EVA (Economic Value Added) may be making a comeback as a performance measure for companies, and this matters for compensation governance. Though popular in the 1990s, EVA fell out of favor over the past two decades and is today used as a measure by fewer than 10 percent of companies. But the acquisition of equity research firm EVA Dimensions by Institutional Shareholder Services (ISS), one of the two top proxy advisory firms, in February 2018 resurrected the possibility of EVA returning as a major force in performance measurement. According to an ISS paper published last month entitled “Using EVA in Pay-for-Performance Analysis, ISS plans to present EVA metrics for informational purposes in the 2019 proxy season. The ISS report highlights that they will compute, report and analyze a set of EVA metrics, and include them in this year’s proxy reports while continuing to seek guidance from institutional investors regarding the value they see in EVA metrics for future use. The return of EVA could have major implications for how boards, proxy advisors and equity analysts decide on executive compensation, as it would raise the issue of the rules of the game and the definition of good performance being changed at a stroke. Companies and investors should pay close – and educate (or re-educate) themselves on EVA’s fundamentals.
What Is EVA And What Are Its Benefits?
EVA is equal to Net Operating Profit after Tax (NOPAT), minus [Total Capital (TC) x Weighted Average Cost of Capital (WACC)].
Sample EVA Calculation
This equation enables the tracking of value creation from one period to the next, including “apples-to-apples” comparisons of companies with significantly different business models and capital structures. Tying executive compensation to EVA allows for boards and shareholders to see clearer correlations between executive performance and pay. EVA has advantages over other, more widely-used measures such as the GAAP earnings, which fails to account for significant company differences, and stock prices, which track only perceptions which may or may not have much at all to do with management activities and achievements.
To create value under the EVA performance metric, earnings must grow more than the return required by investors on any new capital invested. In other words, a 20 percent growth in earnings is much more likely to drive up value if it is achieved with minimal capital expenditure than if it is the result of a major acquisition. This excludes major “one-off” increases in how much a company is worth which result from spending more money, instead focusing on how executives generate growth through less costly, more sustainable means. This was a major reason why investors embraced EVA in the 1990s when they built evaluation models around the principle of measuring earnings relative to the cost of capital, and whether value was really being created or it was merely the “smoke and mirrors” of acquisitions or temporary spending sprees.
EVA was also used by many companies in their incentive plans by essentially awarding management a defined share of EVA growth over time. This EVA plan worked particularly well for large, multi-divisional, capital-intensive firms, promising an enduring, definitive linkage between management rewards and value creation. Once calibrated, this mechanism could operate without budget-based goal setting or any significant plan changes over many years. For example, Genesco has had its EVA plan in place for nearly two decades, while Ball Corporation is going on its third decade. This longevity is itself a benefit, with EVA companies knowing that they will reap the rewards of profits exceeding the capital used to generate them, even if it takes years for their projects to mature. This extends management’s time horizon beyond the end of the fiscal year, enabling it to effectively balance short-term and long-term imperatives.
Why Did EVA Fall Out Of Favor?
The Dot-Com boom of the late 1990s exposed one weakness of EVA when the burgeoning tech companies saw value creation heavily lag investment for multiples years in a row. (This issue is once again extremely relevant given the new generation of tech companies – such as Uber’s planned IPO and Lyft’s recent IPO – which are moving into the public realm while having multi-billion-dollar yearly losses). EVA is also a non-standard measure, subject to numerous adjustments, which increase complexity for management while stoking suspicion of possible fiddling among investors. Finally, any incentive plan is only popular if it is paying out. In the wake of the dot-com bust in 2001, many bonus plans, including EVA plans, were dropped. By the time business began to recover in the early 2000s, new standards for accounting and compensation programs had grown up that would run counter to the EVA philosophy and mechanics, including a lower tolerance for non-GAAP metrics driving incentives.
Is EVA Here To Stay?
In spite of these drawbacks, many investors and governance experts have long remained interested in bringing EVA back as a widely-used metric. EVA bonuses require management to overcome a capital hurdle before getting paid, which is attractive to fund managers looking to hold management to a higher standard. And ISS is in the business of creating governance standards, including for compensation governance, to advise their investor clients how to vote their proxies.
With ISS starting to incorporate EVA as a performance metric, companies and their boards will have to invest in learning or refreshing themselves this metric. Companies can prepare for the advent EVA, and potential renewed interest in it by investors, by taking the following steps:
- Calculate both a “basic EVA” (as ISS is likely to calculate it across all companies) as well as an “adjusted EVA” (based on NOPAT, Capital, and Cost of Capital suitable to your sector) to see where they would stack up
- Determine the degree to which their EVA level or growth trends provide an accurate reflection of company value creation over the last three-to-five years
- Prepare to explain the company’s position on the applicability of EVA as a measure in shareholder engagement activities, including in disclosures and other communications, as appropriate
Some companies with the right set of characteristics noted earlier may even find that EVA is a better metric than the one(s) they are currently using. And with the mandate by ISS, they will have an easier time justifying tracking and reporting it, and even building it into their reward system.
