In theory, a company’s primary goal is to maximize shareholder value, and (naturally) many companies measure their progress by stock price performance and dividend growth.
Excerpts from full article published on February 22, 2019
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But in practice, it is also well understood that stock prices can be fickle, influenced by market factors well outside of management’s full control such as changing investor expectations and a host of other macroeconomic and competitive factors. Therefore, company executives, board members, and investors often turn to alternative measures of “value creation,” ones that are more often isolated from the vagaries of the market. Many of these common performance measures, however, reflect traditional accounting profit and may not accurately signal where true value creation is occurring, due largely to the inherent limitations of standard accounting practices. In this article, we explore the specific challenges market participants face when using traditional accounting metrics to assess performance, as well as the limitations those metrics place on corporate leadership in informing and guiding proper capital allocation and decision making. In addition, we present a potential solution and alternative framework called EVA. EVA (Economic Value Added), a measure of economic profit, measures the quality of earnings after setting aside a priority return for a company’s full cost of capital, while also correcting key GAAP and accounting distortions, offering a clearer and more complete picture of value creation.
The EVA methodology can be presented in this simple equation:
EVA = Sales – Operating Costs* – Capital Costs**
*Net operating profit after tax **Cost of cap% x net business assets
EVA captures the three key drivers of value creation – top-line growth, profitability, and capital efficiency – in a way that improves on accounting-based profit measures.
- EVA assesses a full cost-of-capital “rental” charge on (debt and equity), holding management to account for the capital employed by the business. Thus, value added is the profit generated by the business above and beyond the returns its investors would expect to realize from alternative investments of equal risk.
- EVA corrects GAAP accounting distortions systematically by applying standardized, rules-based adjustments to better match revenues and expenses. Below are the key adjustments.
- Research & Development (R&D) is treated as an investment, added back to the income statement, capitalized on the balance sheet, and expensed/depreciated over 5 years (or longer for industries with lengthier product cycles). Advertising and Promotional spending is treated in a similar way, but instead is expensed over 3 years. (As the role of intangible assets grows in the digital economy, their accounting treatment may come under greater scrutiny. In fact, last year, South Korean authorities relaxed accounting guidelines for pharmaceutical and biotechnology firms, allowing capitalization of certain R&D expenditures.)
- Leased assets are treated as owned and capitalized on the balance sheet. The decision to rent versus to own is non-operational and should not drive value creation. New GAAP accounting standards, which are being adopted now, will conform to this EVA principle.
- Restructuring charges are added back to the income statement, and are then capitalized on the balance sheet, holding management accountable over future years with the associated capital charge. Such charges are viewed as an investment in future productivity and should be treated as such, not written off at once.
- Other adjustments, such as utilizing a smoother tax rate, account for the inevitable variability between estimated and actual taxes.
Because EVA deducts a full cost of capital charge, it is a more rigorous metric than other measures of accounting profit. On a three-year rolling basis, more than half of all the companies in S&P 500 companies fail to generate an EVA profit margin (calculated as the dollar value of EVA divided by sales) above 4 percent, while about one-quarter do not even produce positive EVA (that is, return on capital is below the cost of capital), even though accounting profits are often overwhelmingly positive. By comparison, in 2018, the S&P 500 median EBITDA margin was 24.1 percent, and the median net income margin (before extraordinary items) was 11.1 percent.
Examples of EVA Reflecting Economic Reality
From an investment perspective, because EVA uniformly and consistently addresses accounting distortions and includes the full cost of capital charge, EVA better approximates economic reality, supports and discounts to net present value (NPV), and, in the long run, correlates more closely to TSR than potential alternatives. From a management point of view, EVA can serve as an invaluable framework to guide value creation. Below are two examples where EVA captured fundamental trends which certain accounting-based measures missed. Both examples indicate that a fixation on GAAP earnings or traditional margins such as EBITDA may lead to underinvestment in productive R&D and come at the expense of future growth and value creation.
Amazon: When Accounting Metrics Fail to Capture EVA Growth
Here we see how GAAP earnings results from AMZN steadily declined for four years, while EVA trended higher along with the stock price. Over this time, Amazon aggressively increased R&D investments, which weighed heavily on GAAP earnings. Meanwhile, under EVA, R&D was capitalized, and expenses spread over five years – a closer reflection of economic reality. Eventually GAAP earnings caught up somewhat with reality (and the stock price) but failed to capture and identify value creating activity the way EVA did.
The Kraft Heinz Company: When Accounting Metrics Overstate Economic Performance
Because EVA captures growth, profitability and capital efficiency, it is also a more effective management signal than accounting measures of profit. A timely example of accounting metrics failing to reflect economic reality is the story of the Kraft Heinz Company. Since the completion of the merger between the two food giants Kraft and Heinz in 2015, company management used zero-based budgeting to aggressively to slash costs, including marketing and R&D expenses, which helped drive industry-leading EBITDA Margins. EVA, however, portrayed a different reality, one burdened by enormous goodwill and acquisition premiums amidst slowing growth due to significant cuts in advertising and R&D investments. At the time of this writing, the stock price and market are just catching up to what EVA foreshadowed since the merger.
While EVA and economic profit have been around for some time – many MBA students and CFA charterholders are at least familiar with the theory – today EVA is easier to apply in practice. EVA has been transformed from a dollar measure into a set of ratios and indicators. These EVA ratios can be more easily and readily used to gain insights into overall profitability, trends, and progress while also enabling better comparisons to peers, or across sectors, and over time. EVA Margin and EVA Spread, scaled to sales and capital, indicate the magnitude of value creation per unit of sales or capital, while EVA Momentum, which measures the change in EVA over time and scaled to prior sales and capital, gives us a way to index and quantify EVA growth or deterioration over time, and through various market cycles and relative to peers.