Five EVA Metrics That Every CFO Should Know
1. What is EVA (Economic Value Added)?
EVA is a firm’s true economic profit after deducting the full opportunity cost of all invested capital, equity as well as debt. It turns balance sheet assets into a charge to profit, just like cost of goods sold. Accordingly, EVA increases when managers streamline operations and cut wasteful costs, invest capital in growth above the cost of any added capital, and when they turns assets faster and release capital from uneconomic assets and activities. In short, EVA illuminates all the ways that performance can be improved and wealth created, in any business.
EVA is also measured after eliminating accounting distortions that cloud perceptions of true value and the frequently lead to sub-optimal business and investing decisions. Here are some prominent examples:
- EVA treats leased assets as if owned. This neutralizes comparisons regardless of the mix of leasing or owning assets a firm employs.
- EVA writes off R&D spending and ad spending over time, subject to cost of capital on the un-amortized balance.
- EVA removes cash from capital, so that a sudden distribution of cash has no impact on EVA (though it confusingly sends EPS and ROE measures haywire). In other words, cash is treated as EVA neutral, as invested in marketable securities at market prices that return the cost of capital, by definition.
- EVA reverses impairment charges are reversed because they are inconsequential non-cash bookkeeping events. In other words, it is EVA that is impaired by a poor investment, by bearing the burden of the cost of capital that cannot be covered.
- EVA “capitalizes” restructuring costs by removing them from earnings and adding them to balance sheet capital. In other words, a restructuring is treating as an investment to streamline the business, not as a knee jerk admission of failure.
Bottom line -- EVA is the best, most complete, comparable and correct way to measure profit and understand the real performance and value of any company or line of business.
2. MVA (Market Value Added)
MVA is the spread between a company’s aggregate market value, given its share price, and the total amount of capital invested in the business. It measures how much wealth the firm has created for its shareholders since the start of the company. It also measures a firm’s "franchise value," the value of the firm as a going-concern business above putting its assets in a pile. Increasing MVA is the key to generating outstanding returns for investors, and is a sign that capital has been allocated, managed and re-deployed effectively to maximize the “net present value” of the enterprise.
In principle, MVA is equal to the present value of the EVA profit a firm is expected to earn in the future – because EVA sets aside the profit that must be earned to recover the value of all capital that has been or will be invested in the business, and thus it directly discounts to the value added on top of the invested capital. It is the profit measure that discounts to and explains a firm’s franchise value. As a result, increasing EVA is the “real key to creating wealth.” As a result, managers should aim to generate sustainable growth in EVA as the key financial goal, a mission made more practical by the advent of three new EVA ratio metric pioneered by EVA Dimensions.
3. EVA Margin (EVA/Sales)
EVA Margin is EVA as a percent of sales. It is the firm’s true economic profit margin net of all operating and capital costs. It is a measure of the total profitability and productivity of the business model, spanning income efficiency and asset management.
EVA Margin neutralizes comparisons between capital lean firms like Wal-Mart that run with miniscule operating margins, and margin rich businesses like Intel that ties up mammoth amounts of high risk production capital. Unlike conventional operating margins, EVA Margins fully and correctly recognize the value of superior asset management and successfully achieving lean, high velocity business models.
EVA Margin is also a ratio, a statistic that can be compared against norms established by line of business. As a general reference point, over the past twenty years, the median Russell 3000 firm earned an EVA Margin of 0.5%. The 75th percentile EVA Margin lies at 4.5%, and 90th percentile at 9%. At any time about half of all companies are either earning an immaterial or negative EVA profit.
Every manager should be aware of the EVA Margin her business is earning, and have a strategy to increase it, as one way to drive growth in economic profit.
4. EVA Momentum (∆EVA/Trailing Sales)
EVA Momentum is the change in EVA over a period, stated as a percent of prior period revenues – in other words it measures the EVA growth rate, scaled to the sales size of the business. It is the only business performance ratio where a bigger result is always better, because when Momentum is bigger, EVA and franchise value are bigger, too. EVA Momentum thus qualifies as every company’s objective function – the ratio indicator everyone should aim to increase over time. And, it is the single best measure a CFO can use to quantify the quantity and value of forward plans, and to stimulate line teams to generate better plans during the planning process.
EVA Momentum measures performance at the margin, not on the average. It’s the news in the data. It is positive for a negative EVA business that is turning around and becoming less negative. It is flat or falling for a profitable business whose business model is fatiguing or under competitive pressure. It reveals true trends and turning points sooner and surer than any other indicator. It is thus the perfect “spanning” measure for CFO’s to use to put diverse lines on business on a common measurement scale.
EVA Momentum is the product of all underling performance factors, but it is convenient to think of it initially as the sum of two main drivers. First, how much did the firm’s EVA Margin change over the period, which indicates the degree of improvement or decrement in the overall productivity and profitability of the firm’s business model spanning income efficiency and asset management. The second is termed "Profitable Growth" – is the value added by adding sales at a positive EVA Margin, it is literally the product of the firm’s sales growth rate and its EVA Margin, which is a critical performance dimension EVA Momentum includes that is totally absent from profitability measures like ROI or profit margin. Ultimately, EVA Momentum unfolds, step by step, to reveal all value drivers, on a convenient percent of sales scale familiar to operating teams, such as EBITDA margin, working capital days, plant intensity, and so on, which can lead to even more company-specific operating and strategic indicators, like sales per square foot, time to market, and so forth. It is an ideal scaffolding to create a truly balanced and value linked scorecard that is topped with an actual score.
EVA Momentum is also a ratio statistic, so useful norms can be established. As basic reference points, the average EVA Momentum rate for the Russell 3000 median firm has been just 0.3% over the past 20 years --- indicating that markets tend to be highly EVA competitive at the margin. Competition, saturation, substitution, bureaucratic creep, fading fads all tend to drive incremental returns down to just the cost of capital rate at some point. The 75th percentile firm increases EVA at a Momentum rate of 1% to 1.5% p.a., and the 90th percentile generates EVA growth at a sustained 3% to 4% pace. Apple, a notable outlier, has racked up 6% to 8% EVA Momentum per year for the past six to eight years.
Bottom line – CFO’s should use EVA Momentum to quantify the quality and value of plans, and use it to stimulate better plans, they should replace DuPont ROI formula and instead use EVA Momentum to more completely and transparently reveal and analyze performance drivers and benchmark with peers, and they should use EVA Momentum to frame their reporting scorecards. And one more thing -- CFOs should adopt EVA Momentum as paramount financial ratio objective applicable across all lines of business.
5. Market-Implied Momentum (MIM):
The Market-Implied EVA Momentum (“MIM”) is the EVA Momentum growth rate baked into a company's share price. It is calculated by solving for the EVA growth trajectory that discounts back to the prevailing MVA. Because it literally discounts to the share value, MIM is a truly reliable indicator of the “consensus” of investor expectations. As such, it is far superior to the familiar “consensus” earnings-per-share, which is not a consensus, but an opinion survey, of sell-side analysts, ignoring buy-side investors, for a near term book earnings that hardly accounts for market value.
Firms or sectors that have large projected MIM rates are expected either to recover sharply from a downturn or to benefit from demand growth, innovation excellence, and process efficiency gains that will propel rapid expansion in their economic profits. Low or negative MIM rates indicate that investors believe a company is apt to face intense competitive headwinds restraining profitable growth opportunities or to tumble from a cyclical peak. Monitoring MIM is a good way to free-ride on the forecast judgments of the investment community. CFOs are using MIM to help them set plan and performance targets, even compensation benchmarks, and investors are using it to get a reliable read on market expectations to compare against their own.