Growth5 Blog

Monday, February 22, 2010

Assessing Value: A Metric that Can't Be Gamed

I was catching up on some reading this weekend and came across this article on a new business metric that is being used by more and more firms: EVA Momentum. The EVA stands for Economic Value Added.

The concept was developed by consultant Bennett Stewart (with Joel Stern) who claims the ratio can't be manipulated.
"It's the only percent metric where more is always better than less," he says. "It always increases when managers do things that make economic sense."
EVA itself is simply profit minus capital costs – here's how much we earned, now let's take out what we invested back into the company to recognize how much value we created.

EVA Momentum takes EVA and divides it by the prior period's sales. A great way to show the value momentum of a business.
"if a company increases its EVA by $10 million and the prior period's sales were $1 billion, then its EVA momentum is 1%. That's not bad, considering that for most companies this figure is zero or negative, and the average for many companies is generally around zero.

Stewart's firm, EVA Dimensions, has crunched the five-year data for firms with revenues of at least $1 billion. The three top performers by EVA momentum: Gilead Sciences (with an average annual EVA momentum of 24.3%), Google (22.7%), and Apple (12.1%).
What I like about this ratio is that it isolates real value in a simple way. Businesses would do well by incentivizing their management and paying them bonuses by focusing on this metric.

As the article points out, a lot of firms tend to focus on ratios that have potentially destructive side effects. Lehman focused on ROE (return on equity) for so long (and paid out huge corresponding bonuses) they didn't realize their people were actually incentivized to drive them out of business by taking on excessive leverage to increase their ROE more quickly.

EVA Momentum is either going in the right direction, or it's not – there's nowhere for management to hide. You are either creating value for your shareholders, or you are not.

Here are three ways the article points out on how to get EVA Momentum right:
1. Don't obsess about sales. Managers fixate on how to increase their company's revenues, but if it doesn't boost EVA, it does nothing to create value.

2. Bail out of EVA-negative businesses. Ford's sale of capital-intensive, EVA-sapping Jaguar and Land Rover shrank the company, but in the end increased its value.

3. Annihilate wasted capital. Cutting working capital, as Wal-Mart did in 2009, and offloading unproductive assets are great opportunities to build EVA when growth is slow.

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