In announcing updates for the 2019 proxy season, ISS put U.S. and Canadian companies on notice: Economic value added (EVA) is about to resurface as a visible measure of corporate performance. Though ISS is not yet including in its quantitative tests, it will be publishing EVA calculations during the 2019 proxy season.
The handwriting seems to be on the wall: Now that EVA performance numbers are part of the ISS data feed, companies will feel obliged to compare each other’s performance” and shareholders will do the same. The result is that shareholders will likely ask fresh questions of companies when performance lags the market. Boards will be challenged to understand and monitor EVA like never before.
Many directors may remember EVA’s surge of popularity several decades ago. The measure introduced in 1982 by Stern Stewart and akin to “economic profit” promised something compelling: Combining three crucial metrics earnings, invested capital, and capital costs into one encompassing measure of company performance. Executives wouldn’t have to play the constant see-saw game of trading off earnings and returns. Instead they would maximize a single measure which combined them.
Problems that kept EVA from gaining traction in the past, however remain. Many managers have always had trouble seeing how the measure works. They criticize it as a “black box,” a measure so opaque that it hampers people’s understanding of what they can do day to day to make it grow. The calculation does require dozens, sometimes scores, of adjustments to the P&L and balance sheet to reverse perceived economic distortions that arise in GAAP accounting. It can also risk understating the true performance of companies making long-payback investments. Meanwhile, executives have chafed over the complexity of the incentive compensation schemes offered with EVA.
Fast forward to today, and the black-box legacy remains. Though ISS’s moves are still in the trial phase, people worry that neither executives nor employees will find EVA accessible, transparent, or useful in offering line-of-sight targets for daily decision making. They don’t see the need for the rebirth of EVA, nor for letting go of old measures and in turn embracing the potential of EVA to help them better create value for shareholders.
And that presents the challenge for boards to find the best way to unlock EVA’s “black box.” How can your company reap the promised rewards?
Experience shows that the key to doing so is to decompose the top-line EVA measure into a broad menu of subordinate measures. That turns out to be straightforward, because EVA is not actually a “new” number. It is a variation of an old one, namely earnings, from which you subtract, in effect, a “rental” charge for the capital tied up in producing those earnings.
Let finance people argue over the details, but for executives and people down through the organization, the way to demystify EVA is to prepare a list of the measures that drive EVA at each level and in each function. Let people down the line focus on what they understand in their own jobs that will boost EVA at the top level. The finance people can easily enough isolate the economic, strategic, and operational metrics that best tie to EVA. They can then use the same approach to cascading targets down through the ranks that many companies already use.
The process should proceed as follows:
- Unbundle EVA into its primary, secondary, and tertiary drivers, which include the key economic, strategic, and operational items that deliver value.
- Isolate the leverage points, the specific measures where changes yield the greatest chance for fresh value.
- Map these drivers to departments, locations, and individuals who have accountability for improving performance.
- Set improvement targets calibrated to deliver the most value, while remaining within resource constraints.
- Educate people on the basics so the old familiar numbers are seen as sitting naturally in the calculation of EVA. The process is summarized in Exhibit 1.
As a final step, of course, you can tie compensation to EVA, which is not common practice. An alternative is to calculate EVA and use it as a proxy to calibrate familiar measures that are controllable, making sure earnings and return numbers, once taken together, assure EVA growth. The calculations are easy enough. You can then use this information for setting payouts for both annual and long-term incentive pay.
Whether or not you take the final step and incorporate EVA into incentive compensation, when you decompose economic profit into drivers, you do indeed unlock that black box. And that enables all employees to deliver improving EVA results. As ISS’s trial run in calculating EVA continues, boards are advised to figure out how to benefit from the use of EVA, as it could turn into a permanent criterion in ISS’s screens for Say on Pay voting. By 2020, if your EVA performance lags your peers’ performance, be ready to answer investor questions. Are your measures for financial decision making up to snuff? Should investors move their capital elsewhere?
Stay tuned. We will have a more expansive article in an upcoming NACD Directorship article.