Beware EVA 21/08/08

Beware EVA

The emperor has no clothes and cash is still King

Prof. Chris Clark and John Kenworthy

It seems odd that business thinkers continue to drift towards a reliance on balance
sheets to establish the value of an organisation in spite of the dangers. The trend in
using Economic Value Added (EVA) measures is worrying, not least because many
companies have adopted E.V.A. as their key performance metric, even linking it to the
fortunes of their executives.

The growing popularity of EVA is in part because the performance metrics used in the
past, notably return on equity and others based solely on accounting figures, are
largely wanting when it comes to measuring the creation of value.

EVA is at first glance, an attractive measure – the return (post tax operating profit) on
the opportunity cost of capital employed (weighted average cost of capital x adjusted
book assets). EVA is also seemingly simple in its application, but the technique brings
substantial challenges if it is to be used well. If EVA is to reflect the unique identity of
each company the ‘right’ factors and adjustments must be taken into account when
applying EVA otherwise it becomes difficult to get an accurate picture of value.

Proponents of EVA argue that balance sheets are adjusted to compensate for changes
in the “real value” of assets and liabilities to accurately calculate EVA. But which
factors and which adjustments, and how many? Too many factors and adjustments and
the process becomes too complex to use. Too few and the picture could be distorted.
According to EVA’s developers, including Bennett Stewart, there are 164 potential
accounting adjustments that must be made to obtain a "real" reflection of company
performance. In other words, although the concept is frequently applied in a very
basic, easy-to-understand format, numerous complex adjustments must often be made
to correctly assess a company's situation. Mr. Stewart's list of adjustments includes the
following:

"... inventory costing and valuation; seasonality; depreciation; revenue recognition;

the writing off of bad debts; the capitalisation and amortisation of R&D; market-
building outlays, restructuring charges, acquisition premiums and other 'strategic'
investments with deferred payoff patterns; mandated investments in safety and
environmental compliance; pension and post-retirement medical expense; valuation of
contingent liabilities and hedges; transfer payments and overhead allocations; captive
finance and insurance companies; joint ventures and startups; and special issues of
taxation, inflation and currency translation.”1

In the recent controversial regulators’ reviews of British Gas Transco and the National
Grid Company much of the argument has been around balance sheets. Regulators
argue that the companies’ assets have a low value and that the returns the utilities are
1
G. Bennett Stewart 3d, "E.V.A.: Fact and Fantasy," Journal of Applied Corporate Finance (Summer
1994).
Beware EVA 21/08/08

getting are therefore, too high and worthy of reduction. The utilities argue that the
‘real’ value of their assets are much higher than the regulator estimates and therefore,
their returns on them are barely adequate and certainly cannot stand further predation
from the regulator in favour of consumers. Meantime, accounting firms and other
advisors charge fat fees to do fantastic peregrinations in order to appraise asset values
for both sides in the regulatory utility wars. In all industries a range of accountants
and consultants are selling value-based management based on modifying balance
sheets to make them “accurate”.

One of the purposes of EVA is to be able to compare performance in one company

with another, but the question of comparability becomes tangled, however, in trying to
assess one company's EVA against another's. Currently there is an absence of
generally accepted rules to guide the application of EVA and to determine what it is
actually measuring. The result is that companies can pick and choose among the
multitude of possible adjustments, creating something of a free-for-all in the metrics
marketplace.

Stern & Stewart, Rappaport and others effectively demolished the credibility of the
profit and loss account for measuring corporate performance. Profit results from the
calculation of revenue (itself liable to undue influence through manipulation and the
subtraction of various costs, all capable of fudging) and then adjusting for changes in
asset values plus or minus extraordinary items. Sharp, but perfectly legal accounting
can lead to wild variations in results. Hence, we moved to cash flows as a cleaner
measure for business performance.

If you accept the premise that the profit and loss account itself is of dubious value
then it follows that transfers from or to the balance sheet to or from the profit and loss
account must also be doubtful.

Balance sheet assets are recorded at their purchase value and then depreciated and
may be re-valued. Depreciation is a taxation-driven exercise bearing little or no real
relationship to asset value. Purchase value may have been below, above or at market
price. Re-evaluation of assets is an arcane art especially for assets like electricity
wires or gas pipelines, which have no alternative use and very long life. The only real
value of such assets is either as scrap, or as the value of the cash flows generated by
them. In the case of the utilities the regulators influence these cash flows and so to use
them as a basis of regulation seems somewhat circular.

The technical partners of the big six accounting firms well appreciate the failings of
balance sheets and fall into two main camps: those who want to start all over again
and those pushing for reforming each line of the balance sheet one at a time. From the
latter, we see such gems as accounting for brands on the balance sheet. Again, the
only value of a brand is from the added cash flow that it generates. Why not,
therefore, stick to that cash flow as our measure of performance? Id we wish to
describe and measure intellectual capital and the value of processes as a separate
useful exercise, all well and good. Skandia do this in their supplement to their annual
report, virtually ignoring accounting measures to do so.
Beware EVA 21/08/08

The problem with cash flows is that past cash flows are certain, but may be poor
forecasters of the future. Future cash flows are uncertain and the resulting net present
valuations can be made to grow or shrink like plasma by tweaking the assumptions.

The reality is that we should focus on cash flows, but should use strategic analyses
like scenario planning to evaluate possible outcomes. We can best measure past
performance on cash, but if anyone thinks we can be deterministic about the value of
a company based on future cash flows, they are nuts!

Stock market values are only really helpful for quoted companies, becoming more
spurious when we make sector comparisons from quoted to unquoted stocks who are
working in parts of the world without efficient capital markets. Even for quoted
companies, there is a control premium, which is not accurately calculable for the
purchase of control in the firm. In uncontested bids, this averages 25% and in
contested bids is often much higher.

How then should we value business for strategy purposes? We should be humble
enough to accept that it is as much art as science. We should use all available methods
even if dubious. There is always someone out there who believes in an approach and
we need to have an answer for them, especially if they are on the other side of an
M&A deal.

Lastly we should focus on a scenario approach, using multi-functional teams to

develop the scenarios, with net present value calculations for each scenario.

This at least makes us think through and analyse the issues without expecting
deterministic results. Balance sheets and profit and loss accounts are for auditors and
not generally for strategists.

Finally, because companies -- and their business units -- have their own special
characteristics, E.V.A. might not always be the ideal value proxy to use. Companies
that are particularly sensitive to the availability of capital, for example, might do
better to use a proxy known as cash value added, or C.V.A., either alone or in
conjunction with E.V.A.