Demystifying EVA

and
EVA Implementation
Copyright November 16, 1999
Icelandic Management
Association Conference
on EVA

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?
Whats 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
O A cohesive definition of success
O A shared language for each area of
financial management
O A fundamental reformulation of the
way the company structures
incentives
O The tools and understanding to
make EVA line-of-sight, and thus
part of day-to-day decision-making
O A Cohesive Definition of Success
Market
Value of
Invested
Capital

O A Cohesive Definition of Success


Invested
Capital

Total
Market
Cap.
O A Cohesive Definition of Success


Invested
Capital

MVA
Total
Market
Cap.
Invested
Capital


MVA

Invested
Capital

O A Cohesive Definition of Success
MVA
Total
Market
Cap.
MVA
Invested
Capital



Invested
Capital

O A Cohesive Definition of Success
MVA
Total
Market
Cap.
Total
Market
Cap.
MVA


Invested
Capital

MVA


Invested
Capital

O A Cohesive Definition of Success
MVA
Total
Market
Cap.
Total
Market
Cap.
MVA
MVA comes from operations, not finance.
MVA depends on the future, not the past.
O A Cohesive Definition of Success
How do EVA companies drive MVA?
MVA can only be measured externally.
No divisional surrogates.
No internal guidance about how to measure,
promote and reward success.
O A Cohesive Definition of Success
The Limitations of MVA
The single best internal determinant of MVA is
EVAor 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.
O A Cohesive Definition of Success
Thesis
EVA = Operating Profit - Opportunity Cost of Running the Business
EVA can and should be simple...
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 = NOPAT - c* x Beg. Capital
EVA can also be expressed as:
EVA = (Return on Capital - Cost of Capital) x Beg. Capital
4 incentives:
C Improve efficiency, and thus returns.
C Grow, but only if new investments can earn the cost of capital.
C Redeploy capital from underperforming operations.
C Manage risk, and therefore the cost of capital.
EVA is a combined measure of growth and profitability...
EVA relates directly to stock value...
PV CF
1
Value
PV CF
3
PV CF
2
PV

NOPAT
C
Discounted Free Cash Flow Discounted Economic Value Added
PV EVA
1
PV EVA
2
PV EVA
3
PV
EVA

C
Capital
Value
MVA
O The present value of a companys expected EVA is its premium or discount to book value (MVA).
O A companys discounted EVA plus its level of capital employed equals the present value of expected FCF.
O EVA is the simplest combined measure of growth and profitability relating directly to stock value.
EVA = Operating Profit - Capital Charge
Adjustments should be based on common sense...
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
EVAs 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 clientnot upon whats in fashion.
O A Shared Language Information transferred rapidly and
meaningfully
Corporate Office
Investor
Relations
Capital
Budgeting
Human
Resources
Strategic
Planning
Cost
Accounting
Treasury
Management
Discounted
Cash Flow
ROE and Net
Income
Market Share,
Earnings Growth
EPS
Asset Turns
Cash Flow
EVA Financial Management System


Common language for allocating resources,
conducting valuations, measuring performance,
and communicating with investors
Minimal corporate synthesis and reconciliation
Information transfers real-time and meaningful

Strategic
Planning
Investor
Relations
Capital
Budgeting
Human
Resources
Cost
Accounting
Treasury
Management
Annual
Budgeting
Valuation
Traditional Financial Management System


No common denominator of value
Heavily dependent on corporate synthesis
and reconciliation of departmental figures
Information transfers slow and inefficient

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
O A Fundamental Change in Incentives
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 ifson
key value drivers
Tools to track, forecast and simulate
performance and bonus accruals
Ongoing training and communication
Development of EVA coaches
O The Tools and Understanding to Guide Better Performance
Raw Materials
Labor
Other
Plant & Equipment
Property
Inventory
Receivables
Payables
Good Will
Intangibles
Revenue
Tax
Operating Expenses
Cost of Capital
Capital Employed
Capital Charge
NOPAT
EVA
Legend:
High Impact
Medium Impact
Low Impact
Volume
Cost of Goods Sold
SG&A
Cost of Debt
Cost of Equity
Fixed Capital
Working Capital
Other
Price
Example: Using value tree analysis to assess sensitivity
of EVA to value drivers
Stages of EVA Implementation
Understand
and
appreciate
current
readiness
for change
Determine
strategy
(objectives,
messages,
and media)
Develop
training/
communication
materials
Rollout
Evaluate
Results
Step 1 Step 2 Step 3 Step 4 Step 5
Implementation Tasks
O Build EVA awareness
O Link pay decisively to EVA
O Develop EVA-based action
steps for line managers
O Build EVA Awareness
Keep measurement simple.
E There are dozens of potential adjustments. Only a handful are likely to
be material or relevant.
E Use existing accounting systems to your advantage. Dont introduce a
new set of books.
Implementation Tasks...
O Build EVA Awareness
Keep measurement simple.
Keep education simple.
E Explain the difference between market capitalization and market value
added (MVA).
E Note the difficulty of measuring MVA directly, especially for a division.
E Describe how EVA drives MVA, and is thus superior to ROE and EPS.
E Describe what managers can and cant do to influence EVA.
E Illustrate the fundamental relationships and tradeoffs between important
value drivers. Make EVA line-of-sight.
Implementation Tasks...
O Build EVA Awareness
Keep measurement simple.
Keep education simple.
Keep abreast of industry experience.
E The press and the Internet, not war stories, are the most
comprehensive, unbiased and up-to-date source of EVA case studies.
E Academic research on EVA is widely available on the Internet, and
generally more thorough and unbiased than consultants in-house
research.
Implementation Tasks...
The traditional annual incentive plan
Target

$ Bonus
Operating
Profit
Budget 80% 120%
O Link Pay Decisively to EVA
Implementation Tasks...
Target

$ Bonus
EVA
Performance
Target
Key Features:
No caps (or floors)
A bonus bank
Self-adjusting
targets
Greater leverage
O Link Pay Decisively to EVA
Implementation Tasks...
The EVA incentive plan
Target

$ Bonus
EVA
Performance
Target
Key Features:
No caps (or floors)
A bonus bank
Self-adjusting
targets
Greater leverage

Targets can reflect:
Uniform improvement
level
Peer performance
Market expectations
O Link Pay Decisively to EVA
Implementation Tasks...
Example: Expectations-Based Target-Setting
Present Value of
EVA Improvement
Current EVA
Capitalized
$ 50
$80
$100
Capital
MVA
EVA
C
$ 30
PV EVA
PV EVA
PV EVA
O Develop Action Steps
Align key processes around EVA.
Develop the tools for meaningful value
driver analysis.
Furnish training and coaching.
Processes
Business Planning
Resource Allocation
Capital Budgeting
Strategy
Compensation
Acquisitions
Quality
Improvement
Economic
Value
Added
Market
Value
Added
Implementation Tasks...
Implementation Pitfalls
O Concentrating overly on the
metric
O Concentrating insufficiently on
calibration
O Not integrating EVA with other
initiatives such as cycle time,
customer satisfaction, and
balanced scorecard
O Not gaining early buy-in from
operations
O Analogizing too closely to LBOs
Successful companies:
Mold solutions to the company
Keep the solutions simple
Link pay and performance decisively

Commit from the outset to good
communication
Gain insight and build consensus
among key operating players
Develop top-level champions who
participate throughout the rollout

Commit fully to being value-driven

Make their commitment permanent
Unsuccessful companies:
Rely on inflexible, off-the-shelf templates
Over-engineer metrics and plan design
Convolute, water down or simply omit
pay linkages
Address communication as an
afterthought, and execute it narrowly
Steamroll through design and rollout,
alienating key players
Rely on the comparatively weak platform
of a single department to transform the
entire company
Pay lip service to parts of the VBM
mandate
Use an incrementalist, flavor-of-the-
month approach
Bottom Line on Implementation:
The Next Step in EVA Development
O Differentiate management performance
from industry-wide performance.
O 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
20%
10%
0%
(10%)
(20%)
% Change in
S&P 500
(10%)
(5%)
0%
5%
10%
% Change in
Methanol Prices
(15%) (10%) (5%) 0% 5% 10% 15%
% Change in Market Value
(20%) 0% 20%
% Change in Ethylene Prices
Sample:
Georgia Gulf Corp
Lyondell Petrochemical Co
Dow Chem Co
Union Carbide Corp
Olin Corp

R
2
0 637
80 0%
.
.
Contention: Commodity price movements and stock market activity explain the vast
majority of most companies stock price 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.


Differentiating management performance...
Proposed solution? Short the competition
1. Index managements stock options
against industry performance.
Specifically: Exclude value gains
(or losses) attributable
to the S&P or industry.
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, Warner-
Lambert, Itel
($40)
($20)
$0
$20
$40
$60
$80
$100
$120
$40 $60 $80 $100 $120 $140
1 Standard Option 1 Indexed Option 5.6 Indexed Options
1.0 Slope:
Slope: 5.4
Slope: 0.97
Portfolio of 5.6 at-the-
money indexed options is
worth just one out-of-the-
money option, but ...
The difference in upside (and
downside) potential is
enormous, thus greatly
amplifying incentives.
O
p
t
i
o
n

V
a
l
u
e

Stock Value
Proposed solution? Short the competition
1. Index managements stock options
against industry performance.
2. Make capital structure line-of-sight.
E Create equity in the business
units themselves.
Partial public offerings.
Spinoffs and split-ups.
Letter stock.
E Restructure business portfolio to
reflect core competencies.
28 Large Corporate Split-Ups
10-Day Gain
5%
25%
50%
100%
Hanson PLC
W.R. Grace
Nat'l Medical
Marriott
Host
Kodak
Eastman
Chemical
Allegis
Hertz
D&B
Anheuser Busch
Campbell Taggart
Quaker Oats
Fisher-Price
Sears
Dean Witter
General Mills
Darden
Eli Lilly
Guidant
James River
Crown
Roadway
Caliber
GM
EDS
Am. Cyanamid
Cytec
Baxter
AHS
ITT
Hartford
Am. Express
Lehman
Cooper Industries
Cooper Cameron
Coors
ATX
AT&T
Lucent,NCR
Morrison
cafeterias,
hospitals
Marriott
Marriott Int'l
Litton
Western Atlas
Union Carbide
Praxair
Dole
Castle & Cooke
The Limited
Intibrands
Ceridian
Control Data
De-Conglomeratization De-Integration
Proactive
Reactive/
Defensive
Positive
Negative
Proposed solution? Short the competition
1. Index managements stock options
against industry performance.
2. Make capital structure line-of-sight.
E Create equity in the business
units themselves.
Partial public offerings.
Spinoffs and split-ups.
Letter stock.
E Restructure business
portfolio to reflect core
competencies.
17 Large Corporate Split-Ups
365-Day Gain
100%
5%
25%
50%
Union Carbide
Praxair
Marriott
Marriott Int'l
Ceridian
Control Data
Eli Lilly
Guidant
Coors
ATX
Sears
Dean Witter
Kodak
Eastman
Chemical
Litton
Western Atlas
Allegis
Hertz
Am. Express
Lehman
James River
Crown
Dole
Castle & Cooke
General Mills
Darden
Am. Cyanamid
Cytec
The Limited
Intibrands
Cooper Industries
Cooper Cameron
Quaker Oats
Fisher-Price
De-Conglomeratization De-Integration
Proactive
Reactive/
Defensive
Positive
Negative
Proposed solution? Short the competition
1. Index managements stock options
against industry performance.
2. Make capital structure line-of-sight.
E Create equity in the business
units themselves.
Partial public offerings.
Spinoffs and split-ups.
Letter stock.
E Restructure business
portfolio to reflect core
competencies.
Proposed solution? Short the competition
1. Index managements stock options
against industry performance.
2. Make capital structure line-of-sight.
3. Make the stock a management play
rather than an industry play.
E Issue equity-linked debt
pegged to the stock price of
competitors.
Proposed solution? Short the competition
1. Index managements 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 managements 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 managements stock options
against industry performance.
2. Make capital structure line-of-sight.
3. Make the stock a management play
rather than an industry play.
E Issue equity-linked debt
pegged to the stock price of
competitors.
E Issue commodity-linked debt
pegged to the price of raw
materials.
Proposed solution? Short the competition
1. Index managements 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 companys
XEP Dollar increase in EVA during a prescribed
number of years that cannot be explained
by changes in the economic profit of
competitorsagain adjusted to reflect
differences in beginning capital
Proposed solution? Short the competition
1. Index managements 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.
Managements commitment to change
must be fundamental.