For what it's worth

Entrepreneur, Dec, 1998 by Mark Henricks

A reinvented formula tells you if your business is as successful as you think it is.

Al Weatherhead, 73, can recall perfectly the board meeting he attended a few years ago at which one of his directors demanded he get rid of a big chunk of his company. The distribution arm of Weatherhead Industries, Prodco & Ashland Municipal Supplies in Cleveland was earning only an 8 to 9 percent return on capital, in contrast with the benchmark 12 percent.

"It's necessary for you to take corrective action," the director said. "Sell the thing!"

According to the Economic Value Added (EVA) performance measures Weatherhead had been given by New York City management consulting firm Stern Stewart & Co., the director's suggestion was the right one. So Weatherhead sold the distribution side of his business.

"That was one of the truly great benefits of EVA," Weatherhead says. Today he employs 150 people in the original business of plastic bottle cap manufacturing, and the company's revenue of approximately $25 million is up sharply from $15 million at the time of the divestiture in 1993.

A few years before Weatherhead's decision to divest, he had implemented EVA to help provide guidance to company managers. Hundreds of other companies, including such well-known organizations as Coca-Cola, Eli Lilly and Steelcase, have also adopted EVA-style measurement systems. And fans of this performance gauge include management guru Peter Drucker as well as the evangelists at Stem Stewart.

"[EVA] tells you whether you've been as skillful as you'd like to think," Weatherhead says. "It measures your true performance."

ADAM & EVA

EVA's roots go back 40 years to corporate finance studies done by economists Merton Miller and Franco Modigliani. Miller later won a Nobel Prize for research that found for businesspeople to accurately estimate whether they're building the value of a business, they have to subtract the cost of capital from the expected return on any capital investment.

Related concepts, such as net present value, discounted cash flow and residual income, all start with the same idea: Before deciding whether to plow money into something (or to leave money that's already been plowed in untouched), you have to consider what you could earn with that money if it were invested elsewhere.

"EVA is a measure of profits, properly calculated," says Al Ehrbar, a Stern Stewart senior vice president and author of EVA: The Real Key to Creating Wealth (John Wiley and Sons). Most simply put, EVA is net operating profit minus an appropriate charge for the opportunity cost of all capital invested in an enterprise.

Simple? On paper, yes. The basic calculation is something capital-strapped entrepreneurs figure on the fly almost daily. But EVA as practiced by Stern Stewart and others can get pretty complex.

GETTING STARTED

The first step in applying EVA to your business is to adjust your accounting measures. Stern Stewart has identified 160 different potential adjustments to common accounting methods to do this. Most companies generally use between five and 15. Two of the most important are ending the amortization of goodwill and changing research and development outlays from an expense item to a capital investment. Other adjustments are made according to your industry and your company.

After you modify your accounting methods, you take the figure for the net operating profit after taxes and subtract an estimated cost of capital from it. The net operating profit after taxes is basically the bottom line, with financing expenses such as interest and principal payments on loans added back in. The cost of capital varies according to economic conditions and the risk of the underlying business, but it's generally 8 to 14 percent.

The resulting number shows how much - if any - value your company is adding through its operations. This information can help you make decisions that will build your company's value rather than deplete it.

There are three ways business owners can build value, according to Stern Stewart. The first is to increase returns on invested capital. You may, for instance, find ways to boost profit margins or increase sales without adding more capital. The second way is to invest more capital - as long as it's done so that returns exceed capital costs. For example, you might invest in new equipment, marketing campaigns or additional employees. The third way is to reduce the capital you invest by selling assets, shrinking inventory or reducing accounts receivable. Weatherhead's managers found ways to boost value by cutting costs, increasing sales and increasing throughput (raising production volume without increasing investment).

Weatherhead says that while EVA may look like a cost-reduction tool, it's just as much about boosting sales. "It tells you very clearly to look at the top line," he says. "You have to search out ways to get double-digit growth because that helps you cover the cost of your capital."

THE JURY'S STILL OUT

Not everyone who looks at EVA is sold on the concept. Sherry Jarrell, a finance and economics professor at Wake Forest University in Winston-Salem, North Carolina, who specializes in corporate performance measures, says a company that uses EVA may be stifling innovation.