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Article | Executive Pay Memo North America

A global perspective: Is EVA a good incentive metric?

Executive Compensation
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By Kenneth Kuk and Jamie Teo | June 19, 2020

Economic value added has had an uphill climb to adoption since it was introduced in the early 1980s. Perhaps we’ve been overthinking it.

Economic value added (EVA) is a way of measuring a firm’s economic profit, which is an economic concept that refers to the profit above a required return on investment. This requirement is often defined by the opportunity cost of an investment: How much profit could I generate if I were to invest in something else?

EVA is not a novel concept in the worlds of corporate finance and fundamental analysis. Developed in 1983 and popularized by Joel Stern and Bennett Stewart1,2 (co-founders of the consulting company Stern Stewart), it is known as a robust metric for assessing value creation of a business and is an excellent way of looking at company performance. The essence of EVA is simple. It measures a business’s return above a cost of capital hurdle. To break this down, consider its textbook formula, where NOPAT is net operating profit after tax, and WACC is weighted average cost of capital:

NOPAT – [WACC * capital invested]

If we express this formula as a percentage of capital invested, where ROIC is return on invested capital, this formula can be simplified to:

ROIC – WACC

The idea of connecting executive pay and EVA is not new. From an investor’s point of view, it makes perfect sense to pay management once a certain threshold of return on investment is met. In fact, this pay model is ingrained in the investment community.

In most countries, EVA has not gained popularity as a performance metric in general industry executive incentive plans.

In the U.S., while return metrics (e.g., return on equity, ROIC) are commonplace, the prevalence of EVA in incentive plans has hovered around 1% to 3% over the past 20 years. Discussions about EVA were briefly revitalized last year when ISS (Institutional Shareholder Services) acquired EVA Dimensions (an EVA analytics company founded by EVA co-founder Bennett Stewart), generating speculations that EVA would be accentuated in ISS’ pay-for-performance assessments. While we have not observed any immediate impact on incentive plan design, the introduction of a standardized approach to accounting adjustments was a laudable attempt to improve transparency and comparability of EVA as an incentive metric, which we discussed in greater detail in our prior article Economic Value Added – What it is and what you need to know about it – for now.

In most other parts of the world, use of EVA as an incentive metric is equally sparse. In Canada, we have not seen interest in EVA beyond some simple education on its recent development in the ISS context. Interestingly, this has fueled further discussions on the use of return-based measures calibrated with consideration of WACC.

The corporate governance landscape is often shaped by the largest institutional investors in absence of proxy advisor influence. In Europe, most companies and institutional investors find the EVA definition overly complex and therefore prefer simpler accounting alternatives, such as revenue, profitability and return ratios. Relative to public companies, we do observe a slightly higher prevalence of EVA as an incentive metric among private companies. Similarly, little emphasis is given to EVA in Japan, both in terms of an incentive metric and as a way of evaluating subsidiary company performance. There are a few exceptions, where companies set a minimum threshold of EVA (or other definitions of economic profit) for incentive payout.

Where EVA prospers as an incentive metric: The stories of Singapore and state-owned enterprises (SOEs) in China

In Singapore, EVA is often a highlight in executive compensation conversations. It is a preferred standard for performance (with some standardization in accounting adjustments) by Temasek, one of the world’s largest institutional investors. Many Singaporean companies offer a distinctive short-term incentive component based on EVA. These EVA-based incentive plans are often a profit-share pool with some deferral mechanism, and the actual profit-sharing formula varies by company. While Singapore’s influence on EVA may extend beyond its local market through foreign investments, Singaporean investors are mindful of local market practices and do not tend to impose EVA in the context of executive pay.

The story is equally fascinating in China, a distinctively different economy in Asia. Over the past decade, China’s State-owned Assets Supervision and Administration Commission of the State Council (SASAC) has increased its emphasis on EVA as a key performance indicator for the 25 centrally administered SOEs. These SOEs in turn use EVA to assess performance of their portfolio companies, and assets that consistently underperform may be divested. Against this backdrop, EVA is often used as a performance metric in short- and long-term incentive plans among SOEs and, though less prevalent, private enterprises.

While the success of EVA in Singapore and China is circumstantial and somewhat serendipitous, it is an exemplar of how EVA shines as an indicator for business performance and value creation. It also shows that its perceived complexity does not necessarily make it a barrier for widespread adoption as a performance metric.

Bottom line: Is EVA a good performance metric?

EVA is an excellent performance indicator based on proven economic theories, and we have seen great success in some markets where EVA has proven to be an effective incentive metric; however, like all other financial metrics, EVA can be flawed in a few ways:

  1. The classic challenge with EVA, discussed by many before us, is the ability to capture investments in intangible assets. As stated by Robert Kaplan and David Norton in their 2004 article in the Harvard Business Review,3 this could include employee skills, technology systems and organizational cultures. While technology investments could be capitalized under EVA, value of human capital is far more challenging to capture (e.g., building a team of technologists). For a technology- or talent-based business, or one that is investing heavily in digital transformation, EVA may not provide a good view on performance.
  2. The timing of capital investment and the return on such capital investment are not always aligned, making EVA less than ideal for companies in the growth phase. This is particularly true in the modern economy where companies invest heavily in digital transformation and new capabilities. These long-term investments may take years to materialize, requiring precision in determining the length of business cycle and stretching beyond the typical length of long-term incentive plans. While accounting adjustments (such as capital deferrals and standardized approaches to greenfield/brownfield investments) can somewhat mitigate this challenge, using conventional financial and return metrics would be simpler and more effective.
  3. For more acquisitive companies, the constant need to consolidate acquired business units and apply relevant accounting adjustments may be a significant challenge when operationalizing EVA calculations. More important, this could create confusion among management and shareholders, and erode their confidence in EVA as a fair performance measurement vehicle over time.
  4. EVA is an intrinsic measure, meaning that comparing EVA across companies is not meaningful. The lack of comparability is due to the hurdle being set based on a company’s specific capital structure. Consider two competing businesses operating at similar margin levels. If one is more heavily backed by debt than the other, then it would have a lower weighted average cost of capital (debt is typically “cheaper” than equity), meaning a lower return on investment hurdle. While there are adjustments available to level the playing field, EVA is still fundamentally a metric about a company’s efficiency in using capital in its own context. That said, when comparing a company’s ROIC – WACC calculation against its comparators and isolating the calculation components, the company may gain insights into optimizing its capital structure, thereby generating higher returns for its investors. Companies should also be mindful to counteract the incentive of driving down cost of capital by relying more on debt in financing, potentially resulting in undesired liquidity and solvency risks.

Like most things with executive compensation, there isn’t a one-size-fits-all answer to the EVA question, and it is a matter of balance. Whether EVA is effective as an incentive metric will depend on organizational factors such as long-term strategy, business profile, industry, types of assets owned and culture. As boards take on increasing accountability in representing the interests of different stakeholder groups (not just shareholders), striking a balance in how performance is measured is more important than ever. Taking a preliminary look at the 2020 proxy season in the U.S., we have not seen evidence of EVA significantly influencing say-on-pay outcomes, despite the addition of an EVA-based test used as a secondary overlay in ISS’ pay-for-performance assessments.

If there is one thing the stories around the world have taught us, it is that companies often see more value in the concept of EVA than strictly abiding by its formula; the merits of linking executive pay to value creation above an expected hurdle can be manifested in different ways.

  1. Joel M. Stern, John S. Shiely and Irwin Ross, The EVA Challenge: Implementing Value-Added Change in an Organization (2001)
  2. G. Bennett Stewart, III, The Quest for Value (1991)
  3. Robert S. Kaplan and David P. Norton, “Measuring the Strategic Readiness of Intangible Assets,” Harvard Business Review (February 1, 2004)
Authors

Director, Talent and Rewards (Washington, D.C.)

Director, Talent and Rewards (New York)

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Director, Talent and Rewards (Singapore)

 


Senior Director, Executive Compensation Practice Leader, Western Europe

Managing Director, Executive Compensation Practice Leader - North America (Chicago)

Global Leader, Executive Compensation

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