Romancing EVA

THEME/EVA

The use of economic value added as a tool to align employee incentives with shareholder interests is gaining some converts. But as of now only the intrepid have adopted it wholeheartedly

In a country where capital is still expensive, one would have thought managements would be trying to get a bigger bang for every buck invested in the business. Ask Stern Stewart & Co, the New York-based global consultants, and they will convince you otherwise. Here are some scary numbers:

* Nearly a third of India's top 20 companies by market-capitalisation destroyed wealth in the last five years. Nine of the top 10 banks in terms of total assets did so too.

* Nearly 70 per cent of the incremental capital invested in the last five years went to companies that destroyed value.

* Listed public sector units, five per cent of the total, swallowed up 35 per cent of the capital employed and added to their already large capital bases by 40 per cent over the last five years.

No doubt about it. Indian companies guzzle capital, and most of it goes down the tubes. One reason for this was the licence-permit raj. In those days, companies thought more about squeezing higher revenues in protected markets and less about the cost of achieving these revenues.

But another equally important reason is the way companies have been looking at returns: earnings per share, which is basically post-tax profits per share. For an accountant, a company is doing fine as long as debtors and the taxman are paid and depreciation provided for. Since equity is a post-tax charge on profits, it doesn't figure much in calculations. Not surprisingly, managements have been happy to treat equity as "free" money on which no returns are due unless there is a profit. Result: shareholder value is often the result of fortuitous circumstances rather than great management.

Stern Stewart & Co believes they have the answer: EVA, or economic value added, is the proprietary tool they have developed to end inefficient use of capital. The crux of EVA is to effectively put a cost to equity capital and make it a pre-tax charge while calculating returns. In effect, a company is said to be EVA-positive as long as its net operating profit after tax (Nopat) is higher than the cost of the capital.

Says Tejpavan Gandhok, managing director of Stern Stewart India: "If you seek to maximise EVA in the long run, the fundamental performance of the business improves. Capital efficiency will improve because there is a more explicit capital charge; the capital structure will be more optimal because there is greater awareness of the cost of equity. People will be much more bottomline conscious - and conscious about sustainable results - because their own incentives are tied to getting a part of the action."

Many companies are beginning to be convinced. The Godrej Soaps group of six companies, headed by Adi and Nadir Godrej, is of them. The group's experience in just one year: four of the six companies have outperformed on stretch targets, and most employees are awaiting huge bonus payouts. As EVA aligns employee goals with shareholder interests, flagship Godrej Consumer Products has been busy handing over dividends hand over fist and buying back shares to bring down the cost of capital.

Tata Consultancy Services has put almost all its 15,000-plus employees into EVA-linked variable pay under which performance above EVA targets fetches you bonuses every year. The only employees excluded are entry-level employees who are yet to complete a year in service, says S Mahalingam, executive vice-president of TCS, and the main spearhead for the EVA initiative in the organisation.

Others have customised EVA for their own purposes. Marico Industries, makers of Parachute coconut oil, has worked out a simplified version of EVA (styled Seva) but uses it more as a signalling device to tell people that capital is important, that investments and acquisitions must have a justification in terms of shareholder value. At Infosys, EVA is used as a tool to calculate the value delivered to customers. Infosys reasons that if it can tell its customers that what it is delivering in terms of value is higher than what the customer pays Infosys for the service, the customer will be less worried about price alone.

Pharma major Dr Reddy's Laboratories does not use EVA as a measuring device to reward performance. However, it uses EVA as a qualifying criterion for granting performance-based rewards such as variable pay, performance bonuses and stock options (ESOPs), says Saumen Chakrabarthy, senior vice-president (HR). "We use EVA as a qualifying criterion for the grant of ESOPs. Maximising EVA is the basic objective of a business," says Chakrabarthy.

Other companies acknowledge the existence of EVA, but go no further. Hindustan Lever and Satyam Computer are two such companies. Satyam has estimated it's EVA for the year ended March 2002 at Rs 170.11 crore, which is marginally higher than the Rs 167.42 crore value added during the previous year. Some companies feel that they can do without EVA, thank you. Says TVS Motors President C P Raman: "TVS Motors does not use EVA as a measuring device to reward performers. But we have introduced variable pay for senior managers which is based on the targets for the company and that of individuals."

CALCULATING EVA

Internationally, multinationals like Coca-Cola, Siemens, Bausch & Lomb and Dun & Bradstreet have been sold on EVA for long. Back home, though, EVA's allure is less than captivating primarily because it is a difficult animal to understand. Most companies probably can't make it effective on their own. It begins by looking simple, but as you get deeper into it the calculations begin to look daunting. EVA is defined as a company's net operating profit after tax (Nopat) minus the weighted average cost of capital (WACC). Nopat is a no-brainer, and the cost of debt (the interest rate) is simple to understand. So far, so good.

But try calculating the cost of equity. The real cost of equity is the expected return on it, after working in the risk premium. Clearly, it has to earn more than debt, or else shareholders wouldn't be investing in it. So you have to add the risk premium to the equity part of capital. But this premium would again depend on the kind of industry you are in: if you run a pharma business, the risk premium may be higher than if you were running a cement business.

IMPLEMENTING EVA

When a company decides to adopt EVA as a corporate performance measure, here is what it must do:

Step 1: Run an EVA analysis of the company, its publicly traded peers and business units

Step 2: Draw up a definition of EVA that is simple and meets the company's information needs, existing accounting data, organisation and management

Step 3: Work out a compensation scheme that fits into the company's business and culture. The incentive plan has to marry the EVA design with traditional concerns of shareholders and directors

Step 4: Train all employees on the basics of EVA and how it affects shareholder value

Step 5: Demonstrate the difference between EVA-led decisions vis-à-vis conventional methods through computer simulation exercises

Then again, if you make investments in R&D, you can't just write it off in one year. That way, a CEO seeking to maximise EVA will just avoid spending on R&D during his watch since this will push up his costs. To avoid this, the EVA-ngelists make adjustments by treating spending on R&D or training as capital expenditure which should be amortised over the anticipated period of its useful life.

And that's just for starters, when you are trying to calculate EVA for the whole company. But try cascading EVA targets to divisions, business units and individuals, and you could have a nightmare on your hands. Says S Venkatesh, associate professor, finance and control, at the Indian Institute of Management, Bangalore: "A typical EVA implementation adds a large amount to confusion in terms of accounting adjustments, the definition of business units for which EVA would be measured, the bonus plan, the bonus bank, etc.".

EVA SCORECARD - What'S HOT, WHAT'S NOT

EVA positives

* No ceiling on the amount managers can take home as incentive pay

* Managers think like, act like and are paid like owners.

* Targets are set over a time horizon that is more than one year - usually three to five years - forcing a long-term view into managerial decision-making

* Cuts capital cost and inculcates financial discipline among employees

* Increasing EVA directly benefits the shareholder and has been found to have a positive influence on a company's stock price

EVA negatives

* Involves lots of complexity. Globally, Stern Stewart is said, in some cases, to make as many as 165 adjustments to work out the weighted average capital cost of companies

* Works better at the individual level than team level, unless goals are appropriately structured.

* May make companies risk-averse. New investments that look risky or difficult to quantify in terms of expected payback may never be made using EVA.

However, EVA has its ecstatic admirers as well. Explains Nadir Godrej, managing director of Godrej Consumer Products: "EVA is the only financial measure that captures business performance with one measure." Hoshedar K Press, executive director and president of the company, wholeheartedly agrees. According to him, EVA may be difficult to work out, but once this is done, it removes all ambiguities from the decision-making process. It can be understood and applied by all ­ from the CEO down to the sales manager to the salesman. It is transparent and benefits both employee and shareholder at the same time.

EVA Vs ESOPS

More recently, EVA has been getting a second look because of the bear phase in stockmarkets. With share prices tanking after the dotcom bust, most ESOPs are under water - and are likely to remain there. If one were to leave out the ESOPs doled out before the 1999-00 tech stock boom, they have had very few takers. For example, Infosys issued ADS-linked ESOPs in 1998 representing 16 lakh shares. At the end of the year 2002, only 2.88 per cent, or 46,100 shares valued at Rs 6.49 crore, were converted. The company's 1999 ESOP scheme fared even more poorly. Of the 66 lakh shares proposed under this plan, only 1,230 shares valued at Rs 49 lakh were taken up for conversion in two years.

Satyam Computer earmarked 130 lakh shares under its associate stock option plan (ASOP) 1999. Till March 2002, not a single option was converted into shares. There are no takers for NIIT's ESOPs priced at around Rs 1,600. Of the proposed issue of 38.65 lakh shares, over six lakh shares are vested but none of these have been exercised. Wipro's ESOPs, too, have met with a similar fate.

"EVA NOT COMPLETELY OBJECTIVE"

Indian Management queried S Venkatesh, associate professor, finance and control, IIM, Bangalore, by e-mail on the pros and cons of EVA. Here's what he had to stay:

On the EVA experience so far.

Some companies have adopted EVA with the help of consultants. Others have attempted to implement EVA with in-house expertise. Consultants typically advocate linking EVA to compensation. Some companies go all the way linking the entire variable pay to EVA achievement. Others are more cautious, especially keeping room for some subjective evaluation. Of the companies that attempt EVA implementation with in-house expertise, almost none to my knowledge link EVA to compensation.

On EVA Vs ESOPs as employee incentive tools.

One of the things I highlight in my programmes and courses which deal with EVA is that EVA is not as completely objective as it is shown to be. There are several areas of subjectivity in both target setting and in EVA implementation. Consultants promoting EVA have been very persuasive in leading companies to believe that EVA will remove all necessity for management judgement in performance evaluation and reward mechanisms. There can be no such system.

In sum, a comparison of EVA and ESOPs on a scale of objectivity is a non-issue. Either basis for evaluation and reward is as objective as the management allows it to be. The impact of market volatility on the value of ESOPs does not make it any less objective. Managers simply buy in into the risk that they know upfront.

On whether EVA and ESOPs are mutually exclusive.

Certainly (having both) it would add to the confusion. A typical EVA implementation adds a large amount to confusion in terms of accounting adjustments, definition of business units for which EVA would be measured, the bonus plan, the bonus bank, etc. Adding ESOPs to this pot pourri would complicate matters further.

Essentially, the comparison (between EVA and ESOPs) is in terms of their relative effectiveness in inducing the desired managerial behaviour. In small start-ups, employees would be more keen to be rewarded by ESOPs. In large and diversified organisations I suspect EVA would be preferred by employees.

On the key to making EVA successful.

For successful implementation of EVA, top management commitment, patience and perseverance to see through a complex implementation process is important. TCS is going through this. Failure of implementation is hard to define. Some large software companies publish EVA in their annual reports. They do not allow EVA to influence any decisions internally. For such companies there is no question of any failure.

To be sure, this situation could reverse in a bull market. Which could be one reason why Mahalingam feels that TCS may offer stock options to its employees once the company completes it IPO and gets itself listed. While Press of Godrej feels that ESOPs and EVA need not co-exist since the latter anyway aligns employee interests with that of shareholders, others feel that the complexities of EVA are worth avoiding.

Says R Shekar, senior vice-president and head, business excellence and HR, Polaris Software: "ESOP is easier for the employees to comprehend, the best hedge against inflation and discounts the risk continuously. Our employees prefer ESOPs, hence it is a better reward structure." Adds Venkatesh of IIM, Bangalore: "The impact of market volatility on the value of ESOPs does not make it any less objective. Managers simply buy into the risk that they know upfront."

Gandhok says that EVA is more than just a compensation system and it works best when it is accepted from the top down to the lowest possible levels. "The real benefit from EVA comes from making it a way of life inside the company. For, you are delegating accountability within the company to achieve EVA outcomes as opposed to EPS, PBT or other sorts of financial outcome. If you seek to maximise EVA over the long run, you will by definition maximise all other things, whereas if you try to maximise EPS, EVA could be going drastically wrong."

As a clincher, Gandhok points out that Enron became EVA-negative three years before it went belly-up. If investors and managers were watching EVA instead of EPS, the story could have had a different ending. In Gandhok's view, obviously, a happy financial outcome is possible when companies court EVA. Like Godrej and TCS, EVA has a growing band of admirers. The numbers, however, aren't enough to fill a football stadium.

(With contributions from B G Shirsat, Sanjay Pillai, Singa Rao and P V Vasanta Kumar)

This article appeared in the Indian Management magazine issue of July 2002.