other to capturing the true economic profit of an enterprise, and is the linchpin in a proprietary framework for financial management and incentive compensation.
Developed by Stern Stewart & Co, EVA has been adopted by some 250 corporations worldwide, including the Coca-Cola Company, Burton Group, SmithKline Beecham, Eli Lilly and Monsanto. It has proven that it is a useful way to improve corporate performance, motivation and market value.
Stock market evidence shows EVA is the performance measure that can ac-count for changes in share values over time, far more so than earnings, earnings-per-share, earnings growth, profit margins, return on equity, dividends and even cash flow. Thus EVA allows key management decisions to be modelled, monitored, motivated and communicated directly in terms of adding shareholders' value. It offers managers a framework for setting goals and measuring performance, for evaluating strategies, valuing acquisitions, allocating capital, and paying for performance. It can be coupled with other financial measures for investment mangement purposes to best select stock picks from the multitude of equities on offer.
EVA is a company's net operating profit after taxes minus an appropriate charge for the opportunity cost of all capital invested in the enterprise, including equity capital. The capital charge is the most distinctive and important aspect of the EVA measure. Under conventional ac-counting , most companies appear profitable. However, many actually destroy shareholder wealth because the 'profits' they earn are less than their full cost of capital. EVA corrects this error by explicitly recognizing that when managers employ capital they must pay for it, just as if it were a wage. The deduction for the cost of all capital employed makes EVA an estimate of true economic profit, or the amount by which earnings exceed or fall short of the required minimum rate of return that investors could get by investing in other securities of comparable risk.
The calculation of EVA also entails a number of adjustments to conventional earnings in order to eliminate anomalies introduced by generally accepted accounting principles(GAAP). For example, GAAP requires companies to expense outlays for research and development, even though those expenditures actually are investments in future products or processes.
In contrast, EVA capitalises R&D spending and amortises it over an appropriate period. As a result, managers don't boost earnings in a lean year by shortsightedly cutting back on profitable R&D investments. Similarly, GAAP requires companies to gradually write off goodwill from acquisitions.(Goodwill is any premium a buying company pays over the book value of a selling company's assets.) Goodwill write-offs understate profits in the near term. But the accumulating write-offs artificially reduce equity capital and eventually make the return on equity look larger than it really is.
EVA leaves goodwill on the balance sheet under the logic that investors expect management to earn an adequate rate of return on the full purchase price of an acquisition in perpetuity.
Managers incorporate two basic principles of finance into their decisions, to maximise shareholder wealth and that a company's value de-pends on the extent investors expect future profits to ex-ceed or fall short of the cost of capital. Current performance already is reflected in share prices. It is the continuous creation of value improvements that brings continuous increases in shareholder wealth. Turning a negative EVA less negative is as valid a way to create value as making a positive EVA more positive.
EVA has the advantage of being conceptually simple and easy to explain to non-financial managers. That is because it starts with familiar operating profit and simply deducts a charge for the capital invested in the company as a whole, business unit, or even a single plant, office or assembly line.
By assessing a charge for using capital, EVA makes managers care about assets as well as the earnings, and helps them properly assess the tradeoffs between the two.
This broader, more complete view of the economics of a business can make dramatic differences that are quickly reflected in operating results and share prices.
The EVA discipline also brings home the message to operating managers that there are only three ways they can increase value. The first is to increase the return on the assets already in the business by operating more efficiently.
The second is to reduce the amount of capital invested in the business, both by selling assets that are worth more to others and by increasing the efficiency of capital by such things as turning working capital faster and speeding up cycle times.
The third, and the most important for achieving continuing in-creases in value, is to identify new investments that prom-ise to return more than the cost of capital. Top management also can increase value in a fourth way by implementing financial policies, such as leveraged recapitalisations, that reduce the cost of capital.
The EVA systems power comes from using it as the basis for incentive compensation. Firms can design cash bonus plans that simulate an owners payoff and leveraged stock option plans that make ownership real. The result is managers who think like, act like and are paid like owners.
Michael Borkan is senior vice president with Oppenheimer Capital in London