Institutional Shareholder Services (ISS) announced earlier this year that, in its 2019 proxy research reports, it will be displaying financial ratios derived from a base measure called Economic Value Added (EVA). The EVA ratios will initially be used for informational purposes only, meaning they will not factor in to say-on-pay voting recommendations or evaluations of compensation policies. Nevertheless, boards should understand EVA’s value as a means of assessing management performance, and how ISS intends to use the measure in its reports.
EVA is an estimate of a firm’s true economic profit, that is, its after-tax operating profit adjusted to account for the capital used to earn the profit. It is calculated as follows:
EVA = net operating profit after tax – capital charge
= [operating income X (1 – tax rate)] – (weighted average cost of capital X
In the above equation, ‘capital’ is defined as a firm’s total assets less accounts payable, accrued expenses and other sources of interest-free trade funding. If a company’s net operating profit exceeds its cost of capital, it has created value.
According to an analysis published on the Harvard Law School Forum for Corporate Governance and Financial Regulation, proponents of EVA believe that this measure is aligned with value creation for shareholders. By factoring in the cost of capital (i.e. the opportunity cost of having the capital tied up in the company) the measure rewards management only where returns exceed what shareholders could otherwise expect to earn with their funds. Managers are therefore incentivized to create real value through operating efficiencies, portfolio management and investing in profitable growth. On the same note, another benefit of EVA is that managers are not easily able to manipulate results through artificial means, such as taking on more capital to increase gross returns.
Detractors claim that EVA is difficult to measure and communicate to stakeholders. There may be some truth to this. EVA was originally formulated in the 1990s, but failed to reach critical momentum as most companies retained incumbent, better-understood measures such as revenue growth, profit margin or returns. In this regard, ISS’s vote of support for EVA is an important step towards more widespread adoption of the metric. If and when the investment community perceives – across a wide enough data set – that EVA is an accurate measure of a management team’s success, then pressure will increase for compensation to be aligned accordingly.
ISS will use four ratios derived from EVA in their 2019 proxy research reports. They are:
- EVA margin *EVA/sales
- EVA spread *EVA/capital
- EVA momentum (sales) *the Change in EVA/Prior Year Sales
- EVA momentum (capital) *the Change in EVA/Prior Year Capital
Boards and compensation teams that seek to familiarize themselves with these ratios should refer to the detailed discussion in the ISS whitepaper, which is available for download here. In the longer term, compensation teams should continually search for the best means of creating incentives for good management. EVA may well be an important element of achieving this goal in the future, and one that investors may increasingly look towards when determining where to invest or how vote their shares.
The author would like to thank Eric Vice, articling student, for his assistance in preparing this legal update.