Transcript SRA mission and objectives

Icelandic Management
Association Conference
on EVA®
Demystifying EVA and
EVA Implementation
Copyright © November 16, 1999
Discussion Topics
®

Why has EVA become so popular?

Why is there a mystique associated with EVA adoption?

How do companies become “EVA companies”?

What are the pitfalls encountered in implementing EVA?

What’s next in EVA development?
EVA® is a registered trademark of Stern Stewart & Co.
What it means to become an “EVA company”
2 Key Ingredients

A comprehensive framework for
evaluating all business decisions and
activities based on their respective
contribution to shareholder value
(“Value-Based Management”)

Coordination of VBM activities
through EVA, or Economic Value
Added
What it means to become an “EVA company”
 A cohesive definition of success
 A shared language for each area of
financial management
 A fundamental reformulation of the
way the company structures
incentives
 The tools and understanding to
make EVA line-of-sight, and thus
part of day-to-day decision-making
 A Cohesive Definition of Success
 A Cohesive Definition of Success
Market
Value of
Invested
Capital
 A Cohesive Definition of Success
Total
Market
Cap.
Invested
Capital
 A Cohesive Definition of Success
MVA
Total
Market
Cap.
Invested
Capital
MVA
MVA
Invested
Capital
Total
Market
Cap.
 A Cohesive Definition of Success
MVA
Total
Market
Cap.
Invested
Capital
MVA
MVA
Invested
Capital
Total
Market
Cap.
 A Cohesive Definition of Success
MVA
Total
Market
Cap.
Invested
Capital
MVA
MVA
Invested
Capital
Total
Market
Cap.
 A Cohesive Definition of Success
How do EVA companies drive MVA?

MVA comes from operations, not finance.

MVA depends on the future, not the past.
 A Cohesive Definition of Success
The Limitations of MVA

MVA can only be measured externally.

No divisional surrogates.

No internal guidance about how to measure,
promote and reward success.
 A Cohesive Definition of Success
Thesis

The single best internal determinant of MVA is
EVA—or the “economic profit” remaining after
imputing a charge for the carrying cost of
equity. EVA is also known as “residual income.”

EVA-based planning systems identify and
exploit the causal relationship between internal
performance markers and external markers
like MVA.
EVA can and should be simple...
EVA = Operating Profit - Opportunity Cost of Running the Business
Sales
–
Cost of Sales
–
Overhead
EBIT
–
Tax on Operations
NOPAT
The return foregone by not investing in a
comparably risky portfolio of projects—
the weighted average cost of debt and
equity capital.
Capital Charge = c* x Beg. Capital
EVA is a combined measure of growth and profitability...
EVA = NOPAT - c* x Beg. Capital
EVA can also be expressed as:
EVA = (Return on Capital - Cost of Capital) x Beg. Capital
4 incentives:




Improve efficiency, and thus returns.
Grow, but only if new investments can earn the cost of capital.
Redeploy capital from underperforming operations.
Manage risk, and therefore the cost of capital.
EVA relates directly to stock value...
Value
Value
PV
NOPAT
C
PV CF3
PV
EVA
C
MVA
PV EVA3
PV EVA2
PV EVA1
Capital
PV CF2
PV CF1
Discounted Free Cash Flow
Discounted Economic Value Added
 The present value of a company’s expected EVA is its premium or discount to book value (MVA).
 A company’s discounted EVA plus its level of capital employed equals the present value of expected FCF.
 EVA is the simplest combined measure of growth and profitability relating directly to stock value.
Adjustments should be based on common sense...
EVA = Operating Profit - Capital Charge
Purposes:
1. Differentiate substantive economic
performance from bookkeeping entries.
2. Discourage manipulation.
Concerns:

Acquisition accounting

Product development expenditures

Off-balance sheet financing

Reserves

Start-ups and high technology
The bottom line on metrics: Be practical!

EVA is one of the few performance measures that
integrates growth and profitability objectives into a
single scorecard.

Defining EVA can and should be simple: net
economic profit after a charge for invested capital.

There is no universal definition of EVA for all
companies. Most asserted proprietary adjustments
are window dressing, doing more to obfuscate
EVA’s directive than promote it.

Whether a company elects to measure
performance in real or nominal terms, measure
investment on a net or gross basis, benchmark
against competitors, make bookkeeping
adjustments, use cash-basis accounting, or
capitalize periodic performance measures should
depend on the specific business circumstances of
the client—not upon what’s in fashion.
 A Shared Language
Information transferred rapidly and
meaningfully
Traditional Financial Management System
EVA Financial Management System
Valuation
Strategic
Planning
Annual
Budgeting
Corporate Office
Investor
Relations
EPS
Treasury
Management
Strategic
Planning
Market Share,
Earnings Growth
Cost
Accounting
Capital
Budgeting
Discounted
Cash Flow



Human
Resources
Investor
Relations
Cash Flow
Treasury
Management
Asset Turns
Capital
Budgeting
ROE and Net
Income
No common denominator of value
Heavily dependent on corporate synthesis
and reconciliation of departmental figures
Information transfers slow and inefficient
Cost
Accounting
Human
Resources



Common language for allocating resources,
conducting valuations, measuring performance,
and communicating with investors
Minimal corporate synthesis and reconciliation
Information transfers real-time and meaningful
 A Fundamental Change in Incentives
More than a formula

A greater portion of pay at risk

Wide and consistent participation

Real at-risk invested capital

Substantially increased leverage

Vast upside potential

Non-negotiated targets

Bonus separated from the budget

Identical long- and short-term
performance measures
 The Tools and Understanding to Guide Better Performance
More than lip service

Management consensus and buy-in

Strong understanding of how value
drivers interact

Tools to reinforce that understanding,
perform sensitivity analysis, and
conduct “what ifs”on key value
drivers

Tools to track, forecast and simulate
performance and bonus accruals

Ongoing training and communication

Development of EVA coaches
Example:
Using value tree analysis to assess sensitivity
of EVA to value drivers
Revenue
NOPAT
Tax
Operating Expenses
EVA
Cost of Capital
Price
Volume
Cost of Goods Sold
SG&A
Fixed Capital
Capital Employed
Other
Plant & Equipment
Property
Inventory
Working Capital
Legend:
 High Impact
 Medium Impact
 Low Impact
Labor
Cost of Debt
Cost of Equity
Capital Charge
Raw Materials
Receivables
Payables
Other
Good Will
Intangibles
Stages of EVA Implementation
Step 1
Understand
and
appreciate
current
readiness
for change
Step 2
Determine
strategy
(objectives,
messages,
and media)
Step 3
Step 4
Step 5
Develop
training/
communication
materials
Rollout
Evaluate
Results
Implementation Tasks
 Build EVA awareness
 Link pay decisively to EVA
 Develop EVA-based action
steps for line managers
Implementation Tasks...
 Build EVA Awareness

Keep measurement simple.

There are dozens of potential adjustments. Only a handful are likely to
be material or relevant.

Use existing accounting systems to your advantage. Don’t introduce a
new set of books.
Implementation Tasks...
 Build EVA Awareness

Keep measurement simple.

Keep education simple.

Explain the difference between market capitalization and market value
added (“MVA”).

Note the difficulty of measuring MVA directly, especially for a division.

Describe how EVA drives MVA, and is thus superior to ROE and EPS.

Describe what managers can and can’t do to influence EVA.

Illustrate the fundamental relationships and tradeoffs between important
value drivers. Make EVA “line-of-sight.”
Implementation Tasks...
 Build EVA Awareness

Keep measurement simple.

Keep education simple.

Keep abreast of industry experience.

The press and the Internet, not war stories, are the most
comprehensive, unbiased and up-to-date source of EVA case studies.

Academic research on EVA is widely available on the Internet, and
generally more thorough and unbiased than consultants’ in-house
research.
Implementation Tasks...
 Link Pay Decisively to EVA
The traditional annual incentive plan
$ Bonus
Target
80%
Budget
120%
Operating
Profit
Implementation Tasks...
 Link Pay Decisively to EVA
The EVA incentive plan
Key Features:
$ Bonus
Target

No caps (or floors)

A bonus “bank”

Greater leverage

Self-adjusting
targets
EVA
Performance
Target
Implementation Tasks...
 Link Pay Decisively to EVA
Targets can reflect:
$ Bonus
 Uniform improvement
level
 Peer performance
 Market expectations
Target
Key Features:

No caps (or floors)

A bonus “bank”

Greater leverage

Self-adjusting
targets
EVA
Performance
Target
Example: Expectations-Based Target-Setting
$80
MVA
EVA
C
PV EVA
PV EVA
PV EVA
Present Value of
EVA Improvement
$ 30
$100
Capital
Current EVA
Capitalized
$ 50
Implementation Tasks...
 Develop Action Steps
Processes

Business Planning

Resource Allocation

Capital Budgeting

Strategy

Compensation

Acquisitions

Quality
Improvement

Align key processes around EVA.

Develop the tools for meaningful value
driver analysis.

Furnish training and coaching.
Economic
Value
Added
Market
Value
Added
Implementation Pitfalls
 Concentrating overly on the
metric
 Concentrating insufficiently on
calibration
 Not integrating EVA with other
initiatives such as cycle time,
customer satisfaction, and
balanced scorecard
 Not gaining early “buy-in” from
operations
 Analogizing too closely to LBO’s
Bottom Line on Implementation:
Successful companies:
Unsuccessful companies:

Mold solutions to the company

Rely on inflexible, off-the-shelf templates

Keep the solutions simple

Over-engineer metrics and plan design

Link pay and performance decisively

Convolute, water down or simply omit
pay linkages

Commit from the outset to good
communication

Address communication as an
afterthought, and execute it narrowly

Gain insight and build consensus
among key operating players

Steamroll through design and rollout,
alienating key players

Develop top-level champions who
participate throughout the rollout

Rely on the comparatively weak platform
of a single department to transform the
entire company

Commit fully to being value-driven

Pay lip service to parts of the VBM
mandate

Make their commitment permanent

Use an incrementalist, flavor-of-themonth approach
The Next Step in EVA Development
 Differentiate management performance
from industry-wide performance.
 Reformulate companies as management
plays, rather than generalized bets on an
industry or the economy.
Implications for:





Defining EVA
Structuring equity incentives
Communicating with investors
Devising capital structure
Planning models
Differentiating management performance...
Contention: Commodity price movements and stock market activity explain the vast
majority of most companies’ stock price performance.
Example:
The Specialty Chemical Industry
10%
% Change in
S&P 500
20%
% Change in
Methanol Prices
10%
0%
(10%)
% Change in Ethylene Prices (20%)
0%
20%
(20%)
5%
Sample:
Dow Chem Co
Georgia Gulf Corp
Lyondell Petrochemical Co
Olin Corp
Union Carbide Corp
0%
(5%)

(10%)

R2
0.637
 80.0%
(15%)
(10%)
(5%)
0%
5%
% Change in Market Value
10%
15%
Differentiating management performance...
Contention: Commodity price movements and stock market activity explain the vast
majority of most companies’ stock price performance.
Impact:
Less than one-fifth of most industries’ stock market performance can be
traced to contributions by management.
Conclusion:




During downturns, conventional stock and cash-based incentives are viewed
as lottery tickets.
During good times, conventional bonus plans perpetuate the impression that
stockholder returns relate mainly to good management.
Over time, even sub-par performance will be rewarded.
Stockholders find all companies in an industry interchangeable.
Proposed solution?
Short the competition
$120
Portfolio of 5.6 at-themoney indexed options is
worth just one out-of-themoney option, but ...
$100
Option Value
$80
1. Index management’s stock options
against industry performance.
Slope: 5.4
Specifically: Exclude value gains
(or losses) attributable
to the S&P or industry.
$60
Slope: 1.0
$40
Impact:
Creates options where
the difference between
option value and
exercise value (and
thus the perception
gap) is small. Justifies
issuing more options
as a consequence.
Examples:
Dresser, WarnerLambert, Itel
The difference in upside (and
downside) potential is
enormous, thus greatly
amplifying incentives.
$20
$0
$40
$60
$80
$100
$120
$140
Stock Value
Slope: 0.97
($20)
($40)
1 Standard Option
1 Indexed Option
5.6 Indexed Options
Proposed solution?
Short the competition
1. Index management’s stock options
against industry performance.
2. Make capital structure line-of-sight.


Create equity in the business
units themselves.

Partial public offerings.

Spinoffs and split-ups.

Letter stock.
Restructure business portfolio to
reflect core competencies.
Proposed solution?
Short the competition
28 Large Corporate Split-Ups
10-Day Gain
De-Conglomeratization
Quaker Oats
Fisher-Price
Cooper Industries
Cooper Cameron
ITT
Hartford
Proactive
De-Integration
AT&T
Lucent,NCR
James River
Marriott
Crown
Marriott Int'l
Dole
Am. Cyanamid
Cytec
Castle & Cooke
Marriott
Roadway
Coors
The Limited
Host
Caliber
ATX
Intibrands
Litton
D&B
Anheuser Busch Western Atlas
Union Carbide
Campbell Taggart
Praxair
General Mills
Darden
Ceridian
Control Data
GM
EDS
Baxter
AHS
1. Index management’s stock options
against industry performance.
2. Make capital structure line-of-sight.

Morrison
cafeterias,
hospitals
Eli Lilly
Guidant
Positive
Hanson PLC
Reactive/
Defensive
Kodak
Eastman
Chemical
Am. Express
Lehman
W.R. Grace
Nat'l Medical Sears
Dean Witter
Allegis
Hertz
Negative

100%
50%
5%
25%
Create equity in the business
units themselves.

Partial public offerings.

Spinoffs and split-ups.

Letter stock.
Restructure business portfolio to
reflect core competencies.
Proposed solution?
Short the competition
17 Large Corporate Split-Ups
365-Day Gain
De-Conglomeratization
Quaker Oats
Fisher-Price
Proactive
Coors
ATX
2. Make capital structure line-of-sight.
Cooper Industries
Cooper Cameron
Am. Cyanamid
Cytec
Litton
Western Atlas
Ceridian
Control Data
De-Integration
James River
Marriott
Crown
Marriott Int'l
Dole
Castle & Cooke
The Limited
Intibrands
General Mills
Darden
1. Index management’s stock options
against industry performance.
Union Carbide
Praxair

Eli Lilly
Guidant
Positive
Reactive/
Defensive
Kodak
Eastman
Chemical
Am. Express
Lehman
Sears
Dean Witter
Allegis
Hertz
Negative

100%
5% 50%
25%
Create equity in the business
units themselves.

Partial public offerings.

Spinoffs and split-ups.

Letter stock.
Restructure business portfolio to
reflect core competencies.
Proposed solution?
Short the competition
1. Index management’s stock options
against industry performance.
2. Make capital structure line-of-sight.
3. Make the stock a management play
rather than an industry play.

Issue equity-linked debt—
pegged to the stock price of
competitors.
Proposed solution?
Short the competition
1. Index management’s stock options
against industry performance.
2. Make capital structure line-of-sight.
3. Make the stock a management play
rather than an industry play.
Specifics: DECS or Prides issued against
competitors.
Hybrid debt instruments whose
interest payments are linked to the
performance of a particular stock—
in this case, a market-weighted or
equally-weighted portfolio of
competitors.
Examples: Lyondell, Enron, NationsBank,
Netscape, Nextel, Telecom
Argentina
Proposed solution?
Short the competition
1. Index management’s stock options
against industry performance.
2. Make capital structure line-of-sight.
3. Make the stock a management play
rather than an industry play.
Indexed capital structures...

Are an inexpensive way for company, and thus its
shareholders, to place an extended bet against the
competition while investing long in management.

Lessen industry risk (and thus beta).

Lower the cost of capital.

Improve cash flow.

Transform investing in company from an industry
play into a management play without shuffling
investors.
Proposed solution?
Short the competition
1. Index management’s stock options
against industry performance.
2. Make capital structure line-of-sight.
3. Make the stock a management play
rather than an industry play.

Issue equity-linked debt—
pegged to the stock price of
competitors.

Issue commodity-linked debt—
pegged to the price of raw
materials.
Proposed solution?
Short the competition
1. Index management’s stock options
against industry performance.
2. Make capital structure line-of-sight.
3. Make the stock a management play
rather than an industry play.
4. Index MVA and EVA.
XVA Dollar amount of MVA created during a
prescribed number of years, over and
above the MVA created by competitors—
after indexing competitors’ beginning
capital to the company’s
XEP Dollar increase in EVA during a prescribed
number of years that cannot be explained
by changes in the economic profit of
competitors—again adjusted to reflect
differences in beginning capital
Proposed solution?
Short the competition
1. Index management’s stock options
against industry performance.
2. Make capital structure line-of-sight.
3. Make the stock a management play
rather than an industry play.
4. Index MVA and EVA.
5. Make planning models real-time
and contingency aware.

Build probabilistic models, not
charts of account.

Plan contingencies in advance.

Adapt targets based on real-time
changes in externalities.
EVA in a nutshell

EVA is more than a metric.

EVA can and should be simple.

Incentives must be powerful, consistent,
and involve real at-risk capital.

Relative performance measures would
address a significant defect of many
EVA initiatives: inability to respond to
changing industry or market conditions.

Management’s commitment to change
must be fundamental.