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EVA in Canada - an uncertain legacy By Howard M. Armitage, CMA, FCMA, Ellen Wong and Alan Douglas
There have been a number of dimensions to this debate. First is the question of whether the current fascination with shareholder value is appropriate. Philosophically, there are two distinct camps on this issue. On one side are those who argue that the only objective of an organization should be to maximize shareholder value. Corporations should not be involved in such pursuits as charitable activities or community building events. It is up to the shareholders to decide where to allocate these resources, through the dividends or capital gains they receive. This is the ‘‘pure shareholder” view and resonates most strongly in the United States. Another view holds that it’s not only immoral to focus exclusively on shareholder value - it’s also bad business. This view argues that equal attention must be paid to all stakeholders - employees, customers, the community and shareholders - if a firm is to enjoy long-term success. This is the ‘‘pure stakeholder” view and is supported in many European countries. Between these views is the position of ‘‘the shareholder is the first among equals” and is probably best characterized by the late Robert Goizueta, CEO of Coca-Cola, who was fond of saying, ‘‘We work hard to remember that the wonderful things our company is capable of - serving our customers, creating jobs, positively impacting society - happen only as long as we fulfil our vision of creating value for our shareholders.” A second debate is taking place at the measurement level. It’s clear that the increased focus on shareholder value creation is here to stay, and as it intensifies, so have the metric wars. Traditional accounting measures such as net income, EPS and ROA have been routinely criticized as misleading, manipulative and ineffectual in disclosing an organization’s value creating performance. In turn, proponents of economic value measures have responded with specific metrics and methodologies that claim to both better measure and motivate the creation of shareholder value. Wealth vs. Value To understand this debate, it’s important to distinguish between the notions of ‘‘wealth” and ‘‘value.” Stock market performance is a direct external measure of wealth. Wealth measures are important and straightforward, but they also have limitations. By definition, they are only useful for publicly traded corporations. As market measures, they are clearly influenced by events beyond the control of the firm such as general economic and industry trends and by bullish/bearish public sentiments. Furthermore, stock market measures seldom provide an adequate measure of senior employee performance below that of CEO and can’t measure the success or failure of individual subsidiaries or business units that are not separately traded. This is where value comes in. Value is an internal performance measure - one that derives from internal company reports. Measuring value and the amount of ‘‘value added” in any period is more problematic than wealth because there is more disagreement on what value is. In recent years, firms such as Stern Stewart, Braxton, Holt, Alcar, Marakon and several public accounting firms have developed practices that encourage their clients to reduce their reliance on traditional measures of ‘‘accounting value” and move toward a closer approximation of cash flow, or ‘‘economic value.” Perhaps the best known of these firms is Stern Stewart and its registered Economic Value Added measure called EVA. Early claims by Stern Stewart asserted a link between economic value and wealth performance. It argued, for example, that firms should ‘‘forget EPS, ROE and ROI - it is EVA that drives stock prices,” that ‘‘EVA stands well out from the crowd as the single best measure of wealth creation” and that ‘‘EVA is almost 50% better than its closest accounting-based competitor in explaining changes in shareholder wealth.” Subsequent research casts doubt on the validity of these assertions but there is no doubt that this claim of high correlation between economic value and wealth creation was behind much of the press coverage received by economic value proponents. However, proponents still argue that the use of economic value measures within a corporation strongly influences the behaviour of employees to pursue value-creating opportunities. The Canadian experience We have followed the progress of this ‘‘economic value’‘ development in Canada. There’s no question that the notion of shareholder value creation is widely debated and practiced here. What is less understood, however, is how Canadian companies have adopted specific economic value metrics to measure and motivate their value creation efforts. Our research on this began in 1995 with a publication entitled ‘‘EVA: A Survey of Canadian Organizations.” 1The first study to look at EVA practices in Canada, this research examined the EVA practices of the top 1,000 Canadian companies. The purpose of the study was to examine how, and to what extent, Canadian organizations were using EVA. Following are the key conclusions reached from the 1995 study:
In the ensuing years, the number of references to EVA has increased dramatically. But how have the early Canadian adopters fared? Do those firms continue to use it and do they continue to be satisfied with it? To answer this second question, we sought out the 26 EVA-adopting firms from the 1995 study to examine their experiences since adoption. User perceptions As readers are, by now, no doubt familiar, EVA is computed by taking the spread between
the return on capital and the cost of capital and then multiplying this difference by the economic book
value2 of the capital committed to the business. The formula is: EVA = (rate of return - cost of capital) x economic capital = (r - c) x ec = rec - cec = NOPAT - Capital charge Where NOPAT = Net Operating Profit After Tax Advocates claim that use of the EVA measure helps managers make better decisions by motivating them (through compensation schemes tied to the metric) to focus their efforts on value creating activities. Compliance with this formula, for example, suggests that managers have four basic strategies for creating value. Managers create value when (a) they increase the rate of return on existing capital; (b) additional capital invested earns more than the cost of capital; (c) capital that does not earn the cost of capital is divested; and, (d) the firm is able to lower its cost of capital. These four basic strategies provide the conceptual foundation from which firms develop plans, guidelines, programs, performance measures and compensation schemes that are all aligned to value creation. This is the theory. But were adopting firms actually motivated by these factors? Specifically, we wanted to know if the 26 companies that had adopted EVA in 1995 were still using it, the primary uses for which they were using the measure and how successful they believed EVA had been in achieving their objectives. We were also interested in a secondary question: since there is still considerable debate about whether there is an improved stock market performance associated with using EVA, we also analysed the returns of these companies relative to their industry stock price index. The results Survey responses from 19 firms were analysed3. Of the 19 companies, 15 are still using EVA. The 15 firms represented 11 different industry sectors with the largest groups coming from industrial products, communications and media and paper and forest products. Respondents ranged from fewer than 500 employees to 50,000 employees. Primary purposes The majority of the respondents (53%) indicated that the most important reason for using EVA was to create shareholder value. Its application within organizations is consistent with what EVA proponents predict but the measure is restricted to the senior management level. The three most important uses to which EVA is put are capital budgeting, goal setting and compensation. These results are similar to those of the 1995 study, indicating that the primary applications of EVA have remained constant over time. When considering strategic or major operating decisions, 15 (73%) of the respondents indicated that they ‘‘always’‘ or ‘‘often’‘ explicitly use EVA to evaluate their decisions. The remaining four also employ the metric but indicated that they only use it ‘‘sometimes.” No firms used EVA below the divisional level. This is an interesting result because a number of well-known U.S. companies, like Coca-Cola and Quaker Oats, indicated that they had driven EVA down to the shop floor. Canadian firms, by contrast, appear to be using the measure only at the senior management level. Satisfaction According to respondents, the adoption of EVA has been largely successful and cost efficient. Approximately three quarters of the respondents (11 firms) indicated that EVA is moderately or highly successful in achieving company objectives, and that the benefits exceed the costs. Most of the companies incurred less than $500,000 in direct costs for implementing EVA and incurred indirect costs that were lower than their direct costs. Three believed EVA has only had a neutral effect on achieving organizational objectives and one company indicated that EVA had not met their expectations. The time it took to implement EVA varied depending on the size of the company. There was a range of less than two months to more than two years. Since none of the respondents employed EVA below the divisional level, implementation time is less than if the measure was driven down to lower levels in the organization. Dropping EVA Of the four firms that discontinued EVA, two cited that they had undergone a corporate reorganization through merger and acquisition. In these circumstances, EVA was discontinued more to ensure consistency of performance measurement systems between the merged companies than because of any dissatisfaction with the EVA measure. The other two, however, indicated they dropped EVA because of employee resistance, insufficient training, failure to fully integrate EVA within the organization, and a lack of commitment from top management. Conflict on the financials Previous evidence shows that Canadian organizations have been slow to adopt measures like EVA. What is not known, however, is whether those that have adopted the measure have found it to be effective. Here we’ve shown that many early adopters in Canada still use EVA and that it has succeeded in meeting corporate expectations. The companies use EVA to focus attention on creating shareholder value and to motivate managerial actions that are consistent with value creation. Furthermore, a majority also believes that the benefits achieved have exceeded both the direct and indirect costs of implementation and that EVA has more than met expectations. What remains questionable is whether the effect of EVA actually brings about greater shareholder value. So far, the evidence is inconclusive. Thus far, 50% of the companies surveyed are underperforming their TSX sectoral indices. Of the other 50%, 36% are outperforming their TSX sectoral indices, and the remainder are at a similar level as comparable companies. In contrast, a 1999 study by Robert Kleiman, ‘‘Some New Evidence on EVA Companies,” in Journal of Applied Corporate Finance, suggests that U.S. companies adopting EVA outperformed the median firms in the same industries by 28.8% during a four-year period including and following the year of adoption. The question one has to ask is, if such a measure doesn’t correlate with greater shareholder value, can it legitimately be considered satisfactory? Is it enough that senior management sees it driving value-added activity? The study results suggest that one stakeholder group is pleased by the use of EVA, but is that enough and how long can a company wait to see results that indicate that a positive correlation can be made in the long term? This study, though limited in its original scope, opens up a substantial and broad area for further debate. Howard Armitage, Ph.D, CMA, FCMA, is a professor at the School of Accountancy, University of Waterloo. Ellen Wong, CA, currently works at PricewaterhouseCoopers. Alan Douglas, Ph.D, is currently at the Centre for Advanced Studies in Finance, University of Waterloo. 1. Armitage, H.M., and C. Ha, Improving Shareholder Wealth, Issues Paper #11, Society of Management Accountants of Canada, Issues Papers Series, 1995. 2. A company’s economic book value represents the accounting book value adjusted for equity equivalent reserves. 3. The number of 19 firms was arrived at as follows. To the 1995 study of 26 firms, we added 5 other companies that we learned had adopted EVA. Twelve were eliminated either because (1) they were no longer public, (2) they informed us that they had actually not adopted EVA in 1995 (even though they indicated adoption on the 1995 survey) or (3) they did not return the survey. |
Shareholder
value creation has become one of the most widely discussed issues in business and society today.
Organizations whose share prices don’t keep pace with market expectations face increasingly impatient and
even hostile boards of directors and shareholder activists. Even small deviations from expectations can have
major implications to share prices and managerial actions. Yet, while many embrace a more dynamic economy and
the generation of wealth, for many others, maximizing shareholder value implies a corporate agenda that is
hostile to employees, the environment, and communities.