ADD'EM & EVA:  Do The Math.  Is Your Latest Initiative Adding Value To Your Firm?

Leader's Edge, May/June 2004
Author:  Robert J. Lieblein

The folklore of a discussion between the consultant and his client goes something like this:

Financial advisor: “Upon closer look at your financial statements, it appears you are losing money on every unit you sell.”
Client: “I agree, but I will make it up in volume!”

Reality isn’t much different.

Owner: “I had another good year and made money.”
Your response: “Did you enhance shareholder value and the value of your business?”
Owner: “I do not understand your question.”

Welcome to the concept of Economic Value Added (EVA).

EVA in its simplest form provides a more accurate measure of profitability than “plain net income” because it measures how well a company has performed in relation to the amount of capital employed. EVA is the performance that most directly links financial performance with the creation of shareholder wealth over time. Another way to look at EVA is if a business returns more value than it has consumed, it has created value. If it returns less value it has destroyed wealth.

While EVA can be a very complex calculation, we can breakdown the concepts to simplify them and demonstrate how an agency owner can greatly enhance financial and operational performance by implementing EVA methodologies.

The theory behind EVA is that an agency should earn at least its cost of capital. If you generate returns in excess of your cost of capital, you increase shareholder value.  Conversely, there are many situations when an agency generates positive net income but actually decreases shareholder value. This begs the question: “How?”

Suppose you borrow $100,000 from a bank at 8% and reinvested the money in securities that earn 6%. Did you make money? Yes. You would pay taxes on $6,000. However, did you really increase your net worth? The obvious answer is “no” since it cost you $2,000 more in interest payments than you earned in income (to say nothing of paying taxes on that income). This is no different than the concept of EVA.

EVA is the net operating profit after tax (often referred to as after-tax cash flow) generated by an agency minus the cost of capital deployed to generate the cash flow. The result represents the true profit (economic profit) versus the paper profit (net income). A positive EVA indicates agency value is being created, while a negative EVA suggests a reduction in shareholder value.

Unfortunately, many brokerages are destroying shareholder value because profits are less than their full cost of capital. EVA corrects this oversight by including all capital costs, debt and equity, to determine whether the agency has created or destroyed shareholder value during a reporting period (calculated either quarterly or annually).

One of the benefits of EVA is that it creates opportunities to improve financial and operational performance and helps align the incentives of shareholders (e.g. to increase shareholder value) and employees (e.g. financial rewards for employees). Consider this: in many brokerage firms there are different ways to measure financial goals and objectives.

As a matter of fact, different operational areas or business units often are measured by different financial goals and objectives:

• Sales and marketing departments by new revenue;

• Lines of business by growth in revenue or gross profit;

• Finance areas by cost or expense control; and

• Managers’ bonuses based on profit or other individual financial goals.

These different measurements result in inconsistent standards and often conflicting goals, objectives, incentives and alignments among employees in the same firm. EVA eliminates this problem by using a single financial measure that links all decision making to a consistent focus.

How does the company increase shareholder value? From a financial perspective, EVA is generally an easy concept for financial and non-financial managers to understand. It allows a firm owner to align individual and line of business performance by focusing on a single goal: how to improve shareholder value.

Stern Stewart, a management  consulting firm, developed EVA to help managers understand and care about managing assets as well as income. It helps them assess the tradeoffs between the two.  Historical studies have proven that by understanding and buying into this concept, a business’ financial results can be dramatically improved.

Many owners assume that EVA is only a valid concept for large firms. No so. In smaller brokerages, an owner can educate all employees in a relatively short period, which empowers them to make educated decisions in daily functions. 

For any size firm, EVA methodologies is often the key financial measurement to convert missions into strategies consistent with the brokerage’s long-term goals and objectives. By its very nature, EVA requires managers and in smaller firms, all employees, to make decisions that require evaluation of those decisions that create the most value and have the least opportunity cost (e.g. capital investment).

You can expect financial and operational performance improvements from EVA analysis in: actions for cost reductions, improvements in technology, reduction in working capital or optimal use of debt.

EVA results in improved performance because valuation creation can be increased in only three basic ways:

• Increase the returns of existing operating assets by managing them more efficiently and without investing new capital

• Invest additional capital and measure financial performance to ensure expected returns on new investments exceed the cost of capital

• Reduce existing capital from existing operations by selling/discontinuing non-producing assets.

Imbuing personnel with the short- and long-term perspective of an owner is the key to assuring that managers and employees have the same incentive as shareholders is to know your personnel have the short- and long-term perspective of an owner. EVA was designed to link bonuses directly to EVA. Basing incentive compensation on improvements in EVA is the main driver in EVA methodologies. The only way for a manager to make more money is by creating value for the shareholder. In theory, there is no upside limit in EVA bonus plans.

EVA concepts should help owners evaluate some basic aspects of financial performance and its relationship to value creation:

• The primary financial objective of most owners should be to increase shareholder value.

• The true economic value of a brokerage is related to the ability to generate returns in excess of the cost of capital.

• Implementation and analysis of EVA aligns manager and shareholder incentives and makes managers think and act like owners.

• Increasing EVA over time will increase market value that will directly affect an owner’s ability to increase net worth.

Even though most brokerage owners’ largest personal asset is the value of their firm, most don’t know whether they have created shareholder value over the long term and how net income and shareholder value are not necessarily tied together. If they implement EVA, maybe owners will begin to see a truer picture. At the same time, they will be able to identify opportunities to improve performance.

How Does EVA Work?
Click here to view an illustration on how to figure EVA for your firm.