Economic Value Added: What Companies Should Know

Posted by Jim Kroll, Marc Roloson, and Jamie Teo, Willis Towers Watson, on Monday, April 29, 2019

Institutional Shareholder Services (ISS) is adding Economic Value Added (EVA) metrics in its proxy research reports this year, which is causing many companies to wonder: What is EVA? Why is ISS interested in EVA, and how will it be used? And what should boards and management do about it?

What is EVA?

Simply put, EVA is a financial measure of a company’s residual profit after accounting for the cost of capital. If a company’s net operating profit exceeds its cost of capital, it is creating value. If not, it is destroying value.

EVA = net operating profit after tax – capital charge
        = [operating income X (1 – tax rate)] – (weighted average cost of capital X capital)

Proponents of EVA often claim it is highly aligned with shareholder value creation, and it holds managers accountable for generating healthy returns on an organization’s capital. It is also considered harder to game since managers cannot take on additional capital to drive returns because cost of capital is removed from profit. Despite these benefits, critics are quick to point to the measure’s lack of clarity and its “black-box” perception as reasons not to adopt the metric.

EVA first gained popularity in the early 1990s, and a small, but still significant, number of companies adopted the measure. A relatively small number of companies use EVA, or some version of EVA, today. It is an excellent and powerful financial performance measure, but can be challenging to calculate, communicate and incorporate into incentive plans. Most companies choose instead to employ some combination of core value drivers like growth, margins and returns in their incentive plans because they are easier to measure and communicate.

ISS’S interest in EVA

ISS’s focus has elevated interest in EVA. As part of its 2019 policy updates, ISS announced that it would begin displaying EVA-related performance metrics in the pay-for-performance section of its research reports. This interest in EVA-based assessments to inform investment decisions is reinforced by ISS’s recent acquisition of EVA Dimensions, a research firm specializing in this analysis. Since the acquisition, ISS has examined and standardized a series of EVA metrics that will be shown in its reports as another potential lens for investors to use when assessing company performance in addition to its current use of total shareholder return (TSR) and company financials.

How is ISS using EVA?

Now that ISS research reports have begun to show this information, we expect board members and management to raise questions. It is important to note that ISS is only displaying EVA metrics for informational purposes and is not using this information to determine say-on-pay vote recommendations or in pay-for-performance assessments. Perhaps anticipating questions in the marketplace, ISS further notes that its inclusion of EVA metrics is not meant to suggest that companies should use EVA as a metric in incentive programs. Both its Compensation FAQs and resources on EVA affirm this.

Four metrics that aim to assess a company’s ability to generate and increase value on a three-year basis are new to this year’s ISS proxy research reports.

When reviewing EVA performance, companies should take note of the 15 non-GAAP adjustments underlying ISS’s EVA calculation, which are explained in detail in “The EVA Measurement Formula: A Primer on Economic Value Added (EVA)”. Examples include treating R&D and advertising as investments, not expenses, and capitalizing restructuring costs.

What companies should do

Based on what we know today, there is no reason for alarm or to make wholesale changes to incentive compensation metrics. If EVA is not a current incentive metric, companies are under no obligation to make it one. Rather, boards and management should continue to work together to ensure the most relevant and impactful metrics are incorporated into the company’s incentive compensation programs.

That said, it may be a good idea for companies to understand how EVA shapes their perceived performance, including how ISS is calculating it. EVA is a powerful performance metric, and having a baseline understanding can only serve to make it easier to better understand and communicate the company’s performance and how it creates value for shareholders..

Given the potential renewed interest in EVA, companies and boards may also want to revisit their philosophy of value creation and make sure they are using the right combination of value drivers in their incentive plans and performance reporting to the board and investors.