A Better Way to Measure Operating Performance (or Why the EVA Math Really Matters)

• Author: Stephen F. O'Byrne
• Published date: 01 September 2016
• DOI: http://doi.org/10.1111/jacf.12194
• Date: 01 September 2016

In This Issue: Active Investors and Valuation

Columbia Business School Centennial Roundtable

The Achievements and Future of Business Education

8Glenn Hubbard, Columbia Business School; Geoff Garrett,

Wharton School of Business; Nitin Nohria, Harvard Business

School; and Garth Saloner, Stanford Business School.

Moderated by Jan Hopkins

Columbia Business School Centennial Roundtable

Value Creation by Active Investors (and Its Potential for Addressing Social Problems)

26 Russ Carson, Welsh, Carson, Anderson, and Stowe; and

Paul Hilal, PCH Capital. Moderated by Trevor Harris,

Columbia Business School

University of Texas Roundtable

Recent Trends in U.S. Venture Capital

36 Brooks Gibbens, FinTech Collective; Jake Saper,

Emergence Capital; Glenn Schiffman,Guggenheim; and

Venu Shemapant, LiveOak Venture Partners.

Moderated by Ken Wiles, University of Texas at Austen.

Drivers of Shareholder Returns in Tech Industries

(or How to Make Sense of Amazon’s Market Value)

48 Gregory V. Milano, Arshia Chatterjee, and David Fedigan,

Fortuna Advisors LLC

Private Equity, the Rise of Unicorns, and the Reincarnation of

Control-based Accounting

56 Jerold L. Zimmerman, University of Rochester

A Better Way to Measure Operating Performance

(or Why the EVA Math Really Matters)

68 Stephen F. O’Byrne, Shareholder Value Advisors

Estimating the Cost of Capital Using Stock Prices and Near-term Earnings Forecasts 87 Peter Easton, University of Notre Dame

What Cost of Capital Should You Use? The Market Has an Answer 95 Leon Zolotoy and Andrew John, Melbourne Business School

Do Investment Banks Have Incentives to Help Clients

Make Value-Creating Acquisitions?

103 John J. McConnell, Purdue University, and Valeriy Sibilkov,

University of Wisconsin-Milwaukee

Valuation of a Developmental Drug as a Real Option 118 John Lynch and Richard Shockley, Indiana University

VOLUME 28 | NUMBER 3 | SUMMER 2016

APPLIED CORPORATE FINANCE

Journal of

68 Journal of Applied Corporate Finance • Volume 28 Number 3 Summer 2016

A Better Way to Measure Operating Performance

(or Why the EVA Math Really Matters)

1. This is one of the reasons why EVA isn’t used by more than 10% of S&P 1500

companies. See O’Byrne, Stephen F. and S. David Young, “Why Capital Efciency Mea-

sures Are Rarely Used in Incentive Plans and How to Change That,” Journal of Applied

Corporate Finance, Spring 2009, Vol 21, No. 2, pp. 87-92.

2. More precisely, COV is the value of current earnings and capital, and can be ex-

pressed as the sum of book capital and the perpetuity value of current EVA. The perpetu-

ity value of current EVA is EVA/WACC, where WACC is the weighted average cost of

capital.

M

ost top executives and middle mana gers run

their companies or businesses, set their goals,

and reward their employees using ea rnings-based

measures of nancia l performance—for the year,

the quarter, or the month. And the employees are rewarded

handsomely (or not) with pay and promotion that is tied to

these measures. But the focus on current earning s has two

critical weak nesses that undermine the alignment of pay with

investor wealth. It’s often easy to boost current ear nings at

the expense of future ea rnings through short-sighted cuts in

advertising or R&D. At the same time, it’s also easy to bo ost

current earnings by inves ting additional capital that ear ns less

than its opportunity c ost.

Stock compensation is the conventional solution to the

rst problem of excessive focus on current earni ngs. e use

of stock is thought to be eective bec ause stock prices, to the

extent they reect disc ounted future cash ows, are supposed

to deter shortsighted cutbacks in promisi ng long-term corpo-

rate investment. But there are at least two goo d reasons to

doubt the eectiveness of rewarding managers mainly with

stock. The investment community’s focus on consensu s

earnings and reliance on P/E multiples leads many corpo-

rate managers to thi nk that current earn ings are far more

important than f uture earnings. And the weak tie bet ween

stock value and the performa nce of individual business units

causes many business u nit managers to view stock as just par t

of their expected pay, thereby limiting any incentive eect.

Economic prot, or “EVA” in its best-known version,

has been the most common answer to t he second weakness

of current earnings as a performance goal. EVA discourage s

investment that earns les s than a company’s cost of capital by

including a charge for debt and equity c apital. And because

it includes a capital charge, EVA ties direct ly to discounted

cash ow value, unli ke GAAP ear nings and most widely used

performance measure s. But for all the theoretical advantage s

of EVA, many managers complain that its use undermines

longer-term focus because it’s easier to increase EVA, in

the short run, by reducing capital than by investing in new

projects that often have a long ramp-up to full protabil ity.1

In this art icle, I will present two new measures of operat-

ing performance that a re better than either earnings or EVA

because they identif y and discourage both the sacrice of

future earnings and the failure to earn t he cost of capital.

What’s more, both of these new measures are ba sed on the

math that ties EVA to discounted cash ow va lue. But they

make use of what I refer to throughout this article as “the

EVA math” in a new way, taking advantage of its abil ity

to provide investors and corporate managers with a better

understanding of how their companies’ current stock prices

and market values are a ected by not only today’s prots,

but by investors’ view of the company’s prospects for higher

earnings in t he futu re.

e EVA math provides this double perspective by starting

with the recognition that every company’s market enterprise

value can be viewed as the sum of two components: (1) the

discounted present value of its current earnings stream, or

what we refer to as its “current operations value,” or “COV”;

2

and (2) its “future growth value,” or “FGV.” A company’s FGV

can be thought of—and quantied—in at least two dierent

ways. First of all, FGV is the part of a company’s current

market enterprise value—the market value of its equity plus its

debt—that cannot be explained by its COV and can thus be

estimated just by subtracting COV from its current enterprise

value. Alternatively, and as discussed in more detail below,

a company’s FGV can be thought of—and, again, quanti-

ed—as the discounted present value of future increases in its

EVA, or what we refer to hereafter as “EVA improvement.” To

provide one very simple example of what we mean by COV

and FGV, for those publicly traded companies that have yet

to report positive earnings (like so many dotcoms at the end

of the ’90s), their COV is zero (or even negative), and their

FGV accounts for 100% (or more) of their current value. For

such companies, all of their value is on the come.

is division of all compan ies’ values into current and

future growth va lues, COVs and FGVs, is important for at

least two reasons. First, as already sug gested, it gives inves-

tors and managers a rea sonably clear, back-of-the-envelope

picture of whether and how much value the market t hinks

by Stephen F. O’Byrne, Shareholder Value Advisors