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The only financial metric business leaders need to know

7 min read

Modern Money

Bennett Stewart is an expert in shareholder value and corporate performance management, and CEO of EVA Dimensions, a financial technology firm that provides software tools, databases and training and support packages that help companies to test and automate Best-Practice EVA, and investors to earn excess returns. This article was excerpted with permission from the publisher, John Wiley & Sons, from “Best-Practice EVA” (March 2013).

Every business leader needs a way to amplify his or her business instincts and galvanize a team of players to win. The bad news is, conventional financial metrics will inevitably mislead business leaders and their teams into making suboptimal decisions that leave a lot of value on the table because all the measures have blind spots — they hide the truth or tell half-truths.

Earnings, for instance, can easily be inflated with balance sheet investments that don’t earn a decent return, and ROI-fixated companies will limit investments to the highest returns and forfeit lots of profitable growth opportunities that would increase the firm’s value. What’s desperately needed is one measure that correctly consolidates all the pluses and minus of business decisions into a reliable net score — in other words, into a measure that clearly measures value and which readily provides practical insights into how to increase value. That measure is EVA, standing for economic value added.

EVA, pronounced E-V-A, is a corporate profit measure that is better than all others. It measures profit according to economic principles and for the purpose of managing a business and maximizing value, and not by following accounting conventions. In simplest terms, it is net operating profit after tax, or NOPAT, less a full weighted average cost of capital charge for tying up balance sheet assets. If NOPAT is $150, and if a total of $1,000 has been invested in balance sheet assets with a weighted average cost of capital of 10%, for a “capital charge” of $100, then EVA is $50. It is the true profit after setting aside a priority return for the owners.

The goal of an EVA-focused firm is to increase it, to make a negative EVA less negative and a positive EVA more so. It’s the improvement in EVA that is the universal goal, which means it applies as well to laggards as leaders. A mission to increase EVA naturally puts a premium on asset management, on speeding asset turns, and on developing and deploying lean business models, in order to reduce the cost of capital charge. But unlike ROI, it also encourages managers in the best businesses to continue to innovate, to scale, and to invest in all opportunities they believe will earn more than the cost of the added capital.

The bottom line is, EVA measures all the ways that performance can be improved and wealth created — in any business. Beyond that, EVA is a great way — I will argue it is the best way — not just to measure value, but to assist management in driving improvements in shareholder value.

Brief history of EVA

EVA came out a little over 20 years ago with the publication of my first book in 1991, which started a global tsunami wave of corporate adoptions. But beginning about 10 years ago I began to notice chinks in the armor that were inhibiting EVA from being much more widely used. The most glaring deficiency was that EVA was just a money measure and lacked a companion ratio indicator or, better, an entire ratio framework to bring it to life, which was a severe handicap.

Without a ratio framework, CFOs found it difficult to use EVA to compare performance over time and across lines of business or against public peers that differed in scale. Line managers were also frustrated they could not easily trace EVA to familiar levels and performance drivers like sales growth, gross margin, working capital days and plant turns.

A set of pioneering innovations have now addressed these deficiencies. Today there is a new “best-practice” version of EVA that makes the adoption far easier and more rewarding. The biggest advance is a set of EVA ratio statistics that has made EVA an open book brimming with managerial and valuation insights.

These new metrics give business and finance leaders an opportunity to streamline their management equation. They measure profitability performance so thoroughly and accurately, and they so closely align decisions to shareholder value, that all other financial ratio measures become obsolete.

EVA Momentum

The headline ratio measure on the new EVA lineup is called EVA Momentum, which is calculated by taking the change in EVA versus the prior period, and dividing by the revenues in the prior period. It measures the growth rate in EVA, scaled to the sales size of the business. It is the only corporate performance ratio where bigger always is better, because it gets bigger when EVA does, which means it should be every company’s most important financial goal, the one ratio metric that everyone aims to maximize as the key measure of corporate success and added value.

EVA Momentum is also the basis for an incredibly revealing diagnostic tool. It unfolds in stages to reveal all of the underlying performance factors that determine corporate value. It not only shows how much value has been created, but where and why. It is the measure that really matters and a portal to the many that can be managed. Best-practice companies also are using EVA Momentum to measure the value of their business plans and to stimulate their line teams to deliver more value by making them more EVA capable.

EVA Margin

A second EVA ratio, EVA Margin, is a useful statistic in its own right and a key driver of EVA Momentum. It is the ratio of EVA to sales and is every firm’s true economic profit margin — the percentage of sales that falls to the EVA bottom line after deducting all operating costs and capital costs. It is a key summary measure of profitability and productivity, consolidating operating efficiency and asset management into a reliable and comparable net margin score. Unlike operating margins, it neutralizes the capital differences across business models or product lines, and produces an inherently fairer, purer and more comparable measure of performance. The median EVA Margin typically runs at only 0.4% across all Russell 3000 firms. It is 4% to 4.5% for the 75th percentile, and it runs at 9% for the 90th percentile.

EVA Margin provides a simple framework to help managers to think of ways to increase EVA and drive Momentum over time. It turns the question of how to manage a business for value into a familiar sales-based, margin-based construct. By doing so, it illuminates the two main paths to increase EVA and drive Momentum.

The first way is through “productivity gains,” that is, from generating an increase in the EVA Margin by improving pricing power, enhancing the product mix and extending process excellence through greater income efficiency and superior asset management — in other words, it is to make the business engine run stronger, with more torque and spark. The second way is through “profitable growth” by adding sales that can earn positive EVA Margins. It is stepping on the gas and fueling more innovation, more scale and more growth in profitable business models, which is something that pure productivity measures, like profit margin and ROI, overlook completely.

The bottom line is, EVA Momentum — the EVA growth rate — should supersede sales and earnings growth as the growth measure that matters, and EVA Margin, which I call the EVA Momentum up-shifter, should replace ROI and the DuPont ROI formula with a framework that is more intuitive and far more practical as a tool to manage and maximize value.

In the past, EVA was something of a closed system, available to the select few. Now it is open architecture. All are welcome to join the Best-Practice EVA initiative. I call on investors and business consultants of all stripes, along with business school professors in finance, strategy and general management, to join the cause of creating a simpler and more effective corporate management framework.