Economic Value Added or EVA is fast gaining popularity in financial circles as a means of judging the real state of health of corporates. Equally, it is being seen as a useful yardstick by which the likely return on capital investments can accurately be measured. As such, it could be used in IT appraisal. One […]
Economic Value Added or EVA is fast gaining popularity in financial circles as a means of judging the real state of health of corporates. Equally, it is being seen as a useful yardstick by which the likely return on capital investments can accurately be measured. As such, it could be used in IT appraisal. One of the trendiest of financial yardsticks in accountancy circles at the moment for making decisions about a corporate’s operations, its capital investments and its capital structure is Economic Value Added or EVA. Advocates include large companies such as Coca-Cola, Quaker Oats, SmithKline Beecham and AT&T, to name but a few. Touted as a means of encouraging management to focus on the creation of long-term value, EVA is said to be as capable at pinpointing those operating units within an organisation which may consistently earn less than their cost of capital, as it is in helping identify just when to invest money in promising new projects. As such, it could be of significant relevance for executives charged with the management of computing operations and IT investments.
An outline of EVA analysis
The basic idea behind EVA is to find the most appropriate determination of a corporate’s cost of capital, and then to measure the way that capital is actually employed within each project or business unit (or operating division or across the entire company, for that matter) to determine the operating return earned by that investment. In simple terms, EVA represents after-tax net operating profits, minus a charge for the capital absorbed in producing that profit. To illustrate, a business with a 10% cost of capital that earns a 20% return on $100 million of net operating assets could be said to have an EVA of $10 million. The messages EVA sends out to operating heads are all about how to create value. It provokes people into looking for ways of improving business efficiency by making operational changes that would enhance the return derived from assets already tied up in the business. Companies that are adopting EVA appear to be using it as a basis for decision-making at all levels. Indeed, Yankee Group proposes EVA as gauge to measure the cost-effectiveness of technology investments.According to a research document published by Yankee, EVA can be applied equally well at both the project level and the corporate level to measure the value generated by all sorts of investments – whether or not these investments are IT based. ‘CIOs need EVA-based arguments to fully articulate both the ongoing returns and the strategic potential of IT – to vault management information systems from the cellar to the top of hierarchies’ the market researchers say, making the point that the use of EVA could help CIOs be identified as a valued partner of an organization’s management. The Yankee proposal is that EVA could well qualify as the missing metric in the corporate technology appraisal exercise. Its view is that the focus should be, as in any capital investment, on the value added by IT. An investment is deemed worthwhile only when the EVA calculation exceeds its cost of capital. In an interview last February, Bennett Stewart, one of the originators of the technique, illustrated just how a financial measure can change behaviour in a way that increases a company’s financial value. At one time, he recounts, Coca Cola would ship its concentrate to bottlers in stainless steel containers. These containers would sit on the company’s balance sheet as an inventory item.
From the perspective of income generation, this appears to have little in the way of a charge, and so it is attractive for income-oriented companies. But from another view, for share-holders the capital side of the stainless steel containers is costly because it must be financed. Under EVA, that investment on the balance sheet is converted to a charge on the income statement. Operating people at Coca Cola discovered that if they were to substitute cardboard containers for stainless steel containers, then even though those cardboard containers were consumed more quickly in the business, they represented a more immediate charge to the earnings because they were eliminated from the balance sheet. The EVA rating of the drinks corporation actually increased dramatically – purely as a result of making such a minor change. The challenge about EVA, says Stewart, is to integrate a concern for creating value into the very fabric of an organisation’s financial measurement and management processes. After Coca Cola adopted EVA, the company found people far down the organisation altering their behaviour and changing their decisions.
Applying EVA to it
Pioneered by New York-based financiers of Stern Stewart & Co, proponents of EVA see it as a valuable new way of measuring just how well – or not – a company is doing. Used in this way, EVA involves the relatively quick and easy process of checking earnings to see if the business would have made more money simply by selling off everything and investing the cash. There is no need for any concern when incomes beat the EVA reading, but if returns fall below the measure the signs are that the business is in need of improvement in some way, or that some of its assets could well be put to better use elsewhere in the enterprise. Many organizations are now starting to see how EVA could be used to evaluate the performance of business managers and workgroups, and some of the financial software vendors – such as JDEdwards – have built application support for EVA into their latest releases, in the belief that the metric has fewer loopholes than many of the more tried-and-tested accounting methods since it takes into account not just incomes, but the cost of capital as well. But as a nifty economic indicator, EVA goes further than its use as some general corporate health check. The leasing giant of Comdisco sees EVA as a useful tool for evaluating lease versus purchase decisions. While analysis carried out by Paul Strassmann, the veteran ex-IT budget master of the US Department of Defense, suggests that EVA analysis can be used as a pointer to identify those outfits that have most reason to outsource their IT. According to Strassmann, in many cases, it is not strategy that is driving outsourcing, at all. Statistics show the real reason companies outsource is simple: they are in financial trouble. His studies have shown that the occurrence of outsourcing among US corporates was not a random phenomenon, but had a pattern that could be traced using EVA. For each corporation that outsourced most of its IT budget Strassmann listed EVA values for one, two and three years prior to the point they awarding their major outsourcing contract. The outcome – is that those corporations which outsourced heavily were economic losers heading into the outsourcing act. They were shedding IT along with other corporate functions because they were in financial trouble. According to Steven Grundon, executive VP at Comdisco Electronics, EVA also has a role to play in leasing decisions. Typically, lease and purchase comparisons are made using calculations based around discounted cash flow techniques and the use of market interest rates. As such, decisions are very sensitive to the interest rate value adopted in the calculation – and fluctuations in rates subsequently. ‘An EVA interest rate is more appropriate’ he says, ‘as it is based on a cost of capital that is a weighted average. It represents a blend of an organisation’s debt and equity’.
The magic formula is attractively simple: EVA = Operating Profits – Cost of Capital Employed, or put another way, EVA = (Rate of Return – Cost of Capital) x Total Capital where, Rate of Return = Net Operating Profits after Taxes/Total Capital
Looking for the value in EVA
To pump up the EVA coefficient, a business has to focus on one of three factors:
* Operating margins: Increase operating profits without tying up more capital.
* Profitable revenue: Invest money in new projects that earn more than the cost of capital.
* Capital efficiency: Divert or liquidate capital from business activities that do not provide adequate returns.
So EVA can be increased if an emphasis is placed on IT projects that promise high margins – often these will have evolved from simple labor-intensive data-gathering applications to database products and decision-support modelling. The Yankee line is that, on the whole, IT managers have yet to become strategic planners for their organizations, primarily because they lack the right economic framework to demonstrate both ongoing returns and the strategic potential of such computing projects. According to Yankee analyst, Gopi Bala, there is evidence of a huge disconnect between IT appraisal techniques like internal rate of return or return on investment and the business value that may be inherent in a proposed project. By adapting methods like EVA, it should be possible to better reflect the value being created through the provision by IT of more accurate, more timely and more commercially-sensitive information. Look no further than the huge level of interest in data warehousing. These may be high-cost, high-risk projects, but they are being given the go-ahead because they return high-value in the form of highly exploitable business information.The value of information to the corporation over the cost to produce it, is realized, Yankee says, when information is leveraged efficiently by the business (for example, in finding a new revenue stream, by increasing customer retention or by improving time-to-market). As a primary parameter, investment decisions should be based on an IT project’s ability to affect revenue-related business volumes. Sometimes though, its influence on liquidity may be a better target. Here, an IT project would be viewed as favorable if it can affect the timing of cash flows. As a means of analysis, EVA techniques could allow technology appraisals to be fully articulated – both in terms of ongoing returns and the strategic potential of IT. In its report on EVA and IT: Making the Case for the Missing Metric (for more information on availability call Yankee Group on +44 923-246511), it argues that the traditional cost justification procedures involved the economics of substitution. In simple terms, when moving from one hardware, software or business process to another, IT staffs relied on demonstrating the differential system, labour, maintenance costs, and so on, to make a case over a three or five-year period for why the change was good for the firm. ‘The metrics used may have very little to do with the organization’s business, and may only be meaningful to the IT crowd’, it contends. In contrast, the economics of contribution, the value to be derived from specific business benefits furnished by IT, forces a longer view. Decisions are directly related to the overall value to the organization – its EVA. So an investment is worthwhile if its EVA exceeds its cost of capital.
Lease versus purchase analysis
There are those, however, that will argue that EVA’s appeal is limited since it is based principally on historical data and so its effectiveness in forward-looking assessments of whether to embark on new IT projects or take on a new lease has to be questioned. Not surprisingly, ardent supporters of the technique and the likes of Bennett Stewart contend it is useful in both directions. Looking backwards it is valuable as a performance measure, while looking forward it helps in planning strategies and actions. Its application is valid at the strategic level, as it is even in thinking about day-to-day tradeoffs in business operations.’The reason that EVA is so powerful in that regard’ Stewart explains ‘is that, by definition, the forecast of the EVA when discounted to a present value is equivalent to the financial concept known as Net Present Value or NPV. The NPV is a test which asks whether the future payoff from a new project or new strategy will produce a value that exceeds the amount of capital up-front that must be invested to support the new project.’ The bottom-line to any IT appraisal, in other words, must be about whether an investment will create more value that it ties up in capital.