PERFORMANCE MEASUREMENT -A rewarding approach to value

Almost a year ago, the Lex column in the Financial Times said that ICI “needs pre-tax profits of #900m to cover its cost of capital”. It was an unusual observation at the time, though after all the media coverage since then, it now seems quite normal to talk about such things as the cost of capital and economic value added.

The basic formula for EVA hardly seems revolutionary. In its most basic form, stripped of any technical complexities*, it reads:

EVA = (return on capital – cost of capital) x capital.

That much looks simple enough. Indeed, the equation was probably first devised and applied by American giant General Electric in the 1950s. Back then, it was called “residual income” (but GE didn’t turn it into an acronym and slap a trademark on it, the way New York consultancy Stern Stewart has done with EVA). Thirty years earlier, Alfred Sloan’s General Motors was experimenting with very similar ideas.

And yet, Bruce Anderson, group director of finance and planning at diesel engine group Varity Perkins, told delegates at an ICM conference two months ago: “EVA is not really just a financial measure. It is a way of running our business and engaging everybody in the process. It has become a way of life.”

So what’s going on? Why is EVA still being treated like more than just an equation?

The great leap forward was that Stern Stewart found a way to take an intellectually robust formula for performance measurement and investment appraisal – much discussed in business school academic journals in the 1960s and 1970s – and turned it into something that put money in people’s pockets.

“EVA is our term for residual income,” managing partner Joel Stern says.

“But we recognised that having a measurement system wasn’t even half the answer. You have to have an incentive structure that marries to the performance measurement system.”

EVA works, he says, because it “aligns the interests of the management and the shareholders. If you design the proper incentive structure down through an organisation, you can get people to replicate unit-by-unit as if they were maximising the wealth of the investor in that unit.”

Anderson says: “When you are budgeting to have a bad year, and you pay a bonus because you have done less badly than you previously thought, it’s quite a difficult thought for the shareholders.”

Jim Meenan, president and chief executive of AT&T Canada Enterprises Canada, was responsible for rolling out an EVA programme at the American phone company. “We found that earnings per share, return on equity and operating income just didn’t do it for us. EVA was the closest thing to shareholder value we could find.”

The irony is that traditional yardsticks such as projected discounted cashflow or net present value will give the same results as EVA when evaluating investment projects. “The problem is that NPV does not work as a governance system,” Stern says. “There is no recording of the returns that are expected on this year’s investment until future years, so we have the cash out now and the hoped-for cash returns some time in the future. That’s not a current measure of performance.”

On the other hand, EVA has a memory: all the historic investment decisions are still there in the capital line, and being charged out to the profit and loss account at the cost of capital rate. That way, it combines the balance sheet and the profit & loss account. “If you have spent the money, we are going to hold you accountable for that,” Stern says. Coca-Cola chairman Roberto Goizueta says: “If you charge people for capital usage, you’d be surprised at how they economise on its use.”

Return on investment (ROI) fails as a basis for an incentive scheme because it can very easily encourage managers to do the wrong thing. For example, if a division currently earns 20% ROI while its cost of capital is 12%, any manager seeking to maximise ROI will reject any investment project whose projected ROI is below 20% – even if it is expected to earn more than the cost of capital needed to finance it. Yet if a manager’s ROI guideline is changed to “keep it above 12%”, then that is scant encouragement to maximise returns.

“If you measure performance based on something over here on the left, but incentivise people on the basis of what’s here on the right, then the rational person will look to the left but march to the right,” Stern says.

Worried about short-term manipulation of EVA, such as dangerous under-investment so as to increase the return on investment? Stern Stewart has two answers: first, EVA-related bonuses are only earned for improvements in EVA. If EVA falls, no bonus. Second, a large proportion of an employee’s earned bonus won’t actually be paid out straight away but will be held over until subsequent years. “What we want to do is focus people’s attention on continuous and sustainable improvement in EVA,” Stern says.

At Varity Perkins, Anderson says that this “banking” bonus structure “stops you doing one-off things which are non-sustainable. It stops you engineering one year’s results to get a good bonus because you don’t get all your bonus if you don’t achieve all your (subsequent) target.”

Motivation is all. “Under the hierarchical arbitrary incentive systems, the incentive to be creative has been snuffed out in most organisations,” Stern says. “EVA drives down the fixed costs of running your business. It encourages people to get control of the controllables.”

Anderson says: “EVA provided the most effective link between the way we plan our business, measure our performance and reward our success.” He adds that the EVA system “delinks” performance bonuses from the budgeting process, so that the budget can be used for its proper purpose as a five-year business plan. “It’s amazing how many investment programmes always had promised pay-offs in years four and five,” he says. With EVA, “we got rid of all that malarky”.

Stern likes to tell of the secretary at one EVA-driven company who negotiated a deal with British Airways that allowed her boss to fly free of charge on Concorde twice a month – provided her company gave BA 61% of its worldwide air travel business. “The guy at British Airways can’t be on EVA,” she says. “Because if he were, he would have gone and found out that we already give them 71% of our business – and he would have asked for more.”

Andrew Sawers is business editor on Accountancy Age.

* A complementary article examining some of the more technical and accounting aspects of EVA appears in the 29 May issue of Financial Director’s sister title, Accountancy Age.

A BRIEF GUIDE TO IMPLEMENTING EVA

Allow a year

Most organisations seem to take 12 months to roll out their first EVA programme. Subsequent roll-outs – to different subsidiaries, for example – may be done more quickly because of the learning curve.

Small teams of operational people

The working parties typically consist of one to seven people, regardless of the size of organisation. “It was fundamental to the success of the programme that operational heads trained their own teams, not the financial people,” says AT&T Canada Enterprises chief executive Jim Meenan.

Top level support

“The most important thing is: management must make clear that EVA is not just a fad but the way the company has chosen to run its business,” says Varity Perkins director Bruce Anderson. This means the bonus scheme has to be “wheedle-proof” says Oppenheimer Capital chief Eugene Vesell: “You can’t have a compensation committee that says, ‘Well, they didn’t create value as you define it, but they did all these other good things …'” AT&T’s Meenan says: “This programme could never have been done if the chairman and the board weren’t 100% behind it, because there are many people who don’t want to change.”

Keep it simple

There are about 124 possible adjustments to the accounts in order to work out a company’s EVA. No more than five to ten of them are significant.

Many companies go to great lengths to determine their weighted average cost of capital yet still seem to get more or less the same figure: 12%.

“It’s more important to be approximately right than exactly wrong,” Vesell says, quoting US billionaire Warren Buffett.

How quickly?

Adriaan Jooste at South African power utility ESKOM advises: “Take it slowly. Focus on getting people to understand the measure. Then introduce it into the reward system. You don’t have to move quickly.” But Meenan argues: “If we waited until all the I’s were dotted and T’s were crossed and every number was 100% accurate then we wouldn’t be doing it today.

A third of our 110,000 people switched to EVA on the same day. It was a very nervous day for me personally.”

Communication

“This was our simple message,” Meenan says of his communication to employees, “if you borrow at 12% and you earn 14% you’re creating shareholder value.

If you earn 10% you’ve destroyed shareholder value. Forget the complicated mathematical formulas.”

Who’s included?

At TransAmerica Corporation, the EVA programme started with the top five executives. At Eli Lilley, it goes down two levels below the executive committee, covering 600 people. At Briggs & Stratton motors group, “If you’re alive, you’re on EVA.”

EVA of what?

If you take EVA down to the shopfloor workers, don’t incentivise them on a group EVA measure (or at least, not solely a group measure). “The whole point is that you incentivise people on the basis of things that they can influence,” Stern says.

WHOSE CAPITAL IS IT ANYWAY?

“We want a management motivated to act like owners. In other words, able to make the same kinds of decisions that we would make if we had their knowledge.” Eugene Vesell, managing director of Oppenheimer Capital, is in no doubt: “EVA gives us the comfort that management is acting like owners and will deal wisely with the capital we have entrusted to them.”

Given that Vesell has $35bn in equities to look after, his comments suggest Stern Stewart’s claim for economic value added is well founded: it aligns the interests of managers with those of the shareholders. That is why the fund managers at Oppenheimer often work with the directors of their investees to implement EVA-based incentive schemes for managers and employees.

They worked with the TransAmerica Corporation, introducing a scheme that initially gave up to $4.5m to the top five executives if certain EVA targets were met.

When US engineering group and Stern Stewart client Varity acquired a company called Hayes Wheels, Wall Street brokerage Brown Brothers Harriman was so impressed by the effect that EVA could have on management decision-making that it wrote in one of its research circulars: “We were highly confident that EVA-driven Varity would not overpay for Hayes.” Bruce Anderson, group director of finance & planning at Varity Perkins, confirms EVA was used to determining the maximum price the company would pay for its target acquisition.

Last summer, one London-based Morgan Stanley executive was sceptical about British managements’ ability to make the behavioural adjustments EVA demands: “If a company is thinking about making an acquisition that will enhance earnings per share but reduce its EVA, what do you think it will do?” he asked cynically.

But Anderson has seen a change in the City in the last six months: “One of the concerns that I had (when introducing EVA) was that the UK stockmarket was totally focussed on earnings per share,” he says. “What has amazed me is how, in the last six months, the investment community is now totally value-focussed.”

EVA – A PRACTICAL APPLICATION

“EVA is not about a bunch of MBAs measuring the numbers and putting a system in place that will pay the directors a lot of money.” Just as well, because Adriaan Jooste, business consulting manager at South Africa’s electricity utility ESKOM, has a lot of other priorities to juggle, as well as financial performance.

ESKOM, one of the five largest utilities in the world, aims to be the cheapest supplier of electricity, anywhere. “We want to develop ESKOM as a business, not as a utility,” Jooste says.

But the company also has a whole raft of urgent non-financial targets.

The company is electrifying 300,000 homes a year, yet many of these are nothing more than corrugated iron shacks. “If you were to do a straight-forward EVA, calculation it would be a massive loss for the organisation,” Jooste says.

The company also has an affirmative action programme. By the year 2000, 50% of the top 8,000 jobs will be held by black, Asian and coloured managers, up from 25% today. Every employee will be functionally literate by the millennium, too.

At the same time, ESKOM wants to be among the top 3% of world utility companies in terms of its plant availability statistics to minimise downtime.

So is there room for EVA in this? “We use the term ‘gatekeepers’. What we say now is, ‘We’re only interested in your EVA after you’ve achieved all these other things,'” Jooste explains. “‘We’re going to set you some very clear targets in terms of customer satisfaction, affirmative action, and so forth.’ So instead of a situation where a manager says, ‘I can get away with a little bit of this and a little bit of that,’ he now has a clear target.” Miss the targets and the bonus goes out the window (though there is some allowance for coming close).

“With affirmative action, there is always a danger of some kind of tokenism,” he adds. “But because we are only interested in your EVA after you’ve met that target, the message is: if you’re going to hire people, you’d better invest in education, training and mentoring to get them producing good results.

“Most of the gatekeepers are real business issues.”