EVA changes how Detroit measures its executives - economic value-added

Automotive Industries, Feb, 1998 by John McElroy

Economic value-added is forcing managers to focus on improving shareholder value (if they want to bring home the big bucks).

Last year Ford's shareholder value improved 57%. GM's stock hit its highest price in history. Lucky break thanks to a surging stock market? Not according to those who are forcing executives to earn their cost of capital. "Management is becoming more responsive to shareholders," says J. Michael Losh, GM executive vice president and chief financial officer.

The U.S. Big Three and some suppliers are adopting a variation of economic value-added, better known as EVA. Created by Stern Stewart, the accounting firm, EVA is simply after-tax profits minus the cost of the capital used to generate those profits. Many accountants believe EVA paints a clearer picture of shareholder value than traditional measures, such as profits, earnings per share, or growth. That's because EVA forces managers to earn more than their cost of capital.

"EVA is a way of driving the capital charge into operations," explains Jim Donlon, Chrysler vice president and controller. "It's a tool to measure the efficiency of how management is generating a profit. If it takes fifty jillion assets to get those profits, it's not as good as using fewer assets."

If a company is producing profits but didn't cover its cost of capital, it destroyed shareholder value. Ultimately that is reflected in the price of its stock.

Conversely, if a company earns more than the cost of capital, generating a positive EVA, the results can be dramatic.

SPX, an automotive services and parts supplier, began using EVA at the beginning of 1996. By the end of the year its $26.6 million EVA improvement was greater than the total improvement for all of the prior five years. Inventories were reduced 15%, net working capital was reduced more than $33 million, and net debt was reduced $86 million. Since it adopted EVA, SPX's stock price shot from $15 a share to $70 today.

"The markets give a higher multiple to a company that raises its EVA by $1 by growing sales and share, than by cost cutting," says Professor Robert Kleinmen of Oakland University in Rochester, Mich. Companies using EVA generally have stock returns of 3% per year higher than their peers, he adds.

The Cost of Capital

All companies borrow the capital they use to run their business. To get the money they need to build a plant, buy machinery or purchase materials, they can borrow it, issue bonds or sell some of their stock. When borrowing money from a bank, the cost of capital is simply the interest the bank charges. But calculating the cost of raising capital by selling stock is more complex. It involves the return shareholders expect to get for the price they have paid to buy or hold their shares. Investors have the choice of buying low-risk investments, such as Treasury bonds, or investing in other, riskier securities.

They obviously expect a higher return for higher risk. To attract investors, weak firms must offer a premium in the form of a lower stock price. This lower price is the equivalent of a higher interest rate on loans and bonds. The real cost of equity is what shareholders could be earning elsewhere.

The cost of capital varies by company, but is roughly 12.5%. This includes an interest rate of about 6.5%, plus an additional 6% or so for inducing the average investor to purchase stock. But worrying about the cost of capital is something that most companies always left to their finance departments. There was never a line item for capital charges on the profit-and-loss (P&L) statement for managers. Up until now, that is.

"We started using a capital charge at the operating levels in 1997 and we're already seeing results," says William J. Cosgrove, corporate controller at Ford. "Rest assured it's had quite a behavioral change. We thought we'd have to force it down the organization's throat, but it's embraced it and is moving faster than we envisioned."

Ford's capital charge is applied at profit before tax on operating assets. Now, to improve profits, managers have to reduce the assets they use. Cosgrove says it's having a noticeable impact in product development and manufacturing. At Ford's Windstar Assembly plant in Oakville, Ontario, for example, inventory dropped 25% last year.

RONA

In 1993, General Motors began looking for ways to get its managers focused on earning their cost of capital, but it embarked on a somewhat different approach. Back then it was obvious its North American Operations would take years to generate a positive EVA. So GM began measuring its manager's performance based on something they could act upon immediately. It adopted RONA, or return on net assets, coupled with a yearly growth objective that managers must meet.

"In 1996 we improved working capital by about $2 billion, and when we close the books on '97 we'll have furthered that," says GM's bosh. "A good focus on inventory management, that's the area of biggest potential."

GM is not the only one impressed with its results. "GM is probably on the right track," says Professor Kleinmen. "If they follow their path right now, they'll have a significant turn around. You'll see a significant increase in the stock price."