The EVA Paradox

Why So Many Firms Mess with Success


By Marc Hodak
Hodak Value Advisors

______

September 2009

Marc Hodak is also an adjunct Associate Professor at New York University’s Leonard N. Stern School of Business.
Comments are welcome at mhodak@hodakvalue.com.


©
2009
by
Marc
Hodak
 
 




The EVA Paradox: Why So Many Firms Mess with Success

Executive Summary:
• Nearly three-fourths of firms that adopt EVA or similar value-based
management programs end up dropping them within five years of adoption,
even though those firms are seeing the shareholder value gains promised by
these programs.
• The reward to shareholders for sticking it out is significant; the longest-term
adopters (>5 years) have typically performed best, beating their sector peers
by over eight percentage points per year in total returns.
• Five main reasons firms dropped their programs were:
o The incentive plan didn’t pay out
o Managers or board members didn’t understand the measure
o The measure was repeatedly, significantly changing from year-to-year
o The program champion left the firm
o The program lost momentum after initial flurry of gains
• The longest-term adopters consistently did three things well:
o Developed a robust version of EVA (or EP, residual income, etc.)
o Invested significantly in financial literacy via steady training and
communications
o Intelligently incorporated the value-based measure into incentives,
providing managers a definitive share of economic gains
• The firms that successfully integrated all three elements into their
management system found that each element reinforced the others, making it
more likely that the program would survive a departure of its champion, or the
higher expectations created by initial successes.


 
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The EVA Paradox: Why So Many Firms Mess with Success

By Marc Hodak

Those of us who implement value-based management live with the startling, if somewhat
discouraging fact that nearly three-fourths of firms give up a program like EVA® within
five years of adoption.1 Yet firms that adopt such programs have consistently, materially
outperformed their sector peers.2 If they stuck with it for five years or more, they
outperformed by an average of over eight percentage points per year in total
shareholder returns. Even firms that lasted only two, three, or four years on the program
outperformed by an average of five percentage points per year. Even the average firm
that dropped EVA was significantly outperforming its peers while on the program, so the
success of the longer-term adopters is not merely a matter of survivorship bias.

On the one hand, it should not be surprising that, in a business world where four out of
five strategic initiatives fail,3 that major initiatives like EVA might fail slightly less often.
But why would a firm give up a program that is delivering the shareholder value it
promises? The short, sad answer is that the success of an EVA-type program is not
judged solely by shareholder gains. An effective value-based management program
touches every major part of a corporation, with multiple decision-makers needed to
support its continued existence. For many decision-makers, several factors beyond the
firm’s shareholder results can influence whether or not they will provide that support.

Several problems that might doom an EVA program have their seeds in subtle flaws
introduced during the implementation process. EVA implementation is a significant
change management initiative. Compromise is inevitable, and it’s easy to see why
certain, seemingly minor, but subtly dangerous compromises might be made just to get
through the process. Other problems arise after the program has been launched. For
companies seeking to benefit from the power of value-based management, its a shame
to allow fatal flaws to creep in, or to allow post-implementation obstacles to throttle a
program that may very well be adding enormous value to the firm.


























































1
For the purposes of this report, such programs are defined as having a compensation metric
that includes a dollar charge for the use of capital. These may include formal measures of
residual income, economic profit (EP) or economic value added (EVA) specifically designed for
use in incentive compensation plans, or programs that have evolved to incorporate a dollarized
capital charge in regular reporting and variable compensation. We will use the measurement
terms “residual income,” “EP,” and “EVA” interchangeably. We will use the program name EVA
as a generic term for any value-based management program. EVA (the program, not the
measure) is a registered trademark of Stern Stewart & Co.
2
Ferguson, Robert, Rentzler, Joel and Yu, Susana, ‘Does Economic Value Added (EVA) Improve
Stock Performance or Profitability?’ Journal of Applied Finance, Vol. 15, No. 2, Fall/Winter 2005;
Biddle, Gary C., Bowen, Robert M. and Wallace, James S., ‘Evidence on EVA.’ Journal of Applied
Corporate Finance, Vol. 12, No. 2, Summer 1999; et. al.
3
If you believe Kaplan and Norton, 2004



 
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Five main reasons that EVA fails

So, why did some firms hang on to their EVA program while so many didn’t? Having
reviewed the experience of over a hundred firms, and hearing many, varied reasons for
dropping the program, often multiple reasons for a given firm, I can summarize the five
most common as follows:

1. The incentive plan didn’t pay out

In many cases, the EVA measure central to the plan was not designed to
adequately account for the full range of business outcomes, a flaw that could
mess up bonuses. In such instances, the incentive plan would be altered after
the fact to account for changes in the flawed metric, but any payouts had to be
negotiated apart from the original plan. In certain cases, the lack of a payout
could be traced to flaw in plan design, usually an overleveraged pay-for-
performance curve, or a poorly calibrated target setting mechanism.

Even when perfectly implemented, EVA-based incentives build in a lot of

accountability for results. Many managers have no real tolerance for plans that
don’t pay out, even if the performance isn’t there, especially if relative
performance was good (which it often was in these firms).

2. Managers or board members didn’t understand the measure

There is no such thing as a ‘standard’ EVA metric. EVA must be defined

uniquely for every firm or business. Many firms ‘over-engineered’ the metric,
making it more complicated than necessary, turning it into a “black box.” The
most persistent complaint about EVA was “it’s too complicated.”

In many cases, the measure was not in fact any more complicated—and was
often less complicated—than the GAAP measures it replaced; it was simply less
familiar.

3. The measure was repeatedly, significantly changing from year-to-year

Companies change their reports, measures, and scorecards all the time. But
EVA’s promise is a “single-measure” system upon which long-term decision-
making, reporting, and rewards could be based throughout a business cycle. In
such an environment, repeatedly changing a compensation metric undermines its
power in an incentive program, and the faith of management in that program.

The main reason that EVA would continually change is that it keeps failing to
adequately account for “unusual” business outcomes, flaws that are remedied by
changes to how the measure is defined. Behind those flaws were managers or
advisors with too little experience with how EVA behaved under a wide range of
business situations. These managers or advisors would then change the
measure every year as new “surprises” were discovered.


 
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4. The EVA champion left the firm

A successful value-based management program, like any major change

management initiative, requires so much investment in proper development, buy-
in, and communications that it is rarely implemented without an internal, senior
level champion. If that EVA champion leaves, the intellectual capital as well as
the internal power base that maintained the integrity of the program often departs
as well, and the program quickly gets diluted or replaced.

It’s worth noting that most of the CFOs who successfully implemented an EVA
program have subsequently become the firm’s CEO, which significantly
enhanced the odds of the program getting institutionalized at the firm, at least for
as long that that person was at the helm.

5. The program lost momentum after its initial flurry of gains

Nearly every firm that adopted EVA found low-hanging fruit made visible by the
change in mindset created by the program. After that fruit had been plucked, and
the firm’s fortunes and expectations had been raised accordingly, it became
more of a challenge to create additional value.

Relatively few firms managed to exploit the ability of an EVA program to

transform strategy and planning in a manner that enabled managers to
continually find value-creation opportunities. Getting there took additional
training and communications, which many firms simply failed to pursue.

What did the long-term adopters of EVA do differently?

Tolstoy opened Anna Karenina with the famous statement, "All happy families resemble
one another; each unhappy family is unhappy in its own way." What this meant is that
success combines several key elements, and all successes look similar by sharing those
elements. Missing any one of the elements can mean failure; so failed systems can look
somewhat different from one instance to the next based on which element was missing.

Successful, long-term adopters of EVA consistently did three things right: they
developed a robust measure, invested significantly in financial literacy, and intelligently
incorporated EVA into incentives. The EVA adopters most likely to drop their
programs—the unfortunate majority—typically did only one or two of these things. Here
is how the most successful firms did it (and still do):

Get the measure right

Since there is no such thing as a “standard” EVA metric, the measure must be defined
uniquely for every firm or business unit. Successful, long-term adopters invested, up-
front and over a period of years, in a definition of EVA that reflected their business model
such that when value was being created, the number generally went up, and when value
was dropping, the number generally went down. They created their particular version of


 
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EVA to be as complicated as it had to be in order to get this result under a wide range of
possible futures, but not any more complicated than that. This has proved to be a tricky
needle to thread.

Complexity was a major issue for many EVA adopters. The “black box” nature of the
compensation metric was the number-two reason that companies dropped an EVA
program. Within the black box appeared to be a measurement definition that was
“captured” by the finance department, which was apparently easy to do during and
subsequent to the program’s implementation. Finance, after all, is where accounting
and reporting originates; Finance necessarily “owns” the measures. It was much easier
for financial types to see the merit of an additional adjustment in order to make the
measure more accurate (or more palatable to some constituent user) than it was for
them to recognize the point at which cumulative adjustments pushed the metric into
“black box” territory.

As important as it was to avoid ‘over-engineering’ the metric, it was equally important to

avoid ‘under-engineering’ it by making too few adjustments, or the wrong adjustments.
The number-three reason for dropping the plan was that the measure changed too
much, too often, which is a fatal flaw for what is supposed to be a long-term
compensation metric. The main reason adjustments were poorly selected was that the
designers of the measure misjudged their importance with respect to matching
revenues, costs, and capital charges. They didn’t have a sense for how EVA—as they
were defining it—was likely to fluctuate from one period to the next under a wide
spectrum of potential business activities and outcomes. This task is exceedingly difficult
for someone without significant exposure to EVA behavior; even EVA experts are
challenged in modeling this behavior. (NB - Many of the firms adopting value-based
management did so without outside expertise, or using traditional HR consultants.)

For example, a pharmaceutical firm had decided to expense their R&D, as they had
done under GAAP, instead of capitalizing it and amortizing it over the life of their drugs.
They skipped this adjustment because the total R&D expenses would have roughly
equaled the total R&D amortizations year by year over the previous five years, so they
didn’t consider the extra amortization calculation worthwhile. It didn’t occur to them that
slight changes from a historically steady R&D investment could mess up their EVA
results. Soon enough, their strategy gradually shifted their investment from internal R&D
to acquisition of proven drugs, creating bizarre, unintended EVA results that required a
change in the measure’s definition.

As their sense of value creation was not matched by reported changes in EVA,
managers naturally tinkered with the measure. If changes were large or frequent
enough, they undermined the credibility of any evaluation or reward regime based on
that measure. It’s difficult to become familiar with a changing measure. Thus, the
initially poor design of the metric would result in significant changes, which would
contribute to the sense that the measure itself was “too complicated.” This perception


 
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would hold whether or not the measure was, in fact, any more complicated than the
more familiar GAAP measures it had replaced.

Longer-term adopters tended to define EVA in terms of their business model

independent of the firm’s strategy at the time of adoption. While this is counterintuitive—
most companies reflexively derive their measures from their strategies—strategies tend
to shift or change, while EVA is intended to reliably keep score (and provide rewards)
over an entire business cycle. Business models evolve more slowly than strategies,
making them a better basis for defining a robust EVA.

A common situation where enterprise value would diverge from EVA was when profits
significantly lagged asset values. For instance, one real estate client saw property
values significantly rise before those increases would be realized in net operating
income. Another client was able to significantly boost the value of their film library
before they could monetize it into a profit stream. In such instances, the companies
either had to change the incentive system by adjusting EVA capital to account for such
leads or lags, or they had to change the control system to insure that undervalued
assets didn’t get allocated or sold in a sub-optimal manner. Such issues posed a
significant challenge to the use of EVA for evaluating performance, with particular
implications for incentives.

Invest in financial literacy

Once the rigors of this major change management project were met, it was easy to slack
off the EVA program, and move on to more pressing issues, tending to EVA items only
as they come up. But for the program to get institutionalized, the long-term adopters
implemented a program of ongoing communications and training. The firms that were
happiest with their EVA program invested the most in communications.

The most successful adopters recognized a clear distinction between administrators

(e.g., Finance) versus users of the measure (e.g., the business units, executive
committee, board, etc.), and saw to it that both sides regularly communicated with
regards to how the measure was being used. Even the best-designed measure needs
to be tweaked every now and then to adapt to an evolving business model, for instance,
via M&A activity. This was easier to do when the finance “owner” and the business
“users” of the measure had an open line of communication.

Interestingly, these communications were not primarily driven by a “push” from

corporate. Instead, they relied significantly on a “pull” from the business units who
wanted to better understand the system, presumably to increase their bonuses (nothing
wrong with that). The successful firms generously made this training available. They
trained all their new people in the mechanics of EVA, and how to use it for decision
making. They periodically brought in experts to bring them up to speed on newer
VBM/EVA ‘technologies’ to exploit their familiarity with EVA, and bring their use of it to
the next level. Many of them invested in developing EVA templates for the most
common types of decisions made in their key business units. These communications


 
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resulted in a more solid acceptance of the measure, and a better understanding by the
finance staff of where the measure may need to be modified as the business units
evolved, before strange results began to materialize and affect compensation.

While the simplicity and understandability of the measure were critical to the success of
the program, the most successful firms didn’t let the knowledge limitations of their
managers stunt the degree to which they could tailor and apply EVA. In many cases,
they found that a little bit of financial training enabled a slightly more sophisticated, and
therefore more accurate, measure. They consciously traded off the value of added
complexity in the measure against the cost of improving participants’ financial
capabilities to match that level of sophistication.

“Operationalizing” EVA was major focus for the long-term adopters. Some of the earlier
adopters tried to do this by breaking EVA down into its financial elements, often called
“EVA drivers,” in order to better understand how changes in these elements might affect
overall EVA. The longer-term adopters ended up dropping this approach in favor of a
more activity-centered one, where each team would trace their activities to their impact
on their unit’s EVA holistically. They viewed EVA of the whole company as the sum of
divisional EVAs, net of corporate unallocated expenses and capital charges. They
tended to have a bias toward fewer allocations to the divisions. Within the divisions,
activities or initiatives were linked to bottom line impact on EVA via various line items on
the unit’s “P&L” (typically including impact on working capital).

One of the most astonishing findings among the long-term adopters was the number of
times I heard senior executives marvel that their business unit managers were managing
their divisions as “real” or ”whole” businesses. What they meant was that these units
weren’t looking to top management to figure out what the CEO might be asking about in
the next executive meeting (what one referred to as “guessing the metric-du-jour”).
Instead, divisional managers were suggesting to top management what they should be
looking at based on what was driving divisional EVA, and therefore corporate EVA (and,
therefore, value creation and bonuses) over time. This “common language” enabled
everyone to bypass discussions about what was important, and focus on how to achieve
it. This included a more sophisticated approach to requesting and planning for capital,
which managers took very seriously, given that it was a key driver of profit growth while
at the same time they were being charged for it. This more sophisticated approach to
capital drove them to better balance and communicate considerations of short-term vs.
long-term in their planning and budgeting.

In studying and working with companies over the years, I have gotten into the habit
asking employees several layers below the CEO how often they felt conflicted by a
choice between (a) doing what they felt was the right thing for the company versus (b)
doing what they were being told or what was explicitly expected of them in their
performance metrics or reward system. There was a powerful, inverse relationship
between the number of employees that said they sometimes or often faced this tension
and the long-term performance of the firm. Long-term EVA adopters did a remarkable


 
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job of substantially eliminating this tension. I don’t know if the less politicized companies
were more likely to remain on EVA, or if the longer-term adoption of EVA made
companies less politicized, but the two somehow went together.

Incorporate EVA into incentives

On the one hand, the long-term adopters included EVA into their rewards systems.
They based most—though rarely all—of their rewards on changes in EVA from one year
to the next. On the other hand, the number one reason for a company to drop an EVA
program, including its focus on EVA in reporting and decision-making, was because the
EVA-based incentives didn’t pay out.

Some of the dropped plans were fatally overleveraged, which made it more likely that
they would have zero payouts in poor years. Sometimes, good performance wasn’t
reflected in EVA because of a flaw in the design of the measure. In nearly all such
cases, the adopted EVA measure was too simple, i.e., too crude to account for
something unexpected (by the designers), like an unusual surge in inventory that might
mess up the capital charge calculation.

In an unfortunately significant number of cases, there was nothing wrong with the
measure or the plan structure; the firm simply performed poorly. The managers may
have, before the fact, judged the lack of payout as appropriate. Their after-the-fact
assessment was less benign, and they simply blamed the plan for their lack of reward.

Among the successful long-term adopters, EVA was generally implemented in their
rewards systems in two particular ways. First, to the extent that their annual plans were
based on financial performance, their bonus pools were largely funded by improvement
in EVA. There were usually non-financial drivers of bonuses, as well, either as
adjustments to the financially based bonuses or separately funded, e.g., 25 percent of
target bonus based on various non-financial objectives. But basing the financial
component on EVA growth enabled these firms to take advantage of a unique property
of the measure, i.e., its ability to be safely maximized.

This ability has two implications. First, the bonus plan could be kept simple, with a focus
on a single measure instead of two or more needed to account for both operating and
capital efficiency. EVA automatically weights revenue growth, cost control, inventory
turns, etc. in the right balance. If managers are making the number bigger, they were
probably doing the right thing. If the number were shrinking, that generally indicated a
business problem. Second, a well-designed EVA measure has a built-in profit threshold
in the sense that additional capital requires additional profit in order to prevent EVA from
deteriorating. Several of the long-term adopters had incentive plans that essentially
gave management a fixed share of EVA growth over multiple years (paid out annually).
This reward method enabled companies to avoid the use of budget targets for incentive
plan targets. Some of the most successful firms using EVA credit this feature, and its
enablement of aggressive planning, as the single, biggest driver of their long-term
success. Overall, budget-based target setting remained the most common method in all


 
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types of companies, but it was, and is, less common among the long-term adopters of
EVA.

Many EVA firms began with a “bonus bank” methodology. This enabled them to take the
caps off their upside, while maintaining accountability for the downside. Most of the
long-term adopters have since dropped these mechanisms, especially the idea of a
“negative bank.” Many of them reverted to caps and floors, although a couple of firms
are now experimenting with a method of providing the equivalent of an uncapped plan
via a coordinated adjustment to target-setting in a multi-year mechanism.

The most surprising feature of the long-term adopter’s incentive plans was how little their
structure changed over the years. This was probably a function of how well the plan was
designed up front. It seemed that the more stable the plan, the more definitive its
rewards and, therefore, the more powerful its incentive effect over time. While some
tweaks were inevitable, the longevity of the plan in its essential form seemed to reinforce
its power. This may be the most underappreciated benefit of the kind of enduring
incentive program enabled by the key features noted above.

Integrating the separate factors into a coherent program

Firms that retained an EVA program over many years balanced their emphasis across
all three elements: developing a robust measure; upgrading financial literacy via steady
training and communications; and providing managers a definitive share of EVA gains.
Once managers began living with the full program, it was easy for them to see that much
of its power came from the mutually reinforcing aspect of the three elements.

Having all three elements also made it more likely that the program would survive the
loss of its original champion. This champion (usually the CFO, sometimes the CEO)
kept the program going by supporting investment in training and communications and
maintaining the integrity of the measure and incentives. It no doubt helped that this
person also was in the habit of asking “What’s the EP/EVA impact of this idea” whenever
an idea was proposed. In this way, universal acceptance began at the top.

I couldn’t say for sure whether top management’s acceptance of EVA drove continued
investment in the program, or whether the investment in the program perpetuated its
acceptance. But the impact of this program was most remarkably manifested, as
mentioned earlier, by how rarely managers experienced a conflict between growing EVA
and “doing the right thing.” At first, this seemed purely a triumph of training, i.e., having
the “economic view” pushed down into the businesses. But when one saw how rewards
and communications fed off each other, one viewed this achievement in a different light.

When the program was first implemented, the business units wanted to learn about EVA
because their rewards depended on it. Once they began to accept that the measure
was a reliable indicator of value creation, and once they became used to the fact that
their bosses always wanted to know the EVA impact of initiatives, EVA became a
common language in which everyone wanted fluency. The quality of discussions were


 
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much higher in these firms because, as one executive put it, “we weren’t arguing about
where we were going; we were debating how to get there.” So, the diffusion of an
“economic view” throughout the organization was not so much instilled as it was
absorbed by increasing confidence in the system. And that’s how they could continually
find opportunities to increase value. It all worked together. ♦


 
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Marc Hodak is founder of Hodak Value Advisors, a research and

consulting firm advising senior managers, boards, and investors
on corporate performance measurement, executive
compensation, organizational incentives and related governance
issues. HVA’s research is also used by asset managers in
evaluating the alignment of managers and shareholders for
investment purposes.
In his sixteen years as a consultant, Marc has developed or
reviewed compensation plans and practices at over one hundred
firms around the world, both public and private, in diverse
industries such as manufacturing, consumer products,
telecommunications, transportation, health care, and real estate.
Before forming HVA in 2002, Marc led value-based management
(predominantly EVA) implementations and related projects for
Stern Stewart & Co. Marc also led the creation of alternate
delivery of intellectual capital to clients, including development of
software and internet-based training on value-based
management principles and applications used in 17 countries.
Prior to becoming a consultant, Marc managed a $100 million
per year business unit at Conrail, one of the largest U.S.
transportation companies. As manager of their vehicles
distribution business, Marc’s team implemented a strategy for
network operations, terminal placement and expansion,
equipment technology, and logistics information systems that
profitably grew market share in a mature automotive industry by
over 20 percentage points.
Before his career in business, Marc worked in patent law.
Marc has published in both academic journals and popular
magazines on topics such as corporate governance, value-
based management, and incentive compensation. Recent
publications include:
 “The Hybrid Option: A New Approach to Equity
Compensation,” Journal of Applied Corporate Finance,
Summer 2009
 “The Radical Experiment in Pay Regulation under TARP,”
Lombard Street, April 20, 2009
 “Wall Street’s Bonuses” Forbes, February 25, 2009
 "Pay for Performance: Beating 'Best Practices'," Chief
Executive, July/August 2006
Marc has spoken at forums and conferences throughout the U.S.
and Europe on governance and managing for shareholder value.
He is an adjunct associate professor at NYU’s Stern School and
a visiting lecturer at the University of St. Gallen in Switzerland.
Marc earned his MBA in Finance at the Wharton School
following a Bachelor of Science in Aerospace Engineering at the
University of Maryland. He passed the Patent Bar exam in 1984.


 
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