Getting Down to Fundamentals. Part 2: All About EVA

Want to know the best way to dig up whether a company's creating wealth or destroying it? Check out EVA.

Part 1: Debt Ratios

Part 2: All About EVA

Part 3: Asset Management Ratios

What sets EVA, or economic value added, apart from more common measures of financial performance is that it shows profit after the cost of all a company's capital, both equity and debt. In contrast, measures like net income and earnings show only how much money goes toward paying for debt. In the second part of TSC's three-part Getting Down to Fundamentals series, we'll take a look at EVA and how it can enhance investors' stock-picking savvy.

The ideas behind EVA were being developed by management consulting firm Stern Stewart in the 1980s, though the idea didn't really catch on until the '90s. EVA shows whether a company's really making a profit after paying the going rate for capital. (Here's the hitch: It's virtually impossible for retail investors to determine EVA for a particular company because companies don't make public some of the information that goes into the formula. But you can check out Stern Stewart's Web site for the lowdown on the 200 biggest U.S. companies by market cap .)

"Though you may show profitability in a GAAP [Generally Accepted Accounting Principles] sense, if you're not recovering the cost of equity capital, you're destroying shareholder value, not building it," says Joseph Carcello, a professor at the University of Tennessee's business school. "You can't assume equity capital is free, just because it's not explicit. There's an opportunity cost of no longer having that cash to use for other purposes."

To think of EVA another way, says Carcello, imagine two companies that each generated $1 million in annual net income. In the first case, the assets used to crank out that profit were financed by selling shareholders one share of stock for $1. In the second case, assets were financed by selling stock worth $1 million. Though equally profitable, one company devours shareholder capital, while the other scarcely uses any. From a shareholder point of view, there's no question that the first company is the better investment.

What EVA Can Tell Investors

EVA is a dollar figure that tells how much wealth a company has created above and beyond its cost of capital. But the actual number matters less than the trend in EVA, says Dennis Soter, a partner at Stern Stewart. "If EVA is positive, but is expected to become less positive, that's not a very good situation. Conversely, if a company has negative EVA but it's expected to improve, that can be a tremendous investment opportunity."

Even in healthy companies, trends in EVA may foreshadow stock performance better than trends in the bottom line. Wal-Mart (WMT) offers a case in point: From 1991 to 1994, net income rose steadily while EVA slowly dropped, though it remained positive. Though Wal-Mart generated profits of $8.6 billion for the period, it added economic value -- money over and above the cost of equity and debt capital -- of only $1.3 billion. Its stock price, up 38.6% for the period, bested the S&P 500 by a mere 1.9%.

But then business took off. Wal-Mart created $5.4 billion in value from 1995 to 1999 -- and its stock price soared 379%, outpacing the S&P by 182%.

Wal-Mart's Good Face of EVA Wal-Mart's stock price soared in the late '90s as EVA surged. The chart shows EVA performance

Source: Stern Stewart

After that, EVA started gaining momentum: From 1994 to 1999 Wal-Mart added $5.4 billion in wealth above the cost of capital, on profits of $19.1 billion -- a much healthier ratio of adding shareholder wealth to net income. In that period, the stock zoomed 379%, trumping the S&P by 182%.

Likewise, shareholders who got wind of the gloomy EVA trend at Kmart (KM) early would have been clued in that it showed no signs of a turnaround. For most of the time between 1989 and 1999, Kmart could say it was profitable -- it reported accounting losses three times in that 11-year period. But judged by EVA, it was losing a cumulative $7.1 billion in shareholder wealth.

Accordingly, its stock price staggered. It underperformed the S&P's gain in that period by 302 percentage points with a return of 67.1%.

Kmart's Bad Face of EVA As Kmart lost wealth for shareholders, its stock price trailed the market, too

Source: Stern Stewart

The equation for EVA looks like this:

EVA = NOPAT* - (Operating capital) (After-tax cost of capital).

*NOPAT is a company's net operating profit after taxes.

This may seem like complicated accounting-speak. But it's really just common sense: The wealth a company creates is equal to what's left over after you subtract the cost of capital from its profit.

EVA reflects the use of both kinds of capital, equity and debt, via the operating-capital piece of the equation. That's because operating capital represents the sum of the interest-bearing debt, preferred stock and common equity used to buy the company's operating assets. (If you're a fan of definitions, operating assets consist of net operating working capital -- things like cash, marketable securities, accounts receivable and inventories -- plus net plant and equipment).

But figuring out the cost of capital is a lot more complicated. Outside of the managers at a given company, few if any people are likely to know what it is. For that reason, it's tough for retail investors to use EVA. "One of the tricks is that you need to know the weighted average cost of capital, and companies aren't required to publish that," says Carcello.

Also, the management firms that help companies put EVA principles in place have developed a fairly elaborate system for rejiggering conventional accounting numbers so it all makes sense. For example, Stern Stewart treats research and development outlays as investments rather than expenses, and it has identified scores of other potential adjustments to earnings and balance sheets in the areas of inventory costing, depreciation, bad-debt reserves, restructuring charges and amortization of goodwill.

Without making similar adjustments, lay investors seeking a company's EVA may get misleading results.

How EVA Affects Your Investments

Even if you can't conduct sophisticated EVA analysis on your own, it's worth knowing how the idea can play out in companies. For example, companies that abide by EVA may willingly accept crummy earnings in the short term in exchange for a better return in the future.

Companies that don't care about EVA, on the other hand, may be less willing to sacrifice earnings in the present for gains down the road. They want to max out earnings all the time --though that strategy has a downside. "R&D expenses and advertising expenses constitute the lifeblood of future growth in tech and marketing companies, respectively," explains Soter of Stern Stewart. "Unfortunately, managers who are focused on EPS will often curtail long-term strategic investments in R&D and advertising to produce steady and predictable earnings growth." That's because under traditional accounting rules those costs would have to be expensed right away, which would undercut earnings.

But under an EVA incentive compensation plan, managers are told to treat R&D and advertisement as investments, since they're expected to produce profits down the road.

In the name of EVA, companies may undertake other actions that seem similarly calculated to annoy investors -- cutting dividends or taking on junk debt instead of raising equity capital -- mostly in a bid to cut down on the use of pricey equity capital.

Of course, regardless of the strategic stuff, it's still possible for companies that use EVA to turn out to be shabby investments. Rubbermaid, which implemented an EVA regime to no avail, floundered around until it eventually got bought out by Newell. J.C. Penney (JCP) is another EVA-abiding laggard.

So EVA is certainly no management panacea. But its underlying principles matter. EVA underscores the point that the cost of equity capital is too often ignored, and that's an idea that deserves investors' attention.

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