Using EVA to Measure Management's Contribution to Value - A Missed Opportunity at ISS

Abstract

EVA (Economic Value Added or economic profit) has a long history of intermittent use in corporate performance measurement. It was widely used as a funding formula for corporate incentive plans in the first half of the 20th century, it enjoyed considerable popularity in the 1990s under the leadership of the consulting firm Stern Stewart & Co and it has recently been embraced by the proxy advisor ISS. In all of these periods of popularity, the focus has been on current EVA (or ∆EVA) as a comprehensive measure of performance, ignoring the critical insight of the EVA math that investors’ dollar excess return has two components in addition to the capitalized future value of ∆EVA: the capitalized future value of expected ∆EVA and, most importantly, the unexpected change in future growth value (FGV). FGV is the capitalized present value of expected future ∆EVA. In a simple world with constant ROIC and capital growth rates, current ∆EVA is a perfect proxy for ∆FGV because both are determined by the current EVA spread and dollar capital growth. In the real world, where ROIC and capital growth rates are volatile and capital has delayed productivity, current ∆EVA is a very poor proxy for ∆FGV. In and out of turnaround situations, ∆EVA and ∆FGV move in opposite directions. For growing companies, better estimates of ∆FGV come from using expected, not actual, capital growth and measures of profitability, such as [EBITDA + R&D] ROIC, that are calculated before delayed productivity expenses such as capital charge, depreciation and R&D. In this paper, I show that operating performance measurement can be greatly improved by using regression models to estimate the ∆FGV associated with changes in expected profit from capital growth as well as the FGV fade associated with ∆EVA- and ∆EVA+. I show that operating excess return, using a model of ∆FGV, explains 65% of the variance in market excess returns for the median industry vs. only 38% for ∆EVA. The critical take-away for performance measurement is that we can’t accurately assess current EVA performance without estimating the change in future growth value.