management performance emphasis on shareholders' wealth
EVA: A Business Driver
The Value based Management (VBM) framework is a return to economic values in relation to management performance and places great emphasis on shareholders' wealth. Management need a performance metric that can measure the performance of most promising financial investments and suitable yardstick for monitoring and controlling operations and provide an authentic, more challenging and meaningful base for executive incentive compensation. The best measure for this purpose has been identified and employed in more than 400 companies globally including well-known companies like Coca-Cola, Sony, Siemens etc. Stewart Stern & Co. developed in early 1980s a measure known as “EVA” or Economic Value Added. Since the term EVA® is a registered trademark of Stewart Stern & Co., it is also referred as Residual income or Economic Profit.
Definition & Purpose
EVA® is an instrument of measuring profit, the way economists view it. EVA® in its simplest terms, is the firm's net operating profit after taxes less a charge for using all capital and debt component in its capital structure. Unlike traditional accounting profit, in which after tax cost of borrowing is subtracted, EVA® is to account for by starting with “earnings” only after shareholders have been gained of fair return on their investment. Thus, it calculates shareholder value creation /destruction over the period under consideration. It tracks share prices, more accurately than earnings, earnings per share, return on equity or other accounting tools as strongly supported by empirical studies. Creating sustainable improvement in earnings is tantamount to increasing shareholder wealth. This is a long term metric as opposed to speculative investors. It computes the real profit after deducting the cost of capital as follows:
EVA® = Net Operating Profit After Tax (NOPAT) - [Capital x Cost of Capital]
The EVA® capital charge is determined by multiplying the amount of “capital” of the firm employs, by an interest rate factor commonly known as “cost of capital”. Capital is the sum of funds contributed by lenders and shareholders. It may be calculated as the firm's total assets less the amount of trade financing provided by suppliers and deferred salaries and wages.
From the investor's perspective, for a firm to be an attractive investment, it must focus on higher return on equity capital that investors can achieve easily with diversified and long-term equity market investment. Thus, over the long run, creating less return than the capital charge is economically not feasible nor acceptable from a shareholders' perspective. In such a situation, investors will never compromise and can take away their money from the firm since they have no other alternatives to invest.
Lessons learnt from Enron Debacle
Enron, world's seventh largest energy conglomerate in the United States, was failed in 2002 and made headlines in the newspaper of the world. Its failure was a classic example of following such practices, strategies and plans, which were never thought of before in the financial history. The basic lesson we should learn from the Enron debacle that all those firms manage for earnings per share (EPS), actually asking for big trouble.
Enron terribly stick to the concept of EPS. Its Management was, invariably focused on earning per share. EPS is an accepted norm in accounting model, despite accountants never set market prices of stock. Market prices, certainly reacts strongly to management's instance in response to periodic (quarterly) EPS objective. Moreover to establish EPS link to executive incentive compensation is not a realistic proposition. There are better ways, however to pay and motivate managers instead of using EPS yardstick.
Enron's management was a strong advocate of using EPS and demonstrated as their policy in their 2000 Annual Report, stated in these words:
“Enron performance in 2000 was a success by any measure….The company's net income reached a record in 2000. Enron is lesser focused on earning per share and we expect to continue strong earnings performance.”
It is their focus on EPS proved to be unreliable gauge of corporate performance and stock market value.
Another major aspect, where management pouring too much capital in low returning projects. Unless the project's modest return is more than the cost of debt equity, EPS will increase and if project's return is not high enough to provide shareholders a decent return on equity, it will lead a reduction in the stock price and price/earning multiple. Enron's management sunk huge amounts in low returning investments and risky contracts.
As a major strategic move to increase earnings per share growth was using over-leveraging balance sheet. Management was not ready to issue new common stock to finance growth for fear of losing control or diluting EPS. As a consequence they employed debt, above and beyond the level of financial prudence. As a policy dimension, companies try to manage and maintain a prudent balance of debt and equity proportions in its capital structure after careful thought of risk and return factors. All those companies which rely heavily on EPS, always tempted to borrow too much as compared to issue new common stock, just in an effort to keep EPS growth high.
The most disturbing aspect of Enron EPS facade. They were so consistent and caught up in vicious EPS circle of management and ultimately resorted to inventive accounting practices to hide their debt, they were using to finance their EPS growth. They violated the basic principles of corporate finance policy that risky growth should be financed with equity capital not debt capital.
They also resorted to deceptive and inventive accounting practices in their financial performance reports by following prematurely booking sales, capitalizing expenses, inappropriate conflict of interest transactions, extensive undisclosed off the book activities, establishing huge restructuring reserves and excessive executive compensation. Thus they lost their credibility and ultimately firm broke down, millions of dollars lost, shaken the confidence of investors and wasted their hard earned wealth.
Just after the collapse of Enron, new paradigm shifts. New rules of the old game being written. More stringent corporate surveillance policies being pursued. New controls being introduced. Now emphasis being shifted from the rate of earning growth to the size of returns in terms of cash flows.
In fact, Operating profit depends on (1) past investment and (2) management's operating effectiveness and efficiency. If past managers have identified and invested in promising projects, current managers, of course should be able to generate high operating profits and report high EVAs, provided they have operated efficiently and with due diligence. Financial management demands two different types of decisions:
(1) decisions involving acquisition of new assets or capital budgeting decisions; and
(2) decisions related to the efficient utilization of existing resources.
Both these decisions are important to affect EVA®. When management performance is evaluated by EVA® system, managers have strong incentive to make correct capital budgeting decisions, utilizing efficiently existing assets and financing the firm's operations in an optimal way. This what shareholders are expected to perform diligently to achieve wealth maximization objective.
Firm's tying manager's compensation to the company's performance, is by far considered most important incentive plan. These plans involve executive stock option, which allow managers to purchase stock at some future time at the given price. Options will have value only, if the market price of the stock rises above the exercise price of the option. This plan allows managers to purchase stock at a fixed price that provide an incentive for them and provide impetus to take action, which would ultimately increase the stock price. Therefore, a higher future stock price would result in greater management compensation. Since incentive plans should be based on factors over which managers should have control and since managers cannot control the market movement of stock, stock plans proved to be poor incentive mechanism. These plans compensate management on the basis of its proven performance measured by earnings per share, growth in EPS and other ratios of returns like ROI.
Performance shares, shares of stock given to management as a result of meeting the stated performance goals, are often used in these plans. Another form of performance-based compensation is cash bonuses, cash payments tied to the achievement of certain performance goals. Under performance plans, management understands in advance the formula used to determine the amount of performance shares or cash bonus it can earn during the period. In addition, minimum and maximum benefit threshold of the plan are specified.
EVA® is an effective alternative metric in the hands of firms to tie executive compensation to shareholders' wealth maximization. Compensation based on EVA® provides managers with stronger incentives to create value.
All incentive-based compensation plans are designed to accomplish two broad objectives:
(i) They provide executives with an incentive to take that will contribute to shareholders' wealth maximization;
(ii) It helps companies to attract and retain their managers who have enough confidence to stake their financial future on their own abilities, efforts and destiny and such individuals make the best top-brass executives.
The Enron Board of Directors approved excessive compensation for company executives, failed to monitor the cumulative cash drain or halt abuse by Board Chairman and CEO Kenneth Lay of a company-financed multi-million dollar, personal credit line. Based on the evidence, US Senate Permanent Sub-committee on Investigations, hearing on May 7, 20021 made the following recommendations to prevent excessive executive compensation by:
(i) exercising ongoing oversight of compensation plans and payments;
(ii) barring the issuance of company financed loans to directors and senior officers of the company;
(iii) preventing stock based compensation plans that encourage company personnel to use improper accounting or other measures to improperly increase the company stock price for personal gain.
The VBM framework has tested by conducting studies and several benefits have been observed by adopting and implementing this approach. It was noted that intangible benefits can be derived from the implementation of such framework including strategic planning, efficient resource allocation, improved capital focus, enhanced business literacy, improved decision making, effective organizational communication and owner-like behavior from managers, similar results have also been reported by a study published in Harvard Business Review (HBR, July, 2001)*
*Vol. 12, No: 2, Journal of Applied Corporate Finance.
If we intend to control occurrences of this type, nature and magnitude of loss, our focus should be on EVA® business tool. We may suggest the following points for consideration:
(1) Managers' bonuses should be tied with the improvement in EVA®, if EVA® is not sustained and improved, managers should suffer rather than the firm. There should be no limit on the size of the bonus, it should depend on continuously improved EVA® performance; managers should be compelled to think like an owner of the firm to take initiatives and all actions in the best interest of the firm.
(2) EVA® provides a platform, which discourages over-leverage proposition of balance sheet. Since managers are aware that if they employed debt or other financial vehicles beyond the limit that prudence demands, they will be held accountable for earning a decent rate of return for their shareholders, ultimately they will be liable and suffer with the decline in EVA®.
(3) EVA® will also provide a deterrent for using deceptive and inventive accounting practices. Since EVA® provide more accurate and measurable profit of the firm and afford a better tool in the hands of management, it can be utilized for internal reporting purposes and a supplement to financial accountability, disclosure and transparency.
By comparing two metrics, EPS and EVA®, we will find that EVA® is more balanced, meaningful and effective guide used to determine the executive compensation incentives.
Enron has left an indelible imprint on financial history and provide us many lessons we should learn and avoid to repeat the history once again.
List of References:
(1) Senate Subcommittee Report Charges Enron Board of Directors with Contributing to Enron's Collapse, July 7, 2002. Copies of the report available online at http://govt-aff.senate.gov/psi.htm.
(2) CIMA Research Report on Implementing the EVA Business Philosophy - Accounting and Finance Josie McLaren, University of Newcastle upon Tyne Business School, February 2003
(3) Financial Management: Theory and Practice, 8 ed. 1997, Brigham, F. Eugene and Gapenski, C. Louis, The Dryden Press, Florida. ISBN # 0-03-017789-8
(4) “The EVA® Financial Management System, Stern, Joel M., G. Bennette Stewart, III, and Donald H. Chew, Journal of Applied Corporate Finance, Summer 1995, 32-46
(5) Stern Stewart Roundtable on Management Incentive Compensation and Shareholders Value,” “Journal of Applied Corporate Finance, summer 1992, 110-130.
(6) Stern Stewart Research Report on Clients' performance, Gandhok, Tejpavan and Kulkarni, Sanjay, Jan. 2005 can be found at: http://www. EVA.com
Mr. Syed Zubair Ahmed, obtained Bachelor of Commerce. Completed compulsory audit training with Hyder Bhimji & Co., Chartered Accountants, Karachi, Pakistan from 1983 to 1987 where he conducted audits of various national and multinational companies. He is Master of Commerce and also acquired an Executive MBA (Banking & Finance), and obtained Certification in Factory Management in Medium Scale Industries. (FMMI) from Japan. Obtained Certified Fraud Examiner designation from theAssociation of Certified Fraud Examiners, Texas, USA in July, 2005. Since 1999, he has been striving towards providing training and development courses and dissemination of professional education.
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