Using EVA to measure performance and assess strategy.(Performance Measurement: A Strategic Imperative)(economic value added)

Of all the measures that corporations use to gauge their performance, none is more accurate or useful than economic value added, or EVA. Used to its fullest, EVA can help corporations achieve remarkable success. In fact, most of the companies using EVA as their framework for financial management and incentive compensation have substantially outperformed their competitors.

EVA is the term that Stern Stewart & Co. coined for its particular variety of economic profit, a concept that has been part of mainstream economic thinking for more than a century. Put most simply, EVA is the gain (or loss) that remains after levying a charge against after-tax operating profits for the opportunity cost of all capital - equity as well as debt - used to produce those profits. The calculation of EVA begins with putting operating profits on an economic rather than an accounting basis. That requires the correction of a number of anomalies in GAAP accounting, such as the immediate expensing of investments in research and development. Then the EVA measure deducts a charge for the weighted average cost of all capital. The remainder is the dollar amount by which after-tax operating profits in each period exceed or fall short of the cost of capital.

Charging profits for the cost of capital is crucial. As Peter Drucker put the matter in a 1995 Harvard Business Review article: "EVA is based on something we have known for a long time: what we call profits, the money left to service equity, is usually not profit at all. Until a business returns a profit that is greater than its cost of capital, it operates at a loss. Never mind that it pays taxes as if it had a genuine profit. The enterprise still returns less to the economy than it devours in resources. . . . Until then it does not create wealth; it destroys it."

Many corporate managers have forgotten this basic principle because they have been conditioned to focus on conventional accounting profits, which include a deduction for interest payments on debt but have no provision at all for the cost of equity capital. Worse still, most line managers base their decisions on operating profits, which don't even have a charge for debt. True profits don't begin until the cost of capital, like all other costs, has been covered.

The Relationship Between MVA and EVA

Why is EVA so powerful? First, because it is the performance measure that is linked most directly, both theoretically and empirically, to a measure called MVA, market value added. MVA is the difference between the market value of an enterprise and the capital contributed by shareholders and lenders. The ultimate objective of every corporation should be to produce as much MVA as possible. No matter what goods or …