Monday, November 3, 2003

The Evils of EVA

The Myth of Shareholder Value and Its Relationship to Innovation

EVA or Economic Value Added is touted as a measure of the true economic performance of a company and a strategy for creating shareholder wealth. EVA measures the residual wealth of a company when its cost of capital is deducted from its operating profit.

EVA = Net Operating Profit After Taxes (NOPAT) - Cost of Capital

Stern and Shiely, fathers of EVA, in their book The EVA Challenge, describe EVA in the following way. "Economic Value Added is a measure of the true economic performance of a company and a strategy for creating shareholder wealth. It is also a method of changing corporate priorities and behavior throughout a company, right down to the shop floor. Properly implemented, EVA frees the measurement of corporate performance from the vagaries of accounting conventions and aligns the interest of managers with those of shareholders, ending a decades long conflict of interest."

When we first learned about EVA in the mid-1990s, we immediately became alarmed because of its negative impact on innovation and the potential for abuse. A rationalization of a corporation from executives to all employees and the supporting infrastructure, processes and culture on the basis of EVA principles would inherently reduce the emphasis on innovation. EVA based measurements and incentives explicitly discourage risk taking and focus on today's profit while minimizing the capital invested. EVA is not about the future and innovation is always about the future, so the conflict is inherent.

Moreover, innovation in a corporation is not the only thing that suffers when the EVA concepts are embraced and abused. In addition organizations that wholeheartedly applied EVA have not demonstrated long term financial performance gains. In 2001 Marvin Runyon, Postmaster General, stated, "Joel Stern know this subject matter better than anyone. He adapted EVA so that we could use it to incent management at the United States Postal Service to greatly improve performance. We stopped losing billions and started turning profits." Yet, in 2002 ABC News reported that a "newly released federal audit showed the postal service used questionable bookkeeping analysis to change the perception of its performance." The audit showed that 80,000 postal managers received $805 million in bonuses while the service was losing $2 billion over the last two years. ABC News continued, "when it lost $2 billion between 1998 and 2000 officials found it hard to justify bonuses, so postal executives decided to find a way." Using EVA the executives turned the $2 billion loss into a $1.7 billion gain.

Even Coca Cola, an early adopter of EVA, has had difficulties. Responsible Wealth reported that "Although Coca Cola stock lost 22% of its value in 2001 (compared to a 12% loss for the S&P 500), and 6,000 Coca Cola employees (21% of the company's workforce) were laid off just a year earlier, Coca Cola CEO Doug Daft enjoyed a 47% compensation increase in 2001, to more than $74 million."

Al Ehrbar, author of EVA: The Real Key to Creating Wealth, writes "EVA is the framework for complete financial management and incentive compensation system that can guide every decision a company makes ... that can transform corporate culture, that can improve the working lives of everyone in an organization by making them more successful, and can help them produce greater wealth for shareholders, customers, and themselves." As you can see from the previous paragraphs, EVA works in regard to "themselves".

The pressure to conform is tremendous. For example, listen to what C. B. Rogers, Jr., Chairman of Equifax stated in 1996, "At the monthly meetings, (of Equifax's 29 business units), we separate them (business unit managers) into value creators and value destroyers. You don't want to be a value destroyer. Its a terrible term, but that's what you are doing."

EVA focuses on shareholders. Shareholders are only one of the many groups that make up the stakeholders of an organization. We believe that any approach to wealth creation that fails to take into account the entire stakeholder universe of an organization is doomed. Moreover, a organization's strategy for wealth creation must incorporate three other elements: Opportunities/Threats in the Market; the Current Capabilities of the Organization; and its Capacity for Change.

A successful Innovation Roadmap will include all four elements!

Peter Drucker has written, "Business has only two basic functions: marketing and innovation. Marketing and Innovation produce results. All the rest are costs."

We go even further, to state that innovation in marketing is also essential! Therefore business has only one basic function -- Innovation.

Innovation is the basis of all competitive advantage: the means by which organizations anticipate and fill customer needs and the method by which organizations utilize technology.

Innovation either endows resources with a new capacity to create wealth or it creates a new resource.

Paul Schumann & Donna Prestwood

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