Summary by Chris Hourigan
Master of Accountancy Program
University of South Florida, Summer 2002
This article deals with a relatively new resurgence of a rather old concept of valuing a company's earnings and performance, Economic Value Added (EVA). This system will all but replace the traditional approach of Earnings Per Share (EPS). If it were not for the current requirements of GAAP, EVA would replace EPS. EVA is a residual income based measurement system being reintroduced by Stern Stewart because of over 120 shortcomings they see in conventional GAAP accounting. EVA is basically a long-term approach to accounting and measurement of financial decisions that uses net present value to determine if a project or position should be taken or maintained. It can be rather complex and that is its major downfall, but as Wallace points out, the companies that have implemented this approach have increased shareholder wealth. In fact, EVA produces 3 distinct changes within a company:
1. EVA decreases their new investment and increased their disposition of assets, leading to a decrease in net investment,
2. EVA increases their payout to shareholders through share repurchases, and
3. EVA increases their utilization of assets in place.
EVA makes all assets accountable and makes managers act more like owners.
Earnings Per Share has some disadvantages that make it worthwhile to seek other alternatives. It is quite possible for a management team, especially one that has its incentive programs linked to EPS, to adopt a project that has increased earnings early but overall negative earnings. EVA prevents this with net present value discounting. "Any project expected to earn greater than the embedded cost of debt will increase the absolute level of earnings, however, unless it also earns greater than the firm’s opportunity cost of all (debt and equity) capital, it will reduce shareholder wealth. Thus, the use of earnings-based incentive plans can induce managers to invest in projects with returns too low and retain projects that should be sold."
Wallace goes on to show the results of a survey of companies that have implemented EVA either for incentive plans or other purposes. By and large, the results match empirical data already collected. It seems EVA does increase shareholder wealth but there are two major problems with EVA.
First, it is very complex, or can be. Some data can be very hard to collect accurately for planning purposes. The companies surveyed all tried to keep it as simple as possible so that implementation could go smoothly.
Second, EVA conflicts with the financial market approach of financial analyst. Tremendous pressure is on top management to produce earnings quickly. This often conflicts with EVA’s long-term approach. For EVA to work, all of management must be dedicated to the EVA approach. That’s where incentive based programs come into play. They will discourage the short-term decisions in favor of the long-term goals.
EVA has received a lot of attention in the business community, but surprisingly very little in academia. As financial markets realize the downfalls of EPS, EVA might be the way they turn. Until then, EVA will continue to prove to be a very good planning tool, but as long as the conflict of showing immediate return in the form of EPS lives, EVA will never become the primary valuation tool of a company.
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