The EVA Challenge

The EVA Challenge: Implementing Value-Added Change in an Organization

By Joel M. Stern and John S. Shiely

About the Author

Joel M. Stern is a managing partner of Stern Stewart & Co., the firm that developed the Economic Value Added (EVA) concept. John S. Shiely is the president of Briggs & Stratton, one of the earliest and most successful implementers of EVA. Together, they bring extensive experience and insight into the practical application of EVA in various organizational contexts.

Main Idea

"The EVA Challenge" explores the concept of Economic Value Added (EVA) as a measure of a company's true economic performance and a strategy for creating shareholder wealth. The book argues that traditional accounting measures distort economic reality and that EVA provides a more accurate assessment of value creation. By implementing EVA, companies can align the interests of managers with those of shareholders, thereby driving better decision-making and long-term success.

Table of Contents

1. The Problem: Accounting Distorts Actual Value
2. The Solution is EVA
3. EVA is More Than a Measurement System
4. The Need for a Winning Strategy and Organization
5. The Road Map to Value Creation
6. The Dramatic Results of EVA
7. Extending EVA to the Shop Floor
8. Getting the Message Out: Training and Communication
9. EVA and Acquisitions
10. How EVA Can Fail
11. EVA in the New Economy

The Problem: Accounting Distorts Actual Value

Traditional accounting measures, such as earnings per share (EPS), often provide a distorted picture of a company's true economic value. These measures can be manipulated and do not account for the cost of capital invested to generate profits. For example, research and development (R&D) costs are expensed in the year they are incurred, which can significantly lower profitability in that period despite future benefits. Advertising and marketing costs are also expensed immediately, even though they may build brand value over time.

"Standard accounting measures don't give the true picture. They distort what is really happening and allow manipulation of the profit picture." - Joel M. Stern

Accountants make several calculations that undervalue a company's true economic value. For instance, listing assets at the lower of original cost minus depreciation, or market value can distort the financial reality. A building purchased for $10 million and now worth $20 million might be listed at $9 million on the balance sheet due to depreciation. This misrepresentation leads investors and stakeholders to an inaccurate understanding of the company's financial health.

Furthermore, earnings per share (EPS) can be easily manipulated by senior executives whose bonuses are tied to earnings improvements. They might cut back on essential activities like advertising and R&D to lower costs and present a facade of profitability. This manipulation distorts the actual economic reality, misleading investors who are looking to compare the cash they can take out of the company with the cash they invested.

The Solution is EVA

Economic Value Added (EVA) aligns the interests of shareholders and managers by focusing on real economic profit rather than accounting profit. EVA is calculated by deducting the capital charge (the cost of capital) from the net operating profit after tax (NOPAT). This measure ensures that all costs, including the cost of capital, are considered when evaluating performance.

"EVA is simply the profit that remains after deducting the cost of the capital invested to generate that profit." - Joel M. Stern

For example, a new company starts with $5,000 borrowed at a 12 percent interest rate. The cost of the company's capital, known as the capital charge, is $600 (12 percent of $5,000). If the company makes a profit of $1,000, the $600 capital charge is deducted, resulting in an EVA of $400. This straightforward formula—net operating profit after tax (NOPAT) minus capital charge—allows companies to measure their true economic performance.

To implement EVA, companies must first calculate their cost of capital, which includes both debt and equity. The cost of debt capital is the interest on the company's borrowing, adjusted for tax deductibility. The cost of equity capital starts with the interest an investor could earn on a safe investment like a long-term government bond, plus the equity risk premium associated with the company or industry. By determining the proportion of debt and equity in its capital structure, a company can calculate its blended cost of capital, which is typically between 10 percent and 13 percent.

Once the blended cost of capital is determined, the capital charge is calculated by multiplying the company's total capital by its cost. Adjustments are then made to NOPAT for accounting anomalies, such as capitalizing and amortizing R&D costs over their useful life instead of expensing them immediately. This method provides a clearer picture of the value being created by the company, free from the distortions of traditional accounting practices.

EVA is More Than a Measurement System

EVA is not just a measurement tool but should also form the basis of a performance-based incentive plan. By setting goals for EVA improvement, companies can reward managers for increasing shareholder returns and penalize them for failures. This system encourages managers to make decisions that create long-term value.

"EVA should become the basis of an incentive plan that rewards managers for actions that increase shareholder returns." - John S. Shiely