VI. Strategic Decisions - The Role of Compensation
1. What is it about human nature that makes it possible for compensation based on performance may lead to value creation?
2. What characteristics of a compensation system are important to increase the probability of value creation?
3. What other market forces exists that may reduce the agency problem?
4. What are some traditional performance measures used to base compensation?
5. What are the weakness of using these traditional performance measures to determine compensation?
6. Is the company's stock price movement a good performance measure to determine compensation?
7. Is the use of performance based compensation widespread?
8. What performance measures are used today? What changes have recently been taking place
9. What are the pros and cons of using stock options as a means of performance based compensation?
10. Should employee stock options costs be expensed in the income statement?
Economic Value Added (EVA)
EVA equals after-tax operating profit minus the total cost of capital.
EVA = NOPAT - $ Cost of Capital
EVA = NOPAT - WACC x I
If we multiply the RHS by I/I then:
EVA = (NOPAT - WACC x I) x I/I
EVA = (NOPAT/I - WACC) x I
or
EVA = (ROIC - WACC) X I
where:
o NOPAT is net operating profit after taxes;
o ROIC is the return on invested capital
o (NOPAT/Invested Capital);
o WACC is the weighted average cost of capital;
o I is the total amount of capital invested in the operations ofthe firm that requires an explicit return.
Two Definitions of Invested Capital:
Asset Side: Invested Capital = Operating Assets - Non-Interest Bearing Liabilities
Liab. & Equity Side: Inv. Capital = Int. Bearing Liab. + Equity - Non-Operating Assets
Ways to Increase EVA
EVA = (ROIC - WACC) * capital invested
Three ways to increase value:
1. Increase the rate of return on existing investments (increasing operating profits without tying up additional capital);
2. Additional capital is invested in projects where the rate of return is more than the cost of obtaining new capital; and
3. Capital is liquidated from operations that have earned a rate of return less than their cost of capital.
4. Reduce WACC
Comparing Performance Measures
Just like SVA, EVA dominates traditional performance measures because they are affected by both the income statement outcomes and balance sheets effects and because they consider the cost of equity capital. But how does SVA (DCF analysis) compare with EVA as a performance measure?
1. For Capital Budgeting
o EVA and SVA (NPV or DCF analysis) should lead to similar results.
2. For Shareholder Value Analysis
o EVA and DCF models should lead to similar results.
3. For Compensation
o Is EVA better than stock based compensation methods?
PROS AND CONS OF EVA
Recall:
EVA = After-tax net operating profit - $ cost of capital required to produce that profit.
EVA = NOPAT – (WACC x $ Investment)
Some general observations:
EVA is a flow concept:
o it is a $ amount per year or quarter. NPV is a stock concept, i.e. it is the aggregate $ amount by which a corporation is richer by taking a project at a point in time.
o The present value of all future EVA is equal to NPV.
See Example
o Alternatively, EVA is an ‘amortized’ NPV. The amount amortized per period depends typically on the scale of operations in that period – e.g. the amount of sales, cost of producing that level of sales, and the taxes in that period.
Pros of EVA:
o EVA accounts for the cost of capital (as does NPV/SVA) and reflects the risk of the project. Most accounting measures of performance fail to properly account for project risk.
o EVA reflects the scale of the project (as does NPV/SVA). Rates of return measures such as IRR, ROA, EPS, etc. do not.
o EVA is correlated more closely to shareholder value (e.g. Market-to-book ratios) than accounting performance measures like EPS, ROE etc.
o Incentive compensation based on EVA is superior to those based on accounting measures.
o EVA permits incentive compensation to be implemented at deeper levels of organization, such as at the level of divisional and even sub-divisional managers, and not just at the top (strategic) levels like CEOs, CFOs.
Cons of EVA:
EVA can be short sighted:
For example, cash flows of pharmaceutical, high-tech, Internet companies are typically negative for a considerable period of time from the onset. EVA is biased toward projects that have shorter payback periods.
o EVA can be manipulated:
Measuring value added per period can lead to managers maximizing EVA in the current and near periods at the expense of future, more distant EVA. For example, Diet Coke division can simply increase its EVA by slashing advertising expense, and ‘free ride’ on advertising by Classic Coke, but may hurt the overall brand name and hence EVA in the distant periods.
o EVA is complicated:
EVA requires a myriad of accounting adjustments to measure it properly. For example, and most notably, adjustments need to be made to the definition of dollar investment. Is this historical? book value? replacement cost? Also, investment needs to reflect capitalized value of R&D, advertising, and other activities that benefit intangible values like brand name and goodwill. NPV does not need to make such distinctions. NPV simply needs the dollar cash inflows and outflows and the timing of those cash flows.
o EVA fails to properly account for synergies between divisions and products:
Take a recent example of IBM as reported in the WSJ. IBM’s PC division is making losses (negative current and foreseeable EVAs), yet the managers are reluctant to divest or close the division entirely. The stated reason was that they wish to prevent other companies from making inroads in their more profitable operations – e.g. services and software division – by gaining a foothold and an entry by selling low-margin, high volume products like PCs. How does EVA account for such synergies? Cost, or activity based accounting adjustments are required by EVA and these do a poor job of accounting for synergies.
Addressing EVA’s shortcomings:
EVA attempts to address these issues by:
o adjusting the inputs to EVA measurement
o e.g. capitalizing R&D expense, adjusting for market value of PPE
o by structuring annual compensation on multi-year EVA instead of a single year’s EVA
o e.g. ‘banking’ EVA into a pool that can only be withdrawn slowly over time
However, adjustments to address EVA shortcomings make it increasingly like stock-based compensation
Issues in Implementing EVA:
For successful implementation of EVA, managers’ compensation should be tied to EVA immediately.
Decision making authority must be decentralized for implementing EVA successfully. Managers whose EVAs are computed and evaluated must be empowered to make decisions in not only the way they produce products and services, but also in their choice and source of investment and capital.
EVA vs. Traditional Performance Measures:
No contest. EVA is better.
EVA vs. NPV and Shareholder Value Analysis (SVA):
EVA, when tied to incentive compensation and decentralization, can be a tool to reward shareholder value creation ex-ante as well as ex-post. EVA is useful tool looking forward as well as backward. It is argued that shareholder value is only a forward looking tool, and cannot be used to reward/punish past performance of managers.
Bottom Line on EVA:
Kinds of firms EVA is better suited:
Kinds of firms EVA is not well suited:
EVA allows managers at lower rungs of an organization to make the connection between their efficiency and shareholder value. It is argued that lower level or divisional managers fail to see the connection between their effort and the stock price.
Several high profile firms have implemented EVA and popular press notes the concurrent increase in their stock price. At the same time, some of the top shareholder wealth creators in recent history are non-EVA firms like Microsoft, Intel, and most if not all Internet firms, which rely on stock and option-based compensation.
It is unclear whether the advantages of EVA – namely, incentive alignment at lower levels, and ex-post compensation, outweigh the disadvantages of EVA – namely, short-term focus, gaming by managers, complexity, and poor accounting for synergies.
It is unclear whether EVA-based compensation is always superior to more conventional compensation schemes based on stock and options.
EVA shares one other criticism of NPV/SVA, namely, the need to estimate the cost of capital.
Certain kinds of firms – capital intensive firms in mature industries, seem to be more amenable to EVA implementation than others.
It is unclear whether EVA based compensation and incentives would lead to optimal decisions in firms and industries that have long product cycles, and long-term payoffs, substantial investments in R&D and brand name capital, and substantial synergies between products and divisions. Examples of such firms are pharmaceutical firms and firms in high-tech industries such as software and Internet.