February 7, 2019
Defining “EVA”
– Liz Dunshee
About a year ago, Broc blogged about ISS’s acquisition of EVA Dimensions – and how it would likely impact the pay-for-performance analysis. Sure enough, in the 2019 updates to its voting policies, ISS said that it would start showing EVA measurements in its research reports and would consider adding them to its quantitative pay-for-performance screens in 2020. This Sullivan & Cromwell memo says that ISS essentially defines EVA as net operating profit after tax, less the cost of providing an acceptable return to capital providers.
We don’t know yet whether investors will develop a preference for EVA-based plans. But if this article is correct in asserting that a focus on economic profit improves long-term results, it stands to reason that having the ISS data point will move everyone in that direction. The article notes that some companies are already starting to incorporate these measures into plans – but customization might be necessary. Here’s an excerpt:
Maximized independently, traditional performance measures – e.g. revenue growth, margins, asset efficiency, and rates of return – can actually destroy value when taken to extremes. Luckily, all of those metrics are captured in economic profit measures such as EVA, where economic profit tells you whether the traditional measures of performance are optimally balanced in a way that maximizes value.
For example, a large capacity investment might drive up asset intensity, driving down rates of return. And the incremental sales growth from increased volumes may come at a lower price and, therefore, lower margins. But the growth from a large capacity expansion can be significant and offset the impact of some of the other measures.
An economic profit measure is the ideal tool to decide if growth is worth it or not. You may still convey it to investors using traditional measures and using statements like, “although margins and returns will come down slightly, the significant new growth potential is so valuable that we expect this investment to drive our share price higher over time.”