Is EVA a good measure of value creation?

We have one more thing to do here, and that thing is let’ s agree for just a minute that EVA is a good measure of value creation. You do not have to agree, but just agree, bear with me for one minute. Let us say EVA is a proper way of thinking about whether a company is creating or destroying value. The next question we would pose is, so what do we need to monitor over time. Are we going to monitor the level of EVA or are we going to monitor the change in, in EVA? In other words, if I am going to tie the compensation of an executive to EVA, should I tie it to the level that is created on EVA on each period, or should I tie it to the change in EVA between one period and the next? Well, in order to ask that, to answer that question, we are going to look at that little table.

And as you can see that table has the two possibilities that we’re considering. We can consider the level of EVA or the change in EVA, and we are going to explore what is good and what is bad about these two possibilities. So let us start with what is bad about the level of EVA. Well, what is bad is, is the following. Let us suppose that you appoint me to the iPhone division of Apple. I do not know anything about how to run that division. I have no idea about, you know, how to manufacture phones or what people that use phones really need. How do you produce them efficiently? How you market them efficiently, and so forth, but we know one thing. That the iPhone division of Apple is, or must be, very, very profitable. So even if you are poor and someone like me that has no idea whatsoever about what to do with this division, if I’m hands off, if I’m not doing anything, then this division is going to create value by itself. So, if we measure the level of EVA of this division, and you compensate me on the basis of the level of EVA, you’ll be paying me a lot of money, even if I do actually between nothing and something wrong. Because if I do nothing, this division pretty much works by itself. And if I do something a little wrong, well, the EVA might come down little bit, but it’ll still be a huge EVA. So if you compensate me on the level of EVA, and you happen to give me a division that makes money hand over fist, then you’re going to be compensating me for doing little or nothing, all right? Now, let us suppose that you appoint me and, you know, we are mentioning Apple a company that has been in trouble lately, Nokia. and, and, now you appoint me to Nokia. And let’s say, for the sake of the argument, and these are hypothetical numbers, let’s say that you appoint me to the cell phone division of Nokia, and I take the division from minus \$1 billion to minus \$1 million. That is, I improve the EVA of the division by \$999 million. Well, the problem is that we still have a minus \$1 million EVA. And if you compensate me on the basis of the level of EVA, I’m still getting no compensation, but I actually did a great job. I took this division from minus \$1 billion to minus \$1 million. Still, if you compensate me on the level, the level is negative and I get no compensation. That is what is called an unequal endowments problem. That is, in the first case, you gave me a really good endowment. In the second case, you really give; you gave me a really bad endowment. In the first case, maybe I did not do a whole lot. Maybe I did nothing. I am still making a lot of money. In the second case, I did a great job. But not great enough to create a positive EVA. Therefore, I am not making any money. Obviously, we do not want that situation. So when we look at what is the negative side, what is the bad side of compensating executives on the level of EVA, we have this unequal endowment problem. Now, let us focus on the change in EVA. What is good about focusing on the change in EVA? Well, sort of the opposite of what we discussed, and that is that if you appoint me to the iPhone division of Apple, and I have done a few wrong decisions and I made a few wrong decisions and those actually decreased the EVA. But still, very highly profitable in terms of EVA, well, because I decreased the EVA a little bit, or because I did not increase the EVA, I’m getting no extra money at all. So I get no bonus simply because I have not improved the EVA of the iPhone division, but I will make a lot of money for improving the EVA of the Nokia division from minus \$1 billion to minus \$1 million. So now we’re dealing with the unequal endowments problem. You gave me a good endowment, I did not make it any better, and therefore I am not making any money. You gave me a bad endowment and I made it a lot better than it was, maybe not good enough but a lot better than it was. So I am making some money out of that. So now we are seeing what is bad with compensating on the levels and what is good on compensating on the on the change. Now, what is bad about compensating for the change? What is the shortcoming, what is the limitation? Well, there is a very clear one, and for that let us stop here for just a second. Let us go back to thinking about levels for just a second. And, and consider a very, very competitive industry. And by very competitive I mean that capital can freely come in and go out. And so, yeah, think about what happens when, in a sector in an industry, you see a lot of companies making a lot of money. Well, you want to participate. You would bring capital. You start new companies. You bring capital into the sector. Guess what happens as more and more and more capital flows in? Well, the return that you get on that capital is going to be going down and down and down and down. So eventually, that inflow of capital is going to stop when you do not adequate returns anymore. What we are saying in the EVA framework would be that, in a very competitive industry, sooner or later in the long-term, you would expect the equilibrium EVA to be equal to zero. That is, whenever the return on capital is much higher than the cost of capital, capital is going to come in, the return on capital is going to go down, and this process is going to stop when the spread between when the return on the cost of capital is very close to zero. When a sector is actually destroying a lot of value, well, capital is going to go out. As capital goes out, the return on investment capital is going to go up, and this process is going to end when this EVA is more or less the, the spread between the return and the cost of capital is more or less equal to zero. So what we’re saying is that when a market is very competitive, when a sector is very competitive, what’s going to happen is that sooner or later, we would expect an EVA equal to zero. Now, if you’re going to compensate me on the basis of always creating increasing amounts of EVA, then the competitive market I will not make a whole lot of money, because it will not be possible for me not only to create a positive EVA, let alone a positive and increasing EVA. So the problem with compensating exclusively on the change in EVA is that in very competitive environments it will be very difficult for me the executive to make any money at all, because it will be difficult enough to create a positive EVA. It will be even more difficult to create an increasing amount of EVA over time. And finally, let’s go back to, to the levels, and, and that is now we’re sort of flipping the coins of what we just said. And by this we mean that when we focus on the level of EVA, and that there’s a word that people have been using a lot lately which is a moat. A moat is a competitive advantage that some other companies find difficult to replicate. Warren Buffet actually likes the word moat, and he says, well, you know, the branding of Coca-Cola, that is a moat. That is something that no other company can reproduce, and the reason that this is important for what we are discussing here is that, if you have a mode, then you can actually get away with creating positive EVAs over time. Because more capital can come in, but they not able to reproduce that moat, that competitive advantage that you actually have. So the good thing about compensating in terms of the level is that it is always going to be more sustainable than compensating on increasing amounts of EVA. So as you see now in that in those boxes and surprisingly, there are pros and cons of compensating with the level and compensating with the change. And when you design a proper incentive mechanism, you need to take all these things into account. That is why, and, and this is just a passing comment, but just to round this up, a, a, a little bit. Many times when you see a, a compensation formula, when you see how executives are compensated, within this framework it would not be surprising to finding something finding something like what you’re seeing there, which is basically that, the bonus an executive is going to make depends on both the level of EVA, but also on the change of EVA. You will see that both the level and the change are multiplied by some constant, that some number alpha and, and beta, and ideally, we are saying that beta is larger than alpha. What does that mean? Well, that ideally we would like to compensate more when you keep increasing the EVA, rather than when you always create the same amount of EVA, even if that EVA is always positive. So I want to give you more incentive to create EVA, and that I can do by actually giving more weight to the change rather than to the level of  EVA. And finally you know, we’re saying that sometimes the alpha is equal to zero when the EVA is negative. That sort of goes back to the Nokia example. That is, if you take me to a division that is losing a lot of money, and I do a great job, and I, but I’m still losing quite a bit of money, but I’ve improved the division a lot, well, if you compensate me only on the basis of the change, I am going to participate in the improvement of the company, but we need to set alpha equal to 0. Because if this is a company in a lot of trouble and I actually improve it a lot, but not all the way to a positive EVA, then I am not going to get any compensation. So typically, when you deal with companies that are in a lot of trouble, the alpha is equal to zero. And that basically means that whenever you improve the EVA of the company, even if it remains negative, then you are going to get some compensation. Now, of course, and this is not a topic in which we’re going to be going very deeply, but as a side comment, when you set up a compensation system, the level of EVA should play a role, that changing the EVA should play a role. But at the end of the day, the level of competition in the sector should be one of those variables that you look at in order to set up the compensation scheme problem.

Capital Budgeting TechniquesIs EVA a good measure of value creation? We have one more thing to do here, and that thing is let' s agree for just a minute that EVA is a good measure of value creation. You do not have to agree, but just agree, bear with me for one minute. Let us say EVA...