“Until a business returns a profit that is greater than its cost of capital, it operates at a loss.”
—Peter F. Drucker
The English essayist (and economist) Walter Bagehot once remarked, “No real Englishman in his secret soul was ever sorry for the death of an economist.”
Quite a few security analysts and fund managers on American shores probably feel that way about the economists who came up with the efficient market hypothesis and proved that 95 percent of professionals can’t beat a blindfolded monkey in picking stocks. Highly paid Wall Street analysts don’t like being compared to sightless apes. Yet after decades of heated exchange between Wall Street and academia, the eggheads are winning the argument. Today index funds—the professors’ favorite investment vehicle—are the fastest growing sector on Wall Street.
The latest group to sympathize with the words of Walter Bagehot are the accountants. Over the past decade, ivory-tower economists (mainly professors teaching modern finance theory at MBA schools) have taken on the accounting departments, damning them for not taking into account the full opportunity cost of capital.
Are Accounting Profits for Real?
For years, economists have complained that conventional accounting distorts the true economics of the firm by not including a charge for common equity in its earnings reports and balance sheets. Generally accepted accounting principles treat equity as if it were free. Thus, publicly traded corporations release quarterly reports showing substantial earnings that in fact are losses. “True profits don’t begin until corporations have covered a normal return on investment,” declares Al Ehrbar, senior vice president of consultants Stern Stewart & Co., specialists in EVA—a new performance technique for business.
What is EVA? It stands for “economic value added” (also called economic profit or residual income). Essentially, EVA is a precise measurement of the opportunity cost of capital. For years, opportunity cost was a nebulous concept known only to professors. The term, coined by Austrian economist Friedrich Wieser in the early twentieth century, refers to the universal principle that all human action involves giving up other opportunities. When you invest in a stock, lend money, or create a new product, you give up the chance to invest elsewhere. If you invest in a high-flying computer stock, you can’t buy T-bills. If you build a new office building, your money is tied up for years in concrete and can’t be invested in AT&T.
EVA is a practical application of classical economics and modern finance theory. The Austrians elucidated the concept of opportunity cost, and Nobel laureates Merton H. Miller and Franco Modigliani used it in their model of the firm to determine its true value. In the 1980s, G. Bennett Stewart III created EVA as a financial yardstick to measure opportunity costs in business.
EVA is fairly simple to determine: it is after-tax operating profits minus the appropriate capital charge for both debt and equity. If a company issues debt, the opportunity cost is linked to the Treasury rate (currently 5-6 percent), plus the credit risk of the issuer. If the company issues stock, the opportunity cost is measured by the long-term annualized return on the stock market, approximately 12 percent. In short, EVA recognizes that investors must earn enough to compensate for risk of their investment capital.
If a firm earns more than these opportunity costs, it has “added value” to its shareholders and created wealth in the world economy. Hence, the phrase “economic value added.” If EVA is positive, shareholders and the economy are making real contributions to the bottom line. Otherwise, the business should shut down and invest shareholders’ funds in Treasuries or an index fund. As British economist John Kay declares, “In the long run, firms that fail to add value in a competitive market will not survive, nor do they deserve to.”
Okay, so what good is EVA to corporate managers? EVA analysis helps identify potential acquisitions, expansion plans, and nonperforming assets and assists in eliminating low-profit-margin operations that are clearly unprofitable when full costs are taken into account. EVA is also being used as an incentive system for managers and employees. Bonuses are linked to economic earnings, not just accounting earnings, and EVA has proven effective in boosting productivity.
EVA makes a lot of sense and has made significant inroads into the financial world. Already over 300 major corporations, including Coca-Cola, Eli Lilly, and Sprint, use EVA as a capital accountability tool to reinforce the idea that profits don’t begin until corporations have covered their normal return. Wall Street analysts at Goldman Sachs and First Boston, among others, use EVA to evaluate stocks. According to Ehrbar, EVA explains stock performance and market value better than any other accounting measure, including return on equity, cash flow, earnings per share, or sales. EVA makes company officers focus more clearly on creating shareholder value and a higher stock price. Stern Stewart issues an annual EVA report on the top 1,000 U.S. corporations. For several years now, Intel has had the highest EVA ranking and GM the lowest.
EVA Wins the Battle
Accountants still have a dominant grip on the way corporate financial statements are submitted, but the popularity of EVA has forced them to take notice. All five accounting firms offer an EVA-type statistic to their clients. Most accounting textbooks now include a significant section on economic value added, economic profit, or residual income. Previous editions did not mention EVA or opportunity cost.
Want more? Check out Al Ehrbar’s highly readable EVA or John Kay’s brilliant Why Firms Succeed. See also www.eva.com.
I like EVA. Companies adopting it appear to perform better in creating wealth and shareholder value. But it may have potential drawbacks. EVA puts enormous pressure on managers to overachieve and to create constant above-average profit centers. Imagine not earning a true profit unless your company or division beats last year’s Dow Jones Industrial Average. It could be depressing. Wonder what your company’s EVA will look like in the next recession? Heads could roll.
Some managers may want to join Wall Street analysts and accountants in shooting those dismal scientists.