Transcript Slide 1

Introduction to EVA Management System
New York  Chicago  Los Angeles  London  Paris  Milan  Munich  Tokyo
Sao Paulo  Singapore  Sydney  Johannesburg  Shanghai
Contents
 What is EVA?
 The calculation of EVA
 The EVA management system
Contents
 What is EVA?
 The calculation of EVA
 The EVA management system
EVA® is Earnings After the Cost of Capital
P/L
B/S
Revenues
- Operating Costs
- Depreciation
-/+ Adjustments
- Taxes
= Operating Income After Tax (NOPAT)
- Capital
x c%
Capital Charge
= EVA®
•Objective: Continuous Improvement in EVA
The intrinsic value is the determinant of the market
value in efficient capital market
Operating
metrics
Financial
measures
Intrinsic
value
Market
value
¶ EVA
¶ MVA, Stock
price
¶Competitive
strategy
¶Business
model
¶Management
system
¶Operating
efficiency
¶ Market share,
Unit cost, scrap
rate, delivery time
¶ ROI, Capital
turnover, margin
As a measure of business intrinsic value, EVA
correlates with stock price better than other measures
US as example
50%
Correlation with stock
price
40%
30%
20%
10%
EVA
Revenue
ROE
Cash Flow
EPS
EVA measure gives more insights into the business
From Enron’s 2000 Annual Report (Letter to Shareholders):
Enron’s performance in 2000 was a success by any measure…The company’s
net income reached a record in 2000. Enron is laser-focused on earnings per
share, and we expect to continue strong earnings performance.
EVA
Net Inc
EPS
$1,000
EPS
$1.40
$1.20
$1.00
$800
$0.80
$600
$0.60
$400
$0.40
$200
$0.20
$0
$0.00
1996 1997 1998 1999 2000
$100
$0
(in mil)
(in mil)
Net Inc
$1,200
-$100
-$200
-$300
-$400
-$500
-$600
-$700
1996
1997
1998
1999
2000
Contents
 What is EVA?
 The calculation of EVA
 The EVA management system
From the traditional accounting model
to the economic model of the firm
NOPAT
Capital
EVA
P&L
Balance Sheet
Cash Flow Statement
Accounting
Framework
Adjustments
EVA
Framework
 Separate financing effects from operating performance
 Extend matching of costs with revenue to economic basis
 Separate operating from non-operating
 Eliminate book keeping entries/reserves that distort cash flow
and reduce objectivity
So as to
 To better reflect value creation
 To motivate the right value-creating behavior
9
Optimizing the EVA Measure
 Materiality
– Difference in EVA with or without adjustment – Is it material?
– Set a rule of thumb and use common sense
 Motivation
– Adjustment must motivate managers to do the right thing
– Start with dysfunctional behaviors in standard operating procedures
 Data Availability
– Cost of collecting information must be reasonable
 Simplicity
– EVA is for operating people – keep it simple
– A fully adjusted EVA is too complicated to use and communicate
10
The EVA Calculation Precision Varies
Basic EVA
Basic EVA


Slight
Improvement on
Financial
(GAAP)
Accounting
Recognizes
equity capital
has a cost


Disclosed EVA
Tailored EVA
Disclosed EVA
Tailored EVA
Adjust publicly
disclosed
Financial (GAAP)
Income
Statements &
Balance Sheets.

Use for Peer
Benchmarking

True EVA
True EVA
Custom-tailored
for:

Make all possible
Adjustments
-
Organizational
Culture

Theoretical but not
useful…
-
Business Mix

-
Strategies
-
Processes
…Except when level of
EVA matters; consider
additional adjustments for
specific but limited
decisions
Optimized using 4
criteria
11
In the EVA framework, we must turn the accounting
model into an economic model
Cash to
Economic
Accounting conservatism treats many investments
as current expenses (R&D, significant
Marketing/Training - only those specifically relating
to a “strategic”purpose)
EVA views them as investments in the future
Accrual to
Cash
Accounting misstates cash flow
(Reserves)
EVA seeks to emphasize actual cash events
A
D
J
U
S
T
M
E
Non-recurring
Events
Accounting distorts ongoing operating performance
(Restructuring and Asset sales)
EVA treatment avoids profit peaks and troughs
Non-operating
Items
Items not included in the normal course of
business, or not usually managed at unit level
(Interest Expense from Debt; Other Financing)
N
T
S
12
The cost of capital comprises both debt & equity costs
Cost of Equity
Cost of Debt
•Equity Risk
•Premium
•Debt Premium (Credit spread)
•Risk Free Rate
?%
+
?%
Cost of Capital
?%
13
A Beta value is required to determine cost of equity
Cost of Equity = Rf + (Beta x MRP)
Relationship between
Risk and Return
Cost of
Equity Capital
(required return by
equity holders)
}
Risk-Free
Rate
Rf
Market Risk = 1
14
Market Risk
Premium
MRP
(Rm - Rf )
Risk (ß)
In general, a higher business risk implies higher beta
value, hence higher cost of equity
15
To calculate Beta, a list of peers need to be identified for
{Client}
 A peer company is not necessarily a competitor, but rather a
company engaged in principally similar business subject to the same
underlying economic forces. They may be competitors or
companies in similar industries and business environments.
 Peer comparisons are used to :
– Derive Betas for the respective business units and the corporation to facilitate
cost of capital (COC) calculations. Non-listed companies, wholly-owned
subsidiaries and business units do not have publicly traded shares from which to
measure the levered Betas. Where possible, a pure-play analysis of publicly
traded peer companies is used to estimate the unlevered Beta, or BRI. This is
then translated into the levered Beta for that company, using the capital structure
and the cost of debt.
– Benchmark EVA performance and identify value drivers.
16
Contents
 What is EVA?
 The calculation of EVA
 The EVA management system
EVA provides a comprehensive value management
framework to translate strategy into action
Value
Based
Management
Strategy
Planning &
Formation Goal Setting Budgeting
EVA
Execution
EVA
EVA
18
Evaluation
EVA
Motivation
EVA
Goal setting and benchmarking
20
In the EVA framework, Market Value can be broken down
into Future Growth Value and Current Operations Value
PV of EVA
Improvement
Market Value
Added
(MVA)
PV of current
EVA in perpetuity
Market
Value
Future Growth
Value (FGV)
Capital
Capital
Current
Operations
Value (COV)
MVA = Present Value of Current EVA + Present Value of Expected Improvements to
Current EVA
21
Future growth value represents
an expectation of increase in EVA
Future
Growth
Value
(FGV)
Market
Value
Expected
Improvements
in EVA

Future Growth Value represents the premium on
the value of current operations (Capital +
EVA/c*).

The presence of a Future Growth Value, which
equals PV of all future EVA improvements,
signals the managers that owners/investors
expect increases in EVA.

Increases in EVA will also drive increases in
MVA. As a result Investor Wealth will go up as
well.
Current
Operations
Value
(COV)
22
Applying “industry average growth expectations” to
{Client’s} 1999 EVA, we estimate an FGV of $691m
Conservative
1999 {Client}
EVA
{Client’s} Industry Ratio
Estimated FGV
(using 1999 EVA)
FGV
FGV
FGV
?
39%
691m
FGV
319m
EVA / C
544m
1999 COV
CAPITAL
Estimated FGV
(using avg. 97-00 EVA)
1,069m
1999
COV
COV
61%
1,069m
526m
97-00
COV
493m

If we know {Client’s} 1999 COV is $1060m (COV = 1999 capital + 1999 EVA / WACC)
then we can calculate FGV based on the industry average COV:FGV ratio of 69:31

1999 EVA could be considered an abnormally good year for {Client}, so applying an
average EVA from 97-00 (a lower EVA), the FGV for {Client} would come out to
$319M
23
Taking {Client’s} FGV of $691m, we convert it into
implied annual Expected Improvements in EVA (EI)
Assuming {Client} were to achieve this EVA growth over a 10 year period,
annual EVA improvements would have to be $26 million a year.
Expected
Improvement (EI) $26
million
FGV
$691m
2001
Market Value
2002
$673M
2000 COV
$(18m)
2003
2004
2005 ... 2010
FGV
EI (for 10 Years)
Aggressive
$691m
$26m per year
Conservative
$319m
$12m per year
24
To achieve EIs, management should first understand
the current EVA by focusing on return on capital
Return
on Capital
=
Profit
Margin
NOPAT
Capital
X
Dissecting the rate
of return brings to light
the trade-offs between
profit margin and
capital efficiency.
Capital
Turnover
X
Margin xTurnover = ROC
Scenario A 20% x
or
NOPAT
Sales
A company could achieve a
15% return by either:
Sales
Scenario B 5%
Capital
25
x
0.75
= 15%
3.0
= 15%
A company can use ROC curves to understand and
map out its strategy to improve returns
Nopat per dollar of Sales
30.0%
A:
ROC 15%
20.0%
ROC 20%
10.0%
B
ROC 15%
ROC 10%
ROC 5%
ROC 4%
0.0%
0.0x
0.5x
1.0x
1.5x
2.0x
2.5x
Sales per dollar of Capital
26
3.0x
3.5x
4.0x
{Client} peers use fundamentally different business
strategies to create value in the industry
{Client 1999}
{Client 2000}
27
Benchmarking NOPAT margins give {Client} a sense of
how it falls in terms of operating efficiency
Total Operation Expense Margin
Variable Expenses Margin
120%
80%
70%
60%
80%
% of Sales
% of Sales
100%
60%
40%
50%
40%
30%
20%
20%
10%
0%
0%
NOPAT Margin
Fixed Expenses Margin
90%
70%
35%
60%
30%
50%
25%
% of Sales
% of Sales
80%
40%
30%
20%
20%
15%
10%
5%
10%
0%
0%
-5%
Note: Baltrans and CNF removed from Variable and Fixed Expense drivers analysis due to insufficient data
28
Capital benchmarking points to working capital and
fixed assets as an opportunity for {Client} to drive EVA
upwards
40%
Capital Charge Margin
NWC Capital Charge Margin
7%
35%
6%
25%
% of Sales
% of Sales
30%
20%
15%
5%
4%
3%
10%
2%
5%
1%
0%
0%
Fixed Assets Charge Margin
Other Capital Charge Margin
12%
20%
10%
15%
8%
% of Sales
% of Sales
25%
10%
5%
6%
4%
2%
0%
0%
-2%
29
Summary of Benchmarking study
1999 Data In Thousands of USD
Company / Items
Sales
Var. Exp / Sales
Fixed Exp / Sales
Selling / Sales
Operation Expenses / Sales
Tax / Sales
Other Income / Sales
NOPAT Margin
Baltrans
100%
97%
N/A
N/A
97%
0%
2%
5%
EGL
100%
62%
16%
15%
92%
3%
1%
5%
NWC Charge / Sales
Fixed Assets Charge / Sales
Other Assets Charge / Sales
- Capital Charge / Sales
= Net Margin
1%
1%
0%
3%
2%
1%
0%
1%
3%
2%
+
=
x Sales
= EVA
172,127
3,259
Exped. Client 1999Client 2000 Airborne
100%
100%
100%
100%
69%
34%
54%
34%
23%
45%
45%
58%
1%
1%
1%
2%
94%
80%
101%
95%
1%
1%
0%
2%
0%
0%
0%
1%
5%
20%
-1%
4%
1%
1%
0%
2%
3%
595,173 1,444,575
12,638
45,445
Atlas
100%
11%
59%
0%
71%
12%
15%
32%
CNF
100%
N/A
94%
N/A
94%
2%
1%
5%
Fedex
100%
14%
79%
0%
93%
5%
4%
7%
UPS
100%
8%
78%
0%
85%
4%
-6%
5%
Average
100%
17%
74%
1%
88%
5%
3%
7%
Best in Class
100%
8%
16%
0%
23%
0%
15%
1%
7%
4%
12%
-5%
0%
2%
0%
6%
2%
-1%
8%
11%
6%
3%
3%
12%
-13%
0%
3%
1%
5%
-1%
5%
21%
10%
36%
-4%
0%
2%
2%
4%
1%
0%
4%
5%
9%
-2%
1%
5%
0%
6%
-1%
19,534
2,240
13,418
(1,726)
3,140,226
(24,340)
637,081
(22,405)
5,592,810
68,874
16,773,470
(361,190)
27,052,000
(261,400)
30
Looking at best in class Margin and Turnover, we can
chart the EVA of {Client} under different scenarios
Aboitiz Air
10.0x
ROC 130%
9.0x
Capital Turnover
8.0x
ROC 45%
7.0x
6.0x
(B)
Achieve Best in Class Turns
5.0x
4.0x
3.0x
(C)
Also Best in Class
Turns
(D)
Achieve Best in Class ROC
ROC 26%
(A)
Achieve Best in Class
NOPAT Margin
2.0x
1.0x
0.0x
-5%
0%
5%
10%
15%
20%
25%
30%
NOPAT Margin
History
Peer Benchmark
{Client} Forecast
{Client} 97-99
Best In Class 97-99
Company
{Client}, Inc. 2000-2005
NOPAT Margin
15.0%
25.6%
Atlas Air
7.5%
Capital Turnover
313.6%
505.0%
Expeditors
266.1%
Return on Capital
45.2%
45.2%
{Client}, Inc.
23.0%
31
Using {Client’s} 2000 EVA as an illustration, the largest
EVA opportunity is from NOPAT margin improvement
{Client}
Best In Class Analysis
200,000
138,666
EVA USD'000s
150,000
100,000
EVA
improve by
$224,991
50,000
0
146,190
EVA improve
by a further
$7,524
146,190
Is there
Trade off
between
capital T/O
and Nopat
Margin?
56,438
EVA
improve by
$142,763
(50,000)
(100,000)
(86,325)
Current EVA
Achieve NOPAT
margin of 25.6%
Achieve Cap. T/O of
5x
Achieve ROC = 45%
{Client} Best In Class Analysis, in Thousand Dollars
Current EVA
Sales
NOPAT
Avg Capital
WACC
EVA
670,895
(4,080)
426,138
19.3%
(86,325)
Achieve NOPAT MarginAchieve Capital Turns
670,895
171,829
426,138
19.3%
138,666
(A)
32
Achieve NOPAT Margin & Achieve Return on
Capital Turns
Capital
670,895
(4,080)
132,846
19.3%
(29,720)
670,895
171,829
132,846
19.3%
146,190
670,895
98,516
218,018
19.3%
56,438
(B)
(C)
(D)
The industry value-based strategy map indicates the
market’s approval of certain business strategies
Value Based Strategy Map
100%
UPS
80%
Superstars
Prospects
60%
EGL
FGV per dollar of MV
Fedex
Expeditors
40%
(5%)
0%
5%
10%
15%
20%
20%
Atlas
CNF
Bench Riders
0%
Airborne
Steady Veterans
(20%)
(40%)
(60%)
(80%)
Baltrans
(100%)
EVA per dollar of Capital
Airborne
Atlas Air
Baltrans
CNF
33
EGL
Fedex
Expeditors
UPS