Transcript EVA Implementation

Alpha Corporation
Developing Successful EVA®Based Incentives
Copyright © December 11, 1997
Three Stages of EVA®
Implementation

Building EVA awareness

Linking pay decisively to EVA

Developing EVA-based action
steps for line managers.
EVA is a registered trademark of Stern Stewart & Co. The directors of Finegan & Gressle are former partners and
officers of Stern Stewart who contributed significantly to developing and popularizing EVA.
Measuring Corporate Success:
The Ultimate Financial Test

A large
Market
Rapid
highstock
stock
and growing
price
price? market
capitalization?
appreciation?
premium
to book value? !
Cost of
Invested
Capital
Total
Market
Value
The MVA Scorecard
MVA Winners







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MVA Losers
Coca-Cola
$124.1
 ITT
Microsoft
83.3
 General Motors
The Point: Coke and GM have identical trading values,
Intel
85.0
 Loews
but
GM
invested
$200
billion more than
Total
Market
Value
$134.5
Merck
 American Express
Coke
to 72.5
get there.
Total
Market
Value
$135.5
Capital Invested
10.4
Phillip Morris
59.8
 Ford Motor Company
During the last187.9
5 years alone, Coke
Capital
Invested
MVA
$124.1
Proctor & Gamble generated
54.5
 Travelers Group
$73 billion
more in value than
MVA
($52.4)
Exxon
51.5been expected
 RJRfrom
Nabisco
could have
5-Year XVA
$73.1 the market
contrast,
GM destroyed $83
Johnson & Johnson in general.
 PG&E
5-Year XVAbillion. 48.8By($83.2)
Chase Manhattan
43.7
 Phillips Electronics
Pfizer
40.8
 Digital Equipment
($77.1)
(52.4)
(46.4)
(36.7)
(34.0)
(19.5)
(14.4)
(7.0)
(6.4)
(6.0)
Source: Finegan & Gressle survey of the 1,700 largest companies traded on a U.S. exchange based on year-end 1996 data
($ Billions). A complete listing is available at www.shareholdervalue.com.
How do you drive MVA?


MVA comes from operations, not finance.
MVA depends on the future, not the past.
How do you drive MVA?


MVA comes from operations, not finance.
MVA depends on the future, not the past.
The Performance Measurement Challenge



Reconcile the discrete and often conflicting value
drivers of a business.
Differentiate substantive economic performance
from bookkeeping entries.
Capture the real time cost of money.
Reconciling Value Drivers
Avoid Mixed Signals

The Traditional Financial
Management System
Corporate Office
Investor
Relations
EPS
Treasury
Management
Strategic
Planning
Market Share,
Earnings Growth
Cost
Accounting
Capital
Budgeting
Discounted
Cash Flow



Human
Resources
Cash Flow
Asset Turns
ROE and Net
Income
No common denominator of value.
Heavily dependent on corporate synthesis
and reconciliation of departmental figures.
Information transfers slow and inefficient.
Reconciling Value Drivers
Avoid Mixed Signals

The Traditional Financial
Management System

The Ideal Financial Management
System
Valuation
Strategic
Planning
Annual
Budgeting
Investor
Relations
Treasury
Management
Capital
Budgeting
Cost
Accounting
Human
Resources



No common denominator of value.
Heavily dependent on corporate synthesis
and reconciliation of departmental figures.
Information transfers slow and inefficient.



Common language for allocating resources,
conducting valuations, measuring performance,
and communicating with investors.
Minimal corporate synthesis and reconciliation.
Information transfers real-time and meaningful.
Reconciling Value Drivers
Avoid Mixed Signals

The Traditional Financial
Management System

The Ideal Financial Management
System
Valuation
Strategic
Planning
Annual
Budgeting
Investor
Relations
Treasury
Management
Capital
Budgeting
Cost
Accounting
Human
Resources



No common denominator of value.
Heavily dependent on corporate synthesis
and reconciliation of departmental figures.
Information transfers slow and inefficient.



Common language for allocating resources,
conducting valuations, measuring performance,
and communicating with investors.
Minimal corporate synthesis and reconciliation.
Information transfers real-time and meaningful.
An Integrated Measure of Business Performance
EVA = Operating Profit - Opportunity Cost of Running the Business
Cost of Borrowing?
–
–
–
Sales
Cost of Sales
Overhead
EBIT
Tax on Operations
NOPAT
Dividend Yield?
The return (or expectation)
foregone by not investing in a
comparably risky portfolio of
projects—the weighted cost of
debt and equity capital.
Opp. Cost = Cost of Capital
x Beg. Capital
An Integrated Measure of Business Performance
EVA = NOPAT - c* x Beg. Capital
EVA can also be expressed as:
EVA = (Return on Capital - Cost of Capital)
x
Beg. Capital
EVA introduces four powerful 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.
Value Proposition: EVA Drives MVA
Value
Value
PV
EVA
C
PV
NOPAT
C
PV CF3
MVA
PV EVA3
PV EVA2
PV EVA1
Capital
PV CF2
PV CF1
Discounted Free Cash Flow



Discounted Economic Value Added
The discounted present value of a company’s expected EVA is its market value premium or discount to book
value (“MVA”).
A company’s discounted EVA plus its level of capital employed will always equal the discounted present value
of expected Free Cash Flow.
EVA is the only integrated measure of growth and profitability which relates directly to stock value.
Measurement Challenges:

Differentiate substantive performance
from bookkeeping:





Acquisition accounting
Write-offs and restructuring
charges
Off balance-sheet financing
Expensing of long-term
investments
Capture the real cost of money:

Cash-basis versus accrual
accounting
Linking pay decisively to EVA
Why are incentives so important?
Pressure on Performance





Tremendous opportunities
Fewer competitive barriers
Accelerating change
Rapid competitive response
Investor pressure
Executive Talent

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Decisive edge in
value creation
Highly sought
Strategy: Use performance-based pay to attract top talent
and and encourage value creation
The Reality:
Most incentive plans aren’t
designed to drive value creation
Stock and Options

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Linked to stock price
Competitive
Line of sight often poor
No focus on goals
Cash Incentives
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Mainly annual
EPS, ROE goals, capped
Weak link to value
Battles over fairness
Value-based plans, in contrast, clearly link decisions, results
and shareholder value.
The traditional annual incentive plan
$ Bonus
Target
Operating
Profit
80%
Budget
120%
The EVA-based incentive plan
Key Features:
$ Bonus

No caps (or floors)

A bonus “bank”

Greater leverage
Target
Self-adjusting
targets
Deferred “at risk”

portion of award
EVA
Performance
Target
The EVA-based incentive plan: Target-Setting
Targets can reflect:
$ Bonus
 Uniform improvement
level
 Peer performance
 Market expectations
Key Features:

No caps (or floors)

A bonus “bank”

Greater leverage

Self-adjusting
targets
Target
EVA
Performance
Target
The EVA-based incentive plan: Target-Setting
The expected annual improvement in EVA can be determined
from market expectations:
PV EVA
PV EVA
$80
PV EVA
MVA
EVA
C
Present Value of
EVA Improvement
$ 30
$100
Capital
Current EVA
Capitalized
$ 50
Effective EVA
Implementation Requires:

Management recognition that
current financial measures
distort capital allocation or
weaken incentives to create
shareholder value.

Understanding and appreciation
by Operations, Human
Resources and Finance of
EVA’s role in effecting change.

Sufficient investment of time
and resources to help managers
understand what EVA is and
how it should be used in
managing their business.
EVA Implementation Process
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
Framework Example: A Major Oil & Gas Company
Operating Profit
Distillate
Operating
Profit
Convenience
Store Oper.
Profit
Gasoline
Gasoline
Operating
Profit
Profit
Product Margin
Weighted Margin
Volume
Retained
Accounts
New
Accounts
Premium
Grade Ratio
Mid-Grade
Regular
Lubricants
Operating
Profit
Car Wash
Operating
Profit
Total Costs
Variable Costs
Period Costs
Grade Margin
Framework Example: A Major Oil & Gas Company
Operating Profit
Distillate
Operating
Profit
Convenience
Store Oper.
Profit
Gasoline
Gasoline
Operating
Profit
Profit
Lubricants
Operating
Profit
Product Margin
Retained
Accounts
New
Accounts
Premium
Total Costs
Weighted Margin
Volume
Variable Costs
Regular
Period Costs
Grade Margin
Grade Ratio
Mid-Grade
Car Wash
Operating
Profit
Premium
Mid-Grade
Regular
Improved Implementation:
Making performance measures “line-of-sight”
Price
Revenue
Volume
NOPAT
Tax
Operating Expenses
Cost of Goods Sold
SG&A
EVA
Raw Materials
Labor
Other
Cost of Debt
Cost of Capital
Cost of Equity
Plant & Equipment
Capital Charge
Fixed Capital
Capital Employed
Legend:
 High Impact
 Medium Impact
 Low Impact
Property
Inventory
Working Capital
Receivables
Payables
Other
Good Will
Intangibles
Common Concerns:

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


We have too many initiatives already
underway; this will just confuse
everyone.
It’s too complicated; nobody will
understand it.
We’re already very successful, so why
do we need this?
I’m investing for the future, but you’re
measuring today’s returns.
You can’t compare my SBU to SBU X, we’re different.
We should formulate our strategy first and decide where we’re trying to go
before we start measuring performance.
We just convinced everyone that Return on Capital is the most important
measure to evaluate performance.
EVA Implementation
“If I had to do it over…”


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“Keep it simple!”
Devote greater resources to improving
financial literacy.
Establish clear “line-of-sight” between a
manager’s actions and EVA, and EVA and
shareholder value.
Integrate the EVA initiative with other
efforts such as cycle time, customer
satisfaction, and balanced scorecard.
Develop “EVA Coaches” to provide
continuing support.
Gain early “buy-in” from operations.