A lot of companies chase growth in earnings per share, only to find themselves employing too much capital at too low a rate of return and thereby eroding shareholder value. Economic Value Added offers a beguiling solution: an easy-to-understand measure that recognizes improvements in earnings only to the extent that they exceed the cost of the capital employed to secure them.
A very sensible solution but with only one critical flaw that EVA discourages growth. These conceptual problems have been there all along and now the empirical evidence is beginning to mount. At this point of time when renewing growth represents the major competitive challenge facing most companies, reliance on EVA can become a major problem to building shareholder value. Fortunately, there are other better alternatives to evaluate a company.
The value assigned to a company by financial market reflects its prospects for profitability and growth. A change in value is driven by a change in expectations for one or both. CEOs naturally seek to influence shareholder value. Therefore, the trick is to pick the right metric. A metric that tracks the market valuation process closely and is fairly simple and intuitive.
EVA is simple and easy to understand and to calculate. But at a cost: it tracks actual market valuations rather poorly and introduces three fundamental distortions into managers’ decisions:
- EVA is biased against new assets. EVA shares the bias against new assets of all conventional accounting-based measures. When an investment is made, its complete cost hits the capital charge, and EVA is artificially low. As the investment depreciates, the capital charge declines proportionally. At maturity, EVA is artificially high. Inflation worsens this tendency, since EVA recognizes its impact on earnings but ignores its impact on the replacement cost of assets.
This has the perverse effect of penalizing managers who bet on growth by investing. Except for the rare case where an investment has an immediate payback, growth-oriented managers take a short-term EVA hit.
- EVA encourages managers to milk the business. It’s even worse than punishing pro-growth behaviour, EVA rewards antigrowth behaviour. Investing aggressively at rates of return exceeding the cost of capital may be the preferred way to move the EVA needle. But one quickly learns that the easier way, at least in the short term, is to reduce assets faster than earnings to milk the business.
Pursued long enough, say three to five years, this strategy creates an EVA trap. Lack of investment can leave managers with such a depreciated asset base that any new investment will have a huge negative impact on EVA. The disincentive—whether to grow or to renew with more productive assets—compounds over time.
Little surprise, then, that the record of long time EVA converts is one of delivering enhanced returns but not long-term growth in the capital base. Indeed, several have experienced growth rates in their asset bases close to zero and well below those of their peers.
- EVA is biased in favour of large, low-return businesses. EVA is a marginal measure: it represents the incremental earnings above a base level set by the cost of capital employed. This makes EVA heavily biased by size. Large businesses that earn returns only slightly above the cost of capital can have bigger EVAs than smaller businesses earning much higher returns. What’s more, the rate of change in EVA is accentuated for businesses whose historical performance hovers around the cost of capital. Small improvements in the performance of a marginal business generate large percentage gains in EVA.
This makes EVA a poor metric for comparing businesses, whether to benchmark performance against peers or to allocate resources across a company’s portfolio. Because EVA sends misleading signals about the relative attractiveness of businesses, companies that rely on it run the risk of growing the wrong ones.
References
SIMCON Blog 