Lenta, LLC
ECONOMIC
VALUE-ADDED: ADVANTAGES AND DISADVANTAGES
Discerning investors, always eager to make
above-average returns on their funds, have begun to pay more attention to
non-traditional measures of financial performance that measure value, than to
traditional accounting measures (Dillon & Owers, 1997, p.32). This value
has been defined as the “true economic profit” that a company can be assessed
for (Value Based-EVA, 2008, 1). Many managers have begun to use EVA or similar
concepts to judge the impacts of present decisions and to help make future ones
(Shaked & Leroy, 1997, 3).
Many experts believe that making financial decisions
based only on accounting
data can hurt a company (Stewart, 1991, p. 22, 24-29). Economic Value
Added (EVA∗) is a useful financial metric that measures value based on adjusted
accounting data to assess financial performance and help a company grow
(Stewart, p. 3; Makelainen & Roztocki, 1998, p. 7).
Dissatisfaction
with Earnings Per Share
According to conventional accounting wisdom, Earnings
Per Share, or EPS
(perhaps the most common financial metric), is the key financial metric
for financial
performance assessment (Stewart, p. 22). It is likely one of the most
widely used and well known financial metric in the business world. The equation
for EPS is calculated as: [Net Income – preferred stock dividends] / Either
[Common stock shares outstanding +equivalents] or [The “average amount of
shares outstanding”] (Value Based – EPS, 2008).
Some experts in the field of finance believe that EPS
ratios change too quickly and too much to be of any real use for financial
analysis (Stewart, p. 22). Even worse, they are based on historical costs that
are usually unadjusted for present use. Those dissatisfied with using EPS (and
similar accounting metrics) as an indicator of financial performance have
turned to using “value-based performance measures” instead (Roztocki & Needy,
n.d.-EVA for Small Mfg. Co., 3).
Other Problems Encountered with Accounting Based Measures
Critics of EPS and similar accounting metrics cite
several other reasons why they are displeased with the prevalence of using EPS
as a measure for growth and
performance. According to many analysts, making decisions using EPS (and
subsequently the Generally Accepted Accounting Procedures, or GAAP
necessary to
arrive at EPS) appears to be the cause for a large amount of
misallocation of funds among companies (Stewart, p. 2). Analysts such as G.
Bennett Stewart III show that the use of the current standard accounting
procedures (GAAP) causes companies to do seemingly irrational things to keep a
good EPS figure (Stewart, p. 24-28). Critics of maximizing EPS claim that growing
the EPS metric is the impetus behind much waste and lost opportunities among
companies that should be realizing more growth (Stewart, p. 24-28, Share
Prices In spite of the above-mentioned problems, many managers still pursue
EPS figures because they believe that good EPS figures appeal to investors and
influence stock prices (Stewart, p. 2). However, in this pursuit of growing EPS
to lure investors, the managers tend to compromise the financial strengths of
their companies (Stewart, p. 2).
Managers who believe that share prices are moved by
the movement of EPS are in reality taking the wrong road toward the right goal
of stock price control (Stewart, p. 21). On the other hand, analysts who prefer
to measure value instead of earnings believe that what investors really desire
is not a high EPS , but instead a high cash value of the company (based on
future cash flows) (Stewart, p. 2). This is also what they believe is the
reason that stock prices change; change in value causes change in share prices
(Stewart, p. 2).
These analysts believe that firms should attempt to
increase “value” instead of EPS, and therefore measure financial performance by
a value-measuring metric instead of EPS (Stewart, p. 2, 3).
EVA
EVA, or Economic Value Added, is such a metric that
seeks to improve and
measure efficiency and “value creation” (Shaked & Leroy, 1997, p. 1,
2; Stewart, p. 3). G. Bennett Stewart III., originator of EVA and author of one
of the largest works on the subject (a source heavily drawn on for this paper),
naturally believes that accounting earnings and dividends (and EPS) are
irrelevant concerning stocks and their valuation (Stewart, p. 3, 43). He says
that “Management should focus on maximizing a measure called Economic Value
Added (EVA)…[which] is the only measure to tie directly to intrinsic market
value” and that EVA should replace EPS (Stewart, p. 2 , 3; 32).
The difference between the two measures is reflected
in the two schools of
thought that they represent. Another expert states that “(a)ccounting focuses
on the
residual income available for residual claims, before they receive any
returns” (Dillon & Owers, 1997, p. 33,
7-8). It involves itself with what has already happened in the firm’s
financial history and is to some degree irrelevant for the purposes of judging
financial progress for the present period (Dillon & Owers). This takes a
different approach to the present and forward-looking views of “the economic
concept of income” that judges financial achievement for investors and takes
into consideration future outlays of funds; EVA attempts to reconcile these two
views somewhat but is mostly aligned with the second position (p. 33, 7-8).
EVA’s Advantages
and Disadvantages
Proponents of EVA proudly point to explicit and
secondary benefits of implementing EVA in a company’s structure. A company can
benefit from some of these advantages of EVA even if it is not made the sole
target metric.
Advantages
1. Efficiency
EVA points managers and firms toward
efficiency—essentially a goal of using
EVA is to cause the firm to accomplish more (monetarily) with as little
capital as
necessary (Stewart, p. 3). Efficiency is not the first concern of EVA,
but EVA can show what “value” was made from what capital was used; in
this way it can judge efficiency (Mäkeläinen,; Dillon & Owers, p.
33, 3). Money is not free, so it should be used in such a way that would
maximize its return, or at least pay for the cost of using it (Dillon &
Owers, p. 33, 2). This is a “fundamental notion” of EVA – to get more for less
(p. 33,2). Since the “cost of funds” used is the interest, the lower the price
of the funds the better and more desirable the borrowed funds are (all other
factors equal) (p. 33, 3).
2. Manager’s Incentives
The implications of this efficiency that EVA promotes
is what its proponents
believe is another major reason why EVA should replace EPS. Stewart
believes that a
policy of having managers meet yearly budgets is not as practical as
having them be measured by EVA, which would provide a greater incentive for
performance (Stewart, p. 5). Stewart wisely points out that more than just
financial awards are necessary to get stellar financial performance from
managers; managers need to want to succeed (though the financial reward helps
as well) (p. 223).
Stewart suggests that a firm bases its managers’
incentive on an adjusted
percentage of EVA, suggesting that they should get a portion of the
actual value they help to make (p. 4, 5, 234-240). Utilization of this method
would not limit managers to a particular bonus range (like a majority of
American companies do), so the sky is
essentially the limit to the value they can create and then benefit from
(p. 234). The
managers’ goal is to make the company more profitable and efficient
without incurring any more costs that are not (at least) covered by the
increasing profits – they are not to hurt the company by increasing its debt
without having the new profits pay for it (p. 225).
Under this system, the more efficient and
value-enhanced the firm becomes, the higher a manager’s incentive (bonus
compensation) becomes (p. 233). Improvement in EVA (and therefore the firm’s
worth) is the goal that the managers aim for, resulting in the growth of a
firm’s value (Shaked & Leroy, p. 3,4, 11,2, 12,2; Stewart, p. 233). Stewart
believes in a laissez-faire approach, allowing a manager to do what he sees fit
(obviously within ethical standards) to increase the company’s value (Stewart,
p. 228).
3. Applicability
Another benefit of EVA is that its applicability is
virtually universal. Its simplest application requires only two of the most
commonly used financial statements; the balance sheet and the income statement,
allowing it to be applied to virtually any company with accurate financial
statements (Mäkeläinen & Roztocki, p. 5, 2).
4. Other Advantages
The principles of Economic Value Added are also
relatively simple to understand (Mäkeläinen, 1998, p. 61, 3). The
fact that the principles of EVA (efficiency, increasing wealth) can be easily
conveyed to others, including employees, gives them a common goal that they can
clearly contribute to and appreciate (Mäkeläinen & Roztocki, p.
6).
While the theory underlying EVA and its application
can be complex, the basic points it stands for appeal to common sense. EVA can
also be used as a kind of diagnostic tool, showing managers which sections of
the firm need more work to increase a firm’s value for the next period
(Mäkeläinen & Roztocki, p. 18, 2, 3).
Disadvantages
Like all other things in life, no one solution is a
perfect fit for everyone, and EVA is no exception. Some experts say that while
EVA looks simple, it can be or become cumbersomely complex (Shaked & Leroy,
p. 1, 5, 6). Obviously, the simpler EVA can be made by a company’s finance
department, the easier it will be to understand and the more it will be used
(p. 4, 4, 5). Additionally, there are no official standards pertaining to the
use of EVA, so companies may apply the metric differently than other, similar
companies do (unlike GAAP standards), giving results that do not provide for
fair “comparability” (p. 1,7). This is a major disadvantage of EVA.
1. Disadvantages - Suitability
A major disadvantage is the question of the universal
suitability of EVA. Some
suggest that EVA is not the best choice for all companies (p. 5 ¶ 1, 3,
9). These experts believe that EVA is more suited to established companies
“with few requirements for capital expenditures” likely because capital is a
major factor in the EVA equation (p. 9, 5, 6). Such experts believe that EVA is
not suitable for “companies that are …sensitive to the availability of capital…
[instead, they] might do better to use…CVA” (p. 2, 1).
Those familiar with both metrics will observe that the
formula for CVA (cash value added) is built on essentially the same principal
as EVA. The formula for CVA is “operating cash less the charges for the capital
employed by the unit” (p. 1, 3).
2. Disadvantages - Measurement of Efficiency
Several authors have brought up other disadvantages of
using EVA, four of which will be listed here. The first disadvantage is what
Peter Brewer, along with his co-authors in an article entitled Economic
Value Added(EVA): Its Uses and Limitations, calls the problem of “size
differences” (Brewer, Chandra, & Hock, 1999, p. 7, 3). Brewer mentions that
one can make the comparison of two companies and find that one company has a
higher EVA, yet a lower ROI (Return on Investment). This indicates that
although one company had more value created in terms of the EVA metric, it
still would not seem to be as efficient at creating wealth as the other since
it did not necessarily make more value with fewer funds (p. 7, 3). As he says,
“(a) larger plant or division will tend to have a higher EVA relative to its
smaller counterparts” (p. 7, 3).
3. Disadvantages - Accuracy
Another potential shortfall Brewer lists is that since
the calculation of EVA
depends on the financial statements based on accounting principles,
accountants can
change factors to some degree to change the resulting EVA figure.
Examples he lists
include moving the fulfillment of orders in or out of an “accounting
period” to move the revenues recorded in or out, and shifting expenses in a
like manner (p. 8 ¶ 2). However, one may note that a properly adjusted EVA
metric will take into account such changes.
4. Disadvantages - Short-sightedness
Yet another downfall is what Brewer considers to be a
shortsighted approach to
what appears to be in his article R&D expenses (p. 8, 4-6). He
voices the opinion of
those who believe that EVA and similar metrics prompt managers to make
positive
changes for the present time and present benefits without regarding so
much the projects that provide returns in the future (p. 8, 7).
It is in the author of this paper’s opinion, though,
that a manager who truly looks out for the well being of his company will
secure both current and future returns, yet will merely place a smaller
priority on the current returns, desiring a secure future for the company.
Stewart also presents a kind of rebuttal in his Quest
for Value. He says that a plan in which a bonus is awarded to a manager who
meets a goal and is limited by a bonus cap (or in other words that the
manager’s bonus falls within a high/low range) can be hurtful to a company in
both good times and bad times (p. 234). Stewart says that having such a policy
will only motivate managers to give better performance during good times, when
success is attainable and managers are within the high/low range. However, when
managers realize that they will not be able to meet their goal, or when they
are at the top of the range and will not be rewarded for any further success,
they will have much less incentive to contribute to the well-being of the firm
(p. 234). This is in contrast to his plan, which does provide incentive for
times of less value added (when future returns have not yet been realized),
enough perhaps to tide a good manager over until the success of the future
project is evident (p. 235-241).
5. Disadvantages – Usefulness as a Solution-maker
The last downfall that Brewer mentions is what he
calls the problem of “results
orientation” (p. 9,1). By this he means that EVA is not a very helpful
diagnostic tool to “point towards the root causes of operational
inefficiencies” (p. 9, 2). Therefore, he assumes that when it comes to
strategizing about the next term, EVA will offer little help and guidance
toward improving value (p. 9, 2).
Others believe that the opposite is true and that EVA
can show managers what
needs to be altered to increase value for the next fiscal term
(Mäkeläinen & Roztocki, p.18).
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