of the supervisory board at Siemens, which adopted an EVA-based compensation system in 2001, ‘EVA creates a common language for everyone – the simple employee as well as the top manager.’
24 | Management · optimus 1/2003
it recognizes exactly how the capital markets value companies. All investors in the capital markets – bankers, bondholders and shareholders – commit cash to the companies they invest in, with the hope of getting cash back in the future. Thus, the value of any business is a function of capital market expectations regarding the firm’s ability to return cash to the capital markets in the future, discounted at the cost of capital. The more cash the company can generate in the future, based on investor beliefs, the more valuable the company is now. This simple idea suggests that firms should be managed with the aim of maximizing these cash flows. The
Management as a control function: the control room at the European Space Agency (ESA) in Darmstadt, Germany (right); satellite dish (above)
The mathematics of EVA EVA equals after-tax operating profit minus capital costs, with capital costs equal to capital employed multiplied by the weighted average cost of capital (WACC). When operating profit is divided by capital employed, the result is return on capital employed (ROCE). The difference between ROCE and WACC, multiplied by capital employed, equals EVA. EVA = (ROCE – WACC) x Capital Employed Assuming other variables remain constant, EVA increases when ROCE increases. Boosting asset efficiency, cost-cutting initiatives and structuring investments so that they require less capital can all increase ROCE – and thus EVA. Disposing of unprofitable businesses also increases EVA, provided that improvements in the spread between ROCE and WACC more than offset the reduction in capital employed. As long as the ROCE for the investment exceeds the WACC, investing is profitable and EVA increases.
Page 22–23 Photo left: ESA, photo right: Marcel Grubenmann
EVA is a measure of profit. Not the accounting profit we are accustomed to seeing in a corporate profit and loss statement, but profit as economists define it. Both are measured net of operating expenses; they differ only in the treatment of capital costs. While accountants (and, hence, income statements) recognize only explicit, out-ofpocket costs (such as the interest paid to bankers) EVA recognizes all capital costs, including the opportunity cost of shareholder funds. It is based on a century-old idea generated by the English economist Alfred Marshall: for investors to earn true economic profits, sales must be sufficient to cover all costs, including operating expenses (such as labor and materials) and capital charges. Such economic profits are the basis of value creation. It is easy to prove mathematically that the worth of any business must equal its capital employed (the sum of fixed assets, cash and working capital) plus the present (or discounted) value of future EVA. In other words, value determined in this way is mathematically equivalent to the idea that the worth of the firm equals the discounted value of future cash flows. The upshot: as capital market expectations of corporate EVA increase, so do share prices. Companies can thus use EVA targets to motivate managers to deliver the financial results that capital markets want. EVA is defined in terms of a mathematical formula (see sidebar). The secret of its success, however, is quite straightforward. EVA works because